The Double-Entry System

Simon Idika Written by Simon Idika · 1 min read >

The accounting equation is a simple and direct expression of a balance sheet’s complex, expanded, and multi-item display.

Essentially, the representation equates all the uses of capital (assets) to all capital sources, were debt capital leads to liabilities and equity capital leads to shareholders’ equity.

Every business transaction will be reflected in at least two accounts for a company that keeps accurate accounts.

For example, if a company obtains a loan from a bank, the borrowed funds will be reflected on the balance sheet as an increase in the company’s assets as well as an increase in the company’s loan liability. When a company buys raw materials and pays in cash, it increases the company’s inventory (an asset) while decreasing cash capital (another asset). Because every transaction carried out by a company affects two or more accounts, the accounting system is known as double-entry accounting.

Assets, liabilities, and shareholders’ equity are the three key components of the accounting equation.

The formula is easy to remember: The total assets of a company are equal to its liabilities plus its shareholders’ equity. The double-entry bookkeeping system, which is widely used around the world, is intended to accurately reflect a company’s total assets.

The double-entry method ensures that the accounting equation is always balanced, which means that the left side value of the equation always equals the right-side value. In other words, the total value of all assets will always equal the total value of all liabilities and shareholders’ equity.

The widespread acceptance of the double-entry accounting system standardizes and secures the accounting and tallying processes. The accounting equation ensures that all entries in the books and records are verified, and that there is a verifiable relationship between each liability (or expense) and its corresponding source; or between each item of income (or asset) and its source.

Despite the fact that the balance sheet always balances, the accounting equation cannot tell investors how well a company is performing. Investors must interpret the numbers to determine whether the company has too many or too few liabilities, insufficient or excessive assets, or whether its financing is adequate to ensure long-term growth.

So why is this Important?

The accounting equation asserts the relationship between the three balance-sheet components: assets, liabilities, and equity. If everything else is equal, a company’s equity will rise when its assets rise, and vice versa. Adding liabilities reduces equity, while reducing liabilities (for example, by paying off debt) increases equity.

These fundamental concepts are critical to modern accounting methods.

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