Question

How Accounting Equation Effects Financial Statement Components ( in detail please)

Answer 1

The general accounting equation can be written as:

Assets = Liabilities + Owner's Equity - We can think of this as a soul of all the accounting reports whether it is balance sheet or income statement or cash flow statement.

Let's first understand each component of the above equation;

Assets: Assets in simple words is what the business owns - The resources that the business has through which it operates.

Liabilities: Liabilities are the amounts that the business owes to outside parties - lenders, creditors other payables

Owner's Equity: It is what the business owner has contributed into the business - it is in the form of capital contribution or retained earnings from past years (profits reinvested into the business)

Another, important thing to note is that this relationship of equality is maintained forever in the business. There is no situation which can result in an imbalance of the accounting equation.

Now, let's understand how it affects the financial statements:

Balance Sheet - presents the business position at the year end - which in itself covers the complete accounting equation. Accounting equation covers the transactions occurred during the whole period, whereas the balance sheet shows the summary and end result of all the transactions. Therefore, we can say that the balance sheet is completely based on the accounting equation.

Income Statement - There is no direct relation between the accounting equation and Income statement which record revenue and expenditure during a given period. However, it indirectly leads to net income of the business which forms part of owners' equity. Thus, if there's any change in the owners' equity portion of the accounting equation due to profit or net income, Income statement should be referred to justify the change.

In a similar manner, Cash Flows Statement also depend on the cash portion of the assets side and the rest of the equation to identify the application of cash.