The accounting equation is an essential component of the financial statement and an elementary rule of accounting. The balance sheet presents the information needed by investors to evaluate the risk of capital appreciation and the ability of a company to repay its debts. The accounting equation can be used as an example of a mathematically rigorous approach to accounting. It depicts a process that yields the expected results based on the information recorded in the financial records. The accounting equation can be written as follows:
First, a company’s net worth is defined using the balance sheet and the accounting equation. Net worth is equal to the difference between total assets and total liabilities less retained net worth. The accounting equation then determines the net worth estimate by subtracting the market value of the company’s common equity from the balance sheet value. The net worth estimate is the excess of assets over liabilities.
Second, the net worth estimates are compared to the value of assets using a simple regression analysis. This test compares the value of total liabilities against the value of total assets. Assumptions are made that the operating balance, or gross profit, will be equal to the largest asset in the current market and will equal the largest liability, the stock price, times the largest current credit outstanding. To get the result in the format described above, the slope of the line connecting the current date with the date of last exercise is graphed as a function of the number of years during which the stock has been traded.
The third step of the formula is input into the accounting program. The variables to be entered are: net worth, current stock value, dividend yield, term of the financial statements, and credit outstanding. To allow for the effects of dividends, the gross profit and net income lines should be modified so that the income amount is equal to the gross profit instead of to net income. For financial statements with variable years, substitute the years so that the accounting equation will evaluate a constant year-over-year change in equity. For CCC assets, enter the equity on the appropriate line. The accounting equation now provides the results needed for the reconciliation of financial statement items.
Once all accounting equations have been calculated, they should be compared to the net book value of all existing assets. The accounting equation must be modified so that all assets owned by the company are replaced by the net book value of all existing assets. If there are significant deviations from the target values for some assets, investors may cause the company to fail. The aim of a successful operation is to keep the shareholders within the target range.
The final step is to determine the net worth, or equity, of an enterprise. The accountants use a balance sheet based on the initial public offering and existing tangible assets. However, in more complex operations, they can also use a combination of different types of accounts to determine equity. A good accountant always performs these functions in detail.