In analyzing the compositions of our sample balance sheet, further explanations are provided about the total liabilities.
Understand that in the event that the business is liquidated, $ 4,000 of the cash included as assets will be used to payoff the liabilities. This leaves the owner a net asset value of only $11,000 available for liquidation.
Again, the fundamental accounting equation can be transposed to determine how much is the present capital or equity of the owner as far as the business is concerned, via this equation:
- Capital ($11,000) = Assets ($15,000) - Liabilities ($4,000)
The basic accounting equation above readily shows that the current value of the owner’s equity is $11,000. Reference will then be made as to how much is the original investment, by referring to the account captioned as "Capital, Beginning" of $10,000. The $1,000 increase represents the net income for the whole year, which could be considered as slow .It appears that the business earns an average of $83.33 only, as monthly income (S 1,000 / 12 months).
Consider the total liabilities of the business and the annual income that was earned --- obviously, the amount will not even compensate for the amount of interest being paid for the loan. Thus, it could be largely surmised that the business income is being burdened by the interest paid on the loan.
As we go deeper into our analysis of the fundamental accounting equation, we will also be looking into the sub-components of the total assets. You will note that the asset total includes an accounts receivable balance of $2,000. This is another negative indication in our sample balance sheet, since it could be perceived that the $1,000 net income is still subject to collection.
As a summary of this case study, an in-depth analysis of the basic accounting equation will disclose that the owner encounters difficulty in collecting actual money earned for services already rendered. As a result, the owner has to resort to borrowing instead of relying on income generated by the business. If the $ 2,000 receivable was collected during the year in operation, that and the money used for paying the interest on the loan, could have lessened the need for outsourcing business funds.
The above analysis and the different transpositions presented, provide the answers to the query "What is the fundamental accounting equation?'
It is a summarized form of presenting the true picture of the business by showing the relation of its assets to its liabilities and capital. It is important, therefore, that the balance sheet components are kept balanced, since they represent the basic accounting equation.