Posted: February 1st, 2023

Importance of Accounting Equation Essay

Classification in Balance Sheet
Both sections of the balance sheet are classified on many grounds. One of the common basis of classification is liquidity. More liquid accounts are placed before the less liquid ones. For example, Cash in hand, Cash at bank and Trade Receivables are placed before Plant & Machinery, Equipment, and so on. Sometimes, assets and liabilities are categorized on the ‘current and non-current’ bases. Some of the examples are listed below.

Current Assets: It generally includes: Cash and Equivalents, Accounts Receivable, Inventory, Prepaid Expenses, and Marketable Securities.

Non-current Assets: It includes: Plant, Property, and Equipment (PP&E), Land, Building, Furnishings, Vehicles, and Intangible Assets

Current Liabilities: It includes: Accounts Payable, Current Debt/Notes Payable, Current Portion of Long-Term Debt, and Interest Payable.

Non-current Liabilities: It includes: Bonds Payable, Long-Term Debt, Deferred Tax Liabilities, Long-Term loans Payable, and Long-Term Bonds Payable.

It can be easily seen in the accounting equation that to acquire current assets, mostly current liabilities are created and to acquire the non-current assets, non-current liabilities are created.

Importance of Accounting Equation and Balance Sheet
A balance sheet is one of the most essential financial statements of a company. It represents the final accounts of a company and shows the financial positioning of the company. A company needs a balance sheet in conjunction with other financial statements, such as the shareholder’s statement, income statements, and cash flow statements to get a complete picture of its wealth.

To create a correct and reliable balance sheet, it is necessary that the accounting equations for all transactions have been correctly framed. Accounting equations act as a foundation for the balance sheet.

Balance sheet provides a picture of liquidity to an organization by comparing the current assets of the company with its current liabilities for making future decisions. The balances of the current assets and liabilities can be verified with the balances in the accounting equation.

It interprets the financial risks of a company by displaying the amount of leverage it has. This helps the company to take the necessary precautionary actions in advance to reduce the impact of risk on the organization.

With the help of the income statement (Profit & Loss a/c), a balance sheet shows the status of efficient performance and management of the company. It enables firms to make further investments in big projects.

A balance sheet also evaluates the credibility of a company in the market. It shows how capable a company is to generate financial returns in a year and accounting equations play a vital role in preparing a reliable balance sheet.