Accounting equation


Accounting equation
Accountancy
Key concepts
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Statement of financial position · Statement of cash flows · Statement of changes in equity · Statement of comprehensive income · Notes · MD&A · XBRL
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The 'basic accounting equation' is the foundation for the double-entry bookkeeping system. For each transaction, the total debits equal the total credits.

Assets = Liabilities + Capital[1]

In a corporation, capital represents the stockholders' equity.

Contents

In practice

For example: A student buys a computer for $945. This student borrowed $500 from his best friend and spent another $445 earned from his part-time job. Now his assets are worth $945, liabilities are $500, and equity $445.

The formula can be rewritten:

AssetsLiabilities = (Shareholders' or Owners' Equity or Capital)[1]

Now it shows owners' interest is equal to property (assets) minus debts (liabilities). Since in a company owners are shareholders, owner's interest is called shareholders' equity. Every accounting transaction affects at least one element of the equation, but always balances. Simplest transactions also include:[2]

Transaction
Number
Assets Liabilities Shareholder's
Equity
Explanation
1 + 6,000 + 6,000 Issuing stocks for cash or other assets
2 + 10,000 + 10,000 Buying assets by borrowing money (taking a loan from a bank or simply buying on credit)
3 900 900 Selling assets for cash to pay off liabilities: both assets and liabilities are reduced
4 + 1,000 + 400 + 600 Buying assets by paying cash by shareholder's money (600) and by borrowing money (400)
5 + 700 + 700 Earning revenues
6 200 200 Paying expenses (e.g. rent or professional fees) or dividends
7 + 100 100 Recording expenses, but not paying them at the moment
8 500 500 Paying a debt that you owe
9 0 0 0 Receiving cash for sale of an asset: one asset is exchanged for another; no change in assets or liabilities

These are some simple examples, but even the most complicated transactions can be recorded in a similar way. This equation is behind debits, credits, and journal entries.

This equation is part of the transaction analysis model,[3] for which we also write

Owners equity = Contributed Capital + Retained Earnings
Retained Earnings = Net Income − Dividends

and

Net Income = Income − Expenses

The equation resulting from making these substitutions in the accounting equation may be referred to as the expanded accounting equation, because it yields the breakdown of the equity component of the equation.[4]

Expanded Accounting Equation

 \begin{align}
 Assets & = Liabilities + Stockholders' Equity 

       & = Liabilities + Common Stock + Retained Earnings - Dividends + Revenues - Expenses \\
\end{align}

Balance sheet

An elaborate form of this equation is presented in a balance sheet which lists all assets, liabilities, and equity, as well as totals to ensure that it balances.

References

  1. ^ a b Meigs and Meigs. Financial Accounting, Fourth Edition. McGraw-Hill, 1983. pp.19-20.
  2. ^ Accounting equation explanation with examples, accountingcoach.com.
  3. ^ Libby, Libby, and Short. Financial Accounting, Third Edition. McGraw-Hill, 2001. p.120
  4. ^ Wild.Financial Accounting, Third Edition.McGraw-Hill, 2005. p.13

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