The Accounting Equation

Introduction to the Accounting Equation
Expanded Accounting Equation
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Introduction to the Accounting Equation

The Accounting EquationThe 'basic accounting equation' is the foundation for the double-entry bookkeeping system. For each transaction, the total debits equal the total credits. In a corporation, capital represents the stockholders' equity. The fundamental accounting equation, which is also known as the balance sheet equation looks like this:

Assets = Liabilities + Owner's Equity

On the left-hand-side of the Accounting Basics equation are the resources (assets) of the business. Or more correctly, the term assets "represents" the value of the resources of the business. On the other side of the equation are claims of ownership on those assets. Liabilities are the claims of creditors (those "outside" the business). The equity, or owner's equity, is the claim of the owners of the business (those "inside" the business).

This equation is kept in balance after every business transaction. Everything falls under these three elements in a business transaction.

Double Entry is a type of accounting/bookkeeping system that requires every transaction to be recorded in at least two places (accounts) using debits and a credits to represent increases and decreases.

Well this equation is what double entry is all about. We make two entries for every business transaction. These entries represent increases or decreases in property (assets) and/or property rights (liabilities and owner's equity).

In other words the double entry system based on the Accounting Equation allows to track:

(1) What We Got and What Went (Property)
(2) From Whom and To Whom (Property Rights)

Claims To The Assets
Who has a right or claim to the business's property ? Claims to the property (assets) arise from two sources:

  • Creditors of the business (liabilities)
    Those from whom the business borrows from or buys from on credit are called creditors. The creditors have a claim to the property (assets) of the business until they are paid. These creditor claims are called liabilities. Two common types of creditors are a business's suppliers and banker.

  • Owner(s) of the business (owner's equity)
    Yes the owner(s) also has a claim to the property (assets) for property (assets) invested into their business and any increases or decreases resulting from operating the business. We know that revenues and additional owner investments increase owner's equity while expenses and draws decrease owner's equity.

Another way to think about these increases and decreases to equity is to relate it to your personal financial situation. Your earnings (revenue) increase your personal wealth (equity) and your living expenses and draws decrease your personal wealth (equity).

Developing Different Versions Of the Accounting Equation
(1) Property = Assets and
(2) Property Rights (Claims to the Property) = Liabilities + Owner's Equity (Capital),
the simple or abbreviated accounting equation Property = Property Rights expanded or restated now becomes : Assets = Liabilities + Owner's Equity (Capital).

The balance of Owner's Equity is affected by her kids Revenue, Expense, Investment, and Draws.

Businesses normally operate with the objective of making a profit. Profit is determined by using two "Capital's " (Revenue and Expense) and subtracting the expenses from revenue (income). Any profits made by a business go to the owner. Therefore, the effects of revenue (income) and expenses are shown under the Owner's Equity section of the accounting equation. An increase in revenues represents an increase in profit and therefore an increase in Owner's Equity ("Capital"). An increase in expenses represents a decrease in profits and therefore a decrease in Owner's Equity ("Capital").

Using the above information we can present this information in the following equation:

Current Owner's Equity (Capital) = Beginning Owner's Equity (Capital) + Owner's Investments + Revenues - Expenses - Draws

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Expanded Accounting Equation

Fully Expanded Accounting Equation includes all the components that make up and affect Owner's Equity (Capital).

Assets = Liabilities + Beginning Owner's Equity (Capital) + Additional Owner Investments + Revenues - Expenses - Draws.

While all three of the equations illustrate the relationship of property and property rights, the accounting equation most often used and referred to is the Expanded Equation:
Assets = Liabilities + Owner's Equity

The accounting equation can be expressed in the following different ways:

  • Asset emphasis:
    Assets = Liabilities + Owner's Equity
  • Equity emphasis:
    Owner's Equity = Assets - Liabilities
  • Liability emphasis:
    Liabilities = Assets – Owner's Equity

So, You Can:

  • Calculate Assets if Liabilities and Owner's Equity are known
    Assets = Liabilities + Owner's Equity (Normal Formula)
  • Calculate Owner's Equity if Assets and Liabilities are known
    Owner's Equity = Assets - Liabilities
  • Calculate Liabilities if Assets and Owner's Equity are known
    Liabilities = Assets - Owner's Equity

Types Of Transactions Table Using the Simple (Abbreviated) Accounting Equation

The table illustrates the four basic types of transactions represented by the letters a. b. c. and d. and their effects on our simple or abbreviated accounting equation.

Property = Property Rights
Left Side = Right Side
(a) Increase In Property (a) Increase In Property Rights
(b) Decrease In Property (b) Decrease In Property Rights
(c) Increase In One Type Of Property    
(c) Decrease In Another Type Of Property    
    (d) Increase In One Type Of Property Rights
    (d) Decrease In Another Type Of Property Rights

Although transactions may require increases to both sides of the equation (left and right side both increase - transaction type (a), decreases to both sides of the equation (left and right side both decrease - transaction type (b), or an increase and decreases on the same side of the equation (increase and decrease on the left side - transaction type (c) or an increase and decrease on the right side transaction (d), the equation always balances.

Note The table also illustrates that by using double entry bookkeeping the dollar amount of the property will at all times equal the dollar amount of the property rights.

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