Accounting equation
The fundamental accounting equation, also called the balance sheet equation, is the foundation for the double-entry bookkeeping system and the cornerstone of the entire accounting science. Like any equation, each side will always be equal. In the accounting equation every transaction will have a debit and credit entry, and the total debits (left side) will equal the total credits (right side). It can be expressed as furthermore:
- Assets=(Liabilities+Owner’s Equity)
The accounting equation will always be "in balance", meaning the left side (debit) of its balance sheet should always equal the right side (credit).
The formula can be rewritten:
- Assets − Liabilities = (Shareholders' or Owners' Equity)
Or any variation of a simple formula. For example: A (assets) = L (Liabilitie) + P ( Proprietorship or Owners Equity) which can also be expressed as A - L = P, and so on... Every accounting transaction affects at least one element of the equation, but always balances. Simple transactions also include:
| Transaction Number |
Assets | Liabilities | Equity | Explanation | |||
|---|---|---|---|---|---|---|---|
| 1 | + | 6,000 | + | 6,000 | Issuing capital stock 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, for which we also write
- Owner's equity = Contributed Capital + Retained Earnings
- Retained Earnings = Net Income − Dividends
and
- Net Income = Revenue − 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.
- Assets = Liabilities + Contributed Capital + Revenue − Expenses − Dividends