Accounting equation

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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.

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:

Assets − Liabilities = (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