Expanded Accounting Equation Principle Explained
The basic accounting equation formula is:
total Assets = Liabilities + Equity.
It is used in Double-Entry Accounting to record transactions for either a sole proprietorship or for a company with stockholders. Although the accounting equation appears to be only a balance sheet equation, the financial statements are interrelated. Net income from the income statement is included in the Equity account called retained earnings on the balance sheet.
Accounting Equation Formulas
The accounting equation varies slightly based on the type of capital structure and legal entity. It can be shown as a Basic Accounting Equation or Expanded to show the interrelated income statement components of revenue and expenses as part of retained earnings and the other equity accounts.
To learn more about Basic and Expanded Accounting Equation check out this definition by Wikipedia.
The following table shows the accounting equation formula using different cases for the basic accounting equation and the expanded accounting equation:
|
Case |
Accounting Equation formula |
|
Basic |
|
|
Sole proprietorship |
Assets = Liabilities + Owner’s Equity |
|
Corporation |
Assets = Liabilities + Stockholder’s Equity |
|
Expanded |
|
|
Sole proprietorship |
Assets = Liabilities + [Owner’s Capital - Owner’s Draws + Revenues - Expenses] |
|
Corporation |
Assets = Liabilities + [Paid-in Capital - Treasury Stock - Dividends + Revenues - Expenses] |
When using the Expanded Accounting Equation, include all elements of the owner’s equity or stockholder’s equity, including gains, losses, and other accumulated comprehensive income, if applicable.
The accounting equation can be restated as:
Total Assets - Liabilities = Equity
Relationship to Double Entry Accounting
The accounting equation relates to double-entry accounting and bookkeeping. Under double-entry accounting:
- debits are recorded on the left side
- credits are recorded on the right side
- credits may be indented to indicate that they are on the right.
- each accounting transaction includes at least two accounts
- The total left side and the total right side of each accounting transaction must balance.
When a transaction is coded, the following type of accounts are recorded as:
- debits on the left side of the entry: asset, expense, loss, contra-account to liability or equity account (to reduce that account).
- credits on the right side of the entry: liability, equity account, revenue, gain, contra-account to an asset account (to reduce that account).
Therefore, total Assets = Liabilities + Equity.
An automated accounting system is designed to use double-entry accounting. When you review each entry and the trial balance, you can make sure that total debits equal total credits, and that the accounting equation holds true.
A Few Sample Transactions
The following table illustrates how each transaction affects the accounting equation for a sole proprietorship. Record each transaction using the account numbers from your chart of accounts:
|
Transaction Description |
Debit Amount |
Credit Amount |
|
Cash |
100,000 |
|
|
Owner’s Equity |
100,000 |
|
|
To record capital contribution as the owners invest in the business. |
||
|
Travel expense |
500 |
|
|
Accounts payable |
500 |
|
|
To record office supplies. |
||
|
Office rent |
2,500 |
|
|
Cash |
2,500 |
|
|
To record monthly rent expense. |
||
|
Owner’s Draw |
1,000 |
|
|
Cash |
1,000 |
|
|
To record the owner’s withdrawal of cash from the business. |
||
|
Office equipment |
1,500 |
|
|
Cash |
1,500 |
|
|
To record the purchase of office equipment. |
||
|
Inventory |
25,000 |
|
|
Accounts payable |
25,000 |
|
|
To record purchase of merchandise inventory. |
||
|
Accounts receivable |
249 |
|
|
Sales |
249 |
|
|
To record sale to a customer on account. |
||
|
Total debits and credits |
130,749 |
130,749 |
The Accounting Equation reflecting the transactions in the table is derived as follows:
Total Assets = Cash = $100,000 - 2,500 - 1,000 + 1,500 - 1,500 + 25,000 + 249 = $121,749
Total Liabilities = $500 + 25,000 = $25,500
Total Owner’s Equity = $100,000 - 2,500 + [249 - 500 - 2500 - 100] = $96,249
$121,749 = $25,500 + $96,249
For a corporation, all transactions in the above table are the same except for the capital contribution and owner’s draw transactions. Instead, a corporation with stockholders would record the following transactions:
|
Transaction Description |
Debit Amount |
Credit Amount |
|
Cash |
100,000 |
|
|
Paid-in Capital (at par value) |
|
1,000 |
|
Stockholder’s Equity |
99,000 |
|
|
To record capital contribution as stockholders invest in the business. |
||
|
Dividends declared |
100 |
|
|
Dividends payable |
100 |
|
|
To record dividend declared, not yet paid. |
||
|
Total debits and credits (including transactions from a table above except capital contribution and owner’s draw). |
129,849 |
129,849 |
The Accounting Equation reflecting the transactions in the table is derived as follows:
Total Assets = Cash = $100,000 - 2,500 + 1,500 - 1,500 + 25,000 + 249 = $122,749
Total Liabilities = $500 + 25,000 + 100 = $25,600
Total Stockholder’s Equity = $1,000 + 99,000 - 100 + [249 - 500 - 2500] = $97,149
$122,749 = $25,600 + $97,149
Key Takeaways
The accounting equation is a tool to help you keep the books balanced as you record each accounting transaction and prepare financial statements. Automated accounting systems are designed to use double-entry accounting with debits and credits, and the basic accounting equation, total
Assets = total Liabilities + Equity.
For each transaction, the total debits equal the total credits. The fundamental accounting equation, also called the balance sheet equation, represents the relationship between the assets, liabilities, and owner's equity of a person or business.
