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Accounting Equation Principle

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.

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 or  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 illustrate 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 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

 

Takeaway

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.

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