What is the Accounting Equation that is the Basis for the Double Entry Accounting System?

The accounting equation is the fundamental part of the double-entry accounting method. The equation is a simplified version of the balance sheet. It is a concise expression of the two sides of the accounts in a double-entry accounting system.

Every business transaction in the double-entry accounting system is represented by two entries. Outsourced bookkeeping service providers will make a debit and credit entry for each transaction. Each transaction represents two sides of the equation that will be elaborated on in this blog post.

The Accounting Equation Simplified

The accounting equation represents the capital and debt as the source of assets of the company. In other words, the amount invested by the business owner or credit obtained from the bank will be used to purchase inventory or beef up the bank balance. This essence of the double-entry method is captured by the accounting equation as follows.

Assets = Capital + Liabilities

An increase in assets increases capital or liability. Moreover, an increase in capital or liability results in an increase in assets.

Also, the asset side of the equation balances itself. If a company buys raw material for cash, the cash amount will decrease while raw material which is another asset will increase. The equation will remain balanced on both the left and right sides.

Assets

Assets are the resources of the company. It includes all the resources that are utilized for performing business activities that result in revenue for the business.

The assets can be current or long-term assets. Current assets are easily converted to cash including the following:

• Cash and bank
• Accounts Receivable
• Prepaid expenses
• Inventory

 In contrast, long-term assets are generally not readily converted to cash. Examples of long-term assets include the following.

• Land
• Building
• Equipment
• Patents
• Copyrights
• Trademarks
• Goodwill

Note that patents, copyright, trademark, and goodwill are intangible assets. These assets don’t have a physical form. In contrast, land, building, and equipment are tangible assets.

Capital

Capital is the owner’s equity that represents investment made by the owner in the business. The capital can be calculated by deducting liabilities from assets.

The capital or equity of the owner increases in two situations.

• Income earned by the business increases the owner’s equity. The income from the business can include sales revenue, commissions, rental income, and fees charged for services.
• The capital will also increase when the owner invests additional cash or assets in the business.

On the contrary, the capital will decrease in the following two situations.

• Losses sustained by the business decrease the owner’s equity. Sustained losses can also wipe out the owner’s equity in the business.
• Drawings made by the owner decrease the equity or capital of the owner. The owner may take out cash or personal assets invested in the business that will reduce the capital amount.

Liabilities

Liabilities are obligations of the company. It includes an amount that is owned by creditors and others such as government agencies, employees, banks, and others.

Liabilities can also be classified as current or long-term. Current liabilities include the following.

• Account payable
• Salary payable
• Short term loan
• Utility expenses

In contrast, long-term liabilities are those that are paid over one year or more. These include the following.

• Mortgages
• Long term loan
• Deferred taxes

The assets amount is equal to the capital and the liabilities of the company. This simple equation is valid for all types of companies that use a double-entry accounting system. Let’s take a close look at the three elements of the accounting equation.

Expanded Accounting Equation

The expanded accounting equation contains other sections of the balance sheet. The following is the expanded version of the accounting equation.

Total Assets = Total Liabilities + Contributed Capital + Beginning Retained Earnings + Accumulated Income – Accumulated Loss + Income – Expense – Dividends Paid – Stock Repurchases

The extended accounting statement applies to registered companies. Here is a brief description of the expanded accounting equation.

Contributed Capital

The contributed capital is the paid-up capital of the shareholders.

Beginning Retained Earnings

Retained earnings refer to the income from the business that is retained rather than paid out as dividends. The beginning retained earnings figure is added to the accounting equation.

Accumulated Income/Loss

The accumulated income from business and other sources are added while the losses from business and other sources are deducted.

Accumulated income and expenses are part of the equity of the shareholders in addition to retained earnings and contributed capital. The accumulated income and losses include unrealized gains and losses on foreign currency transactions, the sale of securities, and other non-business transactions.

Stock Repurchases

Stock repurchases are also known as treasure stocks that are canceled. The transaction is sometimes added to the paid-up capital or retained earnings figure.

A simple example can help you understand how to calculate an expanded accounting equation for public companies.

Suppose that a company’s assets are valued at $10,000. The company had liabilities of $5,000 and capital of $5,000. Let’s suppose that the company repurchases stocks valued at $3,000. Moreover, suppose that the company does not have any beginning retained earnings, accumulated income/loss, or dividends for the sake of simplicity.

The expanded equation for the company can be written as follows.

Total Assets ($10,000) = Total Liabilities ($5,000) + Contributed Capital ($5,000) + Beginning Retained Earnings ($0) + Accumulated Income ($0) – Accumulated Loss ($0) + Income ($3,000) – Expense ($0) – Dividends Paid ($0) – Stock Repurchases ($3,000)

$,10,000 = $5,000 + $5,000 + 0 + 0 – 0 + 3,000 – 0 – 0 – 3,000

$10,000 = $10,000

Conclusion

The accounting equation is the reflection of the balance sheet in a double accounting system. The two sides of the equation should always balance out. While the equation tells about the financial position of the company, it does not tell about financial performance or how well the company performed during a period.

Investors must compare the accounting equation of the company with other competitive firms to know about the financial health of the company.

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