All accounting courses start with the accounting equation and the meaning it has. There might be many names or variations for the equation, but it does not change in reality.
The purpose of the equation underlies the purpose of accounting, and that is to account for the flow of resources in and out of an entity. Whether we measure these flows of resources in cash movement or on a full accrual basis, the accounting equation helps us understand how to record these flows.
So let’s take a look at the basic equation first.
Basic Accounting Equation
The equation says that the assets should equal the liabilities plus the equity (the capital and the reserves) at any point in time.
However, we can expand each item in this equation, giving us the expanded accounting equation. The expanded accounting equation will be the same as a more compact view of the statement of financial position or the balance sheet.
Therefore, we can further analyse the assets into cash, accounts receivable, prepayments and other short or long term assets. Similarly, we can expand the liabilities and include financial statement line items such as the accounts payable, the accruals, the short term and the long term interest-bearing debt and other liabilities line items.
The most important thing in the expanded accounting equation is equity. The equity generally consists of the share capital or the capital contributed by the shareholders and the reserves or the retained earnings. There are many different types of reserves, but for simplicity, we will consider the retained earnings.
The retained earnings are the accumulated profits (or losses) less any dividends paid to the shareholders. Therefore, the retained earnings, a statement of financial position line item is the only way the income statement and the statement of financial position can interact.
Expanded Accounting Equation
As mentioned above, the retained earnings include the profits accumulated less any dividends paid. Let’s assume that a company has just started trading and will pay no dividends. The expanded accounting equation can be therefore written as follows:
Worked Example
Let’s assume that company A, a consultancy company, has just started trading. The following transactions have occurred:
- The owner contributed $1,000 capital which was deposited in the company’s bank account.
- $200 was spent to buy stationery
- $200 was paid to for electricity all of which relates to this period
- Cash Sales worth of $600 were made to Company B.
The transactions we need to record are as follows:
| Debit Cash | Credit Equity | Debit Admin Expenses | Credit Cash | Credit Revenue | |
|---|---|---|---|---|---|
| Capital Contribution | $1,000 | $1,000 | |||
| Expenditure for stationery | $200 | $200 | |||
| Expenditure for Electricity | $200 | $200 | |||
| Sales Made | $600 | $600 |
As shown above, we need to record three transactions in the income statement, which is as follows:
- Stationery Expenses
- Electricity Expenses
- Revenue Generated
In addition, four transactions will have an impact on the balance sheet:
- The capital contribution
- The stationery expenses (the cash paid)
- The electricity expenses (the cash paid)
- The revenue generated (the cash received)
The income statement will therefore look like this:
| $ | |
|---|---|
| Revenue | 600 |
| Admin Expenses | (400) |
| Profit for the year | 200 |
We will then close and “clear” the profit and loss account at the year-end and transfer the $200 balance to retained earnings.
Therefore, the balance sheet will be as follows:
| Assets | $ |
|---|---|
| Cash | 1,200 |
| Total Assets | 1,200 |
| Capital | |
| Equity | 1000 |
| Retained Earnings | 200 |
| Total Equity | 1,200 |
Back to the accounting equations, the basic accounting equation for this example is as follows:
Assets = Liabilities + Equity
or
Cash = Capital + Retained Earnings
or 1,200 = 1,200.
The expanded accounting equation is as follows:
Assets = Liabilities + Capital + Revenue – Expenses
or 1,200 = 1,000 + 600 – 400, which is the same as 1,200 = 1,200.