Understanding the accounting equation is esential to a good understanding of accounting.

The Accounting Equation Explained with Examples

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.

The basic accounting equation reflects assets must balance again liabilities and capital.

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:

The expanded accounting equation is a summary of the two key financial statements; statement of financial performance and position.

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 CashCredit EquityDebit Admin ExpensesCredit CashCredit 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:

 $
Revenue600
Admin Expenses(400)
Profit for the year200

We will then close and “clear” the profit and loss account at the year-end and transfer the $200 balance┬áto retained earnings.

Therefore, the balance sheet will be as follows:

Assets$
Cash1,200
Total Assets1,200
Capital
Equity1000
Retained Earnings200
Total Equity1,200

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.

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