The Accounting Equation is a mathematical formula that helps businesses track their finances. The equation simplifies the process of recording revenue and expenses by dividing the total amount of revenue by the total amount of expenses.
This makes it easier for businesses to understand where their money is going and how they are performing financially.
The accounting equation is an ideal formula to calculate the total assets of an organization. You can even extend this formula to deconstruct the different components of net worth to get a better idea of how profits are used.
Understanding and using the accounting equation—and the expanded accounting equation—takes time and practice.
In this article, we discuss what is the accounting equation is and how you can use it. We also share how you can extend this formula and provide a detailed example of how the accounting formula works in real life.
Accounting Equation
The accounting equation is a mathematical formula that is used to show the relationship between the assets, liabilities and net worth of a company.
Also called the balance sheet equation, this formula serves as the basis for double-entry bookkeeping.
With this accounting method, there are always two account entries made for each transaction: a debit to one account and a credit to another.
The balance equation allows you to see if the assets are financed by debt or by company funds.
The accounting equation is as follows:
Assets = Liabilities + Equity
The equation must balance because everything the company owns—its assets—have been purchased with some form of debt (liabilities) or shareholders’ equity (equity).
How to use the accounting equation
Here are the steps to follow to use the accounting equation.
- Locate the total assets of the company. Review the balance sheet for the period and locate the total assets of your organization.
- Add up all the liabilities. Total all liabilities, which should be listed separately on the balance sheet.
- Locate heritage. If other people own stock in your company, find the total stockholders’ equity and add that number to the total liabilities.
- 3. Calculate total assets. The sum of liabilities and net worth is equal to total assets.
Parts of a balance sheet
The balance has three parts:
- Assets: This refers to all items of value, including cash, inventory, building, land, equipment, or accounts receivable.
- Liabilities: These are the debts owed to others. Some examples are bank loans, accounts payable or credit accounts.
- Equity: This indicates your degree of ownership in the business. If you are a sole proprietor, you own the entire business. If you are a partner, you can split the estate 50/50. Shareholders’ own funds are the capital that others have invested in the company. Company profits that are retained from prior periods are also considered equity.
If a company has $20,000 in liabilities, $50,000 in assets, and $40,000 in equity, the accounting formula would be:
- Liabilities ($20,000) = Assets ($50,000) – Stockholders’ Equity ($40,000), or
- Net Worth ($40,000) = Assets ($50,000) – Liabilities ($20,000)
Ways to Expand the Accounting Equation
The expanded accounting equation illustrates in more detail the different components of net worth. By breaking down equity into its different components, you can get a better idea of how profits are used. To do this, own funds can be divided into the following elements:
- Contributed Capital: This is the capital that is provided by the original shareholders.
- Income: It is the money that is generated from the ongoing operations of the company.
- Expenses: Expenses refer to the costs incurred to carry out the operations of the business.
- Dividends: These are subtracted and how are the profits distributed to shareholders.
- 7. Start Retained Earnings: Refers to earnings that are not distributed to shareholders from the prior period.
Terminology may vary depending on the type of organization. For example, withdrawals and distributions could replace the term “dividends” if the organization is a sole proprietorship.
However, the expanded equation helps you understand how a company’s shareholders’ equity changes over time. Allows you to view separately:
- The impact on equity of net income
- The effect of owner transactions
The expanded accounting equation for a company is:
Assets = Liabilities + Paid-in capital + Income – Expenses – Dividends – Treasury
Example of how to use the accounting equation
To understand how the accounting equation works, review the following example:
Tom is an entrepreneur who has just started his sole proprietorship: a business selling furniture made from reclaimed wood. He has saved for a year and has been able to contribute $50,000 to his new business. He forms Grand River Salvage, Inc. and contributes his $50,000 investment to the company in exchange for all of his shares.
Accounting equation* $50,000 (increase) $50,000 Assets = Liabilities + Equity
After completing the business creation process, Tom needs to buy some tools to build or restore furniture. In this case, the company uses the cash to buy another asset. Therefore, although his asset account decreased due to the withdrawal of cash, it also increased due to the addition of the new tools and machinery.
Accounting equation $20,000 (decrease) $20,000 (increase) Assets = Liabilities + Equity
After 12 months, the company has grown rapidly and needs to expand to a new location to accommodate more furniture and improve the shopping experience for potential buyers. Instead of renting, buying a space makes the most sense for Tom. However, he doesn’t have the $400,000 in cash to buy the building outright. So he pays $50,000 in cash and takes out a $350,000 mortgage. The transaction decreases the company’s assets by investing $50,000 of cash in the building, increases the assets by the new building, which is worth $400,000, and increases the liabilities by the $350,000 mortgage.
Accounting equation $50,000 (decrease) $400,000 (increase) $350,000 (increase) Assets = Liabilities + Equity
Conclusion
The Accounting Equation is a mathematical formula that helps businesses track their finances. The equation simplifies the process of recording revenue and expenses by dividing the total amount of revenue by the total amount of expenses. This makes it easier for businesses to understand where their money is going and how they are performing financially.
