Accounting Equation
It is an essential accounting formula that shows a company’s assets, liabilities, and equity at a specific snapshot in time.
What Is the Accounting Equation?
The accounting equation, an essential accounting formula, shows a company’s assets, liabilities, and equity at a specific snapshot in time.
The accounting equation is also known as the balance sheet equation. Furthermore, the equation serves as the building block for the double-entry bookkeeping system in accounting.
The accounting equation is fundamental in analyzing business transactions, the first step in the accounting cycle.
There are three primary financial statements,
- the income statement (IS),
- balance sheet (BS), and
- cash flow statement (CFS).
While we mainly discuss only the BS in this article, the IS shows a company’s revenue and expenses and goes down to net income as the final line on the statement.
The CFS shows money going into (cash inflow) and out of (cash outflow) a business; furthermore, the CFS is separated into operating, investing, and financing activities.
It’s called the Balance Sheet (BS) because assets must equal liabilities plus shareholders’ equity.
There are no exceptions to this rule, except if you are ever dealing with the BS and do not have both sides as the same number, you know you did something wrong and should go back and check your numbers.
We can break down the accounting equation into two essential elements –
- what the business owns (its assets) and
- how it pays for those assets (the liabilities and equity portion of the accounting equation).
While there is no universal definition for liabilities and equity, liabilities are typically external claims (e.g., creditors and suppliers), and equity is internal claims (e.g., owners and shareholders of the business).
The formula is:
Assets = Liabilities + Equity
Key Takeaways
- The basic accounting equation is as follows:
- Assets = Liabilities + Shareholders’ Equity
- A business's assets are resources, and liabilities are the creditors’ claims on total assets. Whereas shareholders’ equity is the owners’ claim on total assets
- It is advised that you expand the basic accounting equation to
- Assets = Liabilities + Common Stock + Revenues - Expenses - Dividends,
- So that you can walk someone through the fundamental transaction analysis of economic events in a company’s lifecycle
- Common stock is increased when the company issues new shares of stock in exchange for cash
- Revenue is affected as a result of business operations that aim to earn money for the corporation
- Expenses are the costs of generating revenue
- Dividends are (annual) payments the company will make to stockholders assuming that revenue exceeds expenses (net income). It has nothing better to do with all that cash sitting on hand.
- Remember, to get to net income, subtract the total amount of expenses from the total revenue earned for the period.
Equity Component of the Accounting Equation
Under the equity component of the formula, we can expand the equity component into common stock and retained earnings.
The common stock section is the money invested/paid-in into the company by investors that purchase stock. Under the retained earnings section, we can divide that component into “revenues - expenses - dividends.”
- Revenue is the money that we generate from the direct sale of a product or delivery of a service.
- Expenses are the direct costs generated during generating revenue.
- Net income is a fancy accounting term for profit – the money the business gets to “take home” after everything is paid off.
- Dividends are the distribution of cash (i.e., cash dividend) or other assets (i.e., stock dividend) to shareholders of a company when the company decides that there is no better use for that residual income.
Note
While dividends DO reduce retained earnings, dividends are not an expense for the company.
Increases from investments by stockholders or increases in revenue will cause an increase in shareholders’ equity. It is crucial to note that the formula for net income is as follows:
Net Income= Revenue - Expenses
Economic Entity Assumption
You have likely heard of the word entity in your life in some shape or form. We think of economic entities as any organization or business in the financial world.
In some situations, accounts may use the terms
- owner’s
- owners’
- shareholders’ equity
about the same component of the accounting equation.
We use owner’s equity in a sole proprietorship, a business with only one owner, and they are legally liable for anything on a personal level.
Owners’ equity typically refers to partnerships (a business owned by two or more individuals).
Similar to a sole proprietorship, partnerships separate their accounting activities from their activities (hence owners’ equity).
However, each partner generally has unlimited personal liability for any kind of obligation for the business (for example, debts and accidents). Some common partnerships include doctor’s offices, boutique investment banks, and small legal firms.
Shareholders’ equity comes from corporations dividing their ownership into stock shares.
Shareholders, or owners of the stock, benefit from limited liability because they are not personally liable for any kind of debts or obligations the corporate entity may have as a business.
Note
Stockholders can transfer their ownership of shares to any other investor at any time.
While there is no notable difference in each term, if you wanted to be technical and saw it come up in a question, you should probably be familiar with the economic entity assumption.
The economic entity assumption states that all of the financial activities associated with the business are kept separate from its owners. For example, the CEO of Apple, Tim Cook, must keep his living expenses separate from Apple’s operating expenses (OpEx).
Note
Operating expenses (or OpEx) are any daily costs that a business or large corporation incurs. OpEx is commonly confused with CapEx – these two accounts are NOT the same!
Classification of Assets and Liabilities
In accounting, we have different classifications of assets and liabilities because we need to determine how we report them on the balance sheet. The first classification we should introduce is current vs. non-current assets or liabilities.
Current assets and liabilities can be converted into cash within one year.
- Examples of current assets include cash, accounts receivable, and in many instances, inventory.
- Examples of current liabilities typically include short-term debt and accounts payable.
Non-current assets or liabilities are those that cannot be converted easily into cash, typically within a year, that is.
Non-current assets could include accounts receivable greater than a year or PP&E.
Furthermore, another common way to classify assets is based on their “physical existence.”
Note
Assets based on “physical existence” are tangible.
Tangible assets can be touched, felt, and seen. Some common examples of tangibles include property, plant and equipment (PP&E), and supplies found in the office.
An intangible asset is an identifiable non-monetary asset without physical substance. Such an asset is identifiable when it is separable or arises from contractual or other legal rights.
For example, goodwill, patents, copyrights, and trademarks are all common examples of intangibles: patents, copyrights, and trademarks best suit inventors, authors, and brands.
Furthermore, patents protect the original designs/workings of the machine or invention, copyrights protect any form of art (i.e., music, literature, etc.), and trademarks protect any catchphrases, designs, symbols, or slogans.
Assets are resources the company owns and can be used for future benefit. Liabilities are anything that the company owes to external parties, such as lenders and suppliers.
Accounting Transactions
Business transactions are economic events recorded by accountants based heavily on the accounting equation (A = L + E). Algebra can be used to find stockholders’ equity (E = A - L).
There are two types of transactions,
- internal, i.e., within a company, and
- external, i.e., outside the company transactions.
Any event that does not affect the business's accounting equation is considered a non-business transaction. Responding to emails, hiring employees, or talking with clients are all examples of non-business transactions.
Under all circumstances, each transaction must have a dual effect on the accounting transaction. For instance, if an asset increases, there must be a corresponding decrease in another asset or an increase in a specific liability or stockholders’ equity item.
Examples of Accounting Transactions
Now that you are familiar with some basic concepts of the accounting equation and balance sheet let’s jump into some practice examples you can try for yourself.
1. Example Transaction #1: Investment of Cash by Stockholders
Nabil invests $10,000 cash in Apple in exchange for $10,000 of common stock.
Solution: The asset, cash, increases by $10,000, and shareholders’ equity increases by $10,000; therefore, it is a balanced equation.
2. Example Transaction #2: Purchase of Equipment for Cash
Apple purchased equipment for its computer for $5,500 cash.
Solution: The asset cash decreases by $5,500, and the asset equipment increases by $5,500 to compensate; therefore, It is a balanced equation.
3. Example Transaction #3: Purchase of Supplies on Credit
Apple buys packages for iPhones and semiconductors from suppliers such as TSMC for $1,500 on the account.
Solution: Supplies, an asset, increase by $1,600, and to compensate, accounts payable also increase by $1,600; therefore,
4. Example Transaction #4: Services Performed for Cash
Apple receives $1,300 cash from Harvard for app development services that it has performed.
Solution: Service revenue, a component of shareholders’ equity, increases by $1,300, and so does the asset cash; therefore, we’re in balance.
5. Example Transaction #5: Purchase of Advertising on Credit
Apple receives a bill for $290 from Google for advertising rights but asks to postpone the payment.
Solution: Accounts Payable, a liability, increases by $290, but the shareholders’ equity item, advertising expense, decreases by $290; therefore, we’re in balance.
6. Example Transaction #6: Services Performed for Cash and Credit
Apple performs $3,500 of app development services for iPhone 13 users, receives $1,500 from customers, and bills the remaining balance on the account ($2,000).
Solution: Service revenue, an item under retained earnings and stockholders’ equity, increases by $3,500, and to compensate, cash increases by $1,500, and accounts receivable also increase by $2,000; therefore, we’re in balance.
7. Example Transaction #7: Payment of Expenses
Apple pays for rent ($600) and utilities ($200) expenses for a total of $800 in cash.
Solution: Rent expense, an item under retained earnings and stockholders’ equity, goes down by $600, and utility expense decreases by $200. To compensate, cash is reduced by $800; therefore, we’re in balance.
8. Example Transaction #8: Payment of Accounts Payable
Apple pays the $290 in cash to Google that it previously had on account in transaction #5.
Solution: Cash, an asset, goes down by $290, and to compensate, so do the accounts payable, the liability; therefore, we’re in balance.
9. Example Transaction #9: Receipt of Cash on Account
Apple receives $600 from customers billed for annual iOS services.
Solution: Cash, an asset, increases by $600, and to compensate, accounts receivable (another asset) decrease by $600; therefore, we’re in balance.
10. Example Transaction #10: Issue of Dividends
Apple pays a $1,300 cash dividend to shareholders.
Solution: Cash, an asset, is decreased by $1,300, and dividends under stockholders’ equity go down by $1,300; therefore, we’re in balance.
It’s important to note that although dividends reduce retained earnings, they are not expenses. Therefore, dividends are excluded when determining net income (revenue - expenses), just like stockholder investments (common and preferred).
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