What is the Basic Accounting Equation?
Double entry bookkeeping and accounting is based on the basic accounting equation which states that the total assets of a business must equal the total liabilities plus the owners equity in the business.
Assets = Liabilities + Owners Equity
One side represents the assets of the business (buildings, inventory, vehicles etc), and the other side represents how those assets were funded (capital, retained earnings, loans, supplier credit etc.). Notice that owners equity includes amounts invested by the owners (capital) and profits of the business which have been retained.
The basic accounting equation sometimes referred to as the basic accounting formula is true at any point in time for a business and is also true for each individual double entry transaction. For example, if the business buys furniture on credit from a supplier for 200 then the basic accounting formula is shown as follows.
The two sides of the basic accounting equation are equal. On one side is the furniture coming into the business as an asset, on the other side is the funding for the asset which in this case is credit from a supplier.
In our examples section we set out typical double entry bookkeeping transactions and show how the accounting formula is affected by each transaction.
The Expanded Accounting Equation
Since owners equity is made up from capital injected and retained earnings of the business, the accounting formula can be expanded as follows:
Assets = Liabilities + Capital + Retained Earnings
In addition, retained earnings can be expanded to cumulative revenue less expenses less owners drawings, giving the fully expanded accounting equation shown below.
Assets = Liabilities + Capital + Revenue - Expenses - Drawings
It should also be noted that since the cumulative revenue less expenses is equal to the cumulative net income of the business for the accounting formula can also be stated as follows.
Assets = Liabilities + Capital + Net income - Drawings
The fully expanded accounting equation is summarized in the diagram below.
The owners drawings represent cash taken out of the business by way of salary, in a company this would be represented by dividends paid to the equity owners.
It is also possible to write the expanded accounted equation in terms of the current period net income.
Assets = Liabilities + Capital + Beginning net income + Current period net income - Current period drawings
The expanded accounting formula effectively shows that retained earnings is the link between the balance sheet and the income statement. The income statement is in fact a further analysis of the equity of the business.
The expanded accounting formula diagram used in this tutorial is available for download in PDF format by following the link below.