What is the Basic Accounting Equation?
Double entry bookkeeping is based on the basic accounting equation. The equation states that the total assets of a business must equal the total liabilities plus the owners equity in the business.
Assets = Liabilities + Owners Equity
The balance sheet is a reflection of the basic accounting equation. One side represents the assets of the business (buildings, inventory, vehicles etc), and the other side represents how those assets are 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. It should be noted that for a corporation owners equity would be replaced by stockholders equity.
The basic accounting equation sometimes referred to as the basic accounting formula is true at any point in time for a business. Furthermore it 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 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 (what the business owns). Additionally on the other side is the funding for the asset in this case credit from a supplier (what the business owes).
In the same fashion our examples section sets out typical double entry bookkeeping transactions and show how each transaction affects the accounting formula.
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. Consequently it is possible to restate the fully expanded accounting equation as follows.
Assets = Liabilities + Capital + Revenue - Expenses - Drawings
Furthermore since the cumulative revenue less expenses is equal to the cumulative net income of the business, it is possible to restate the accounting formula as follows.
Assets = Liabilities + Capital + Net income - Drawings
To summarize the diagram below sets out the fully expanded accounting equation.
In this situation the owners drawings represent cash taken out of the business by way of salary. Correspondingly in a company, the payment of a dividend to the equity owners replaces drawings in the expanded accounting equation.
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
In other words the expanded accounting formula shows retained earnings is the link between the balance sheet and income statement. Moreover 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.
Net worth is another term for equity and is the difference between the assets and liabilities. Furthermore we can get the formula for calculating net-worth by rearranging the accounting equation as follows.
From the above we can see that in the event that the liabilities are greater than the assets of the business, the net worth can be a negative figure.
The calculation of net worth for a business uses the assets and liabilities shown in the balance sheet. This means that it reflects the carrying value of the assets and liabilities and not necessarily their market value.
It should be noted that the term net worth is sometimes used in relation to an individual. In general the calculation for an individual refers to the market value of their assets and liabilities and as such represents the net wealth of the individual.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.