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The Accounting Equation

The Relationship between the Assets, Liabilities, and Owner's Equity

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The accounting formula is how double-entry bookkeeping is established. The accounting formula, also called the balance sheet equation, represents the relationship between the assets, liabilities, and owner's equity of a small business. It is necessary to understand the accounting formula to learn how to read a balance sheet. It is also necessary to understand the accounting formula to understand the relationship between the company's financial statements.

The Basic Accounting Formula

The accounting formula essentially shows what the firm owns (its assets) are purchased by either what it owes (its liabilities) or by what its owners invest (its shareholders equity or capital). This relationship is expressed in the form of an equation:

Assets = Liabilities + Owner's Capital

This equation has to balance because everything the firm owns (assets) has to be purchased with something, either a liability or owner's capital. Assets refer to items like inventory or accounts receivable. Examples of liabilities are bank loans or accounts payable. Owner's capital or equity is the investment or capital the owner has in the firm. Another example is business profit.

The accounting formula or balance sheet equation can be expressed in two other ways:

Liabilities = Assets - Owner's Equity

Owner's Equity = Assets - Liabilities

If you know any two of the three components of the accounting equation, you can calculate the third component. If you look at a balance sheet, you can also see that the balance sheet is just an extended form of the accounting equation.

Keeping the Accounting Formula Balanced

When you start up a new company, your accounting formula will be the following:

Assets = Liabilities + Owner's Equity

$0 = $0 + $0

If this start-up is a very small business, the owner may deposit $1,000 in the business's checking account. If the business is using double-entry bookkeeping, then the accounting equation will now look like this:

Assets = Liabilities + Owner's Equity

$1,000 = $0 + $1,000

Next, this small business may purchase office supplies, using cash, in the amount of $150. Suddenly, the accounting equation looks like this:

Assets = Liabilities + Owner's Equity

$1000 = $150 + $850

because expenses decrease owner's equity

This means that the asset account "Office Supplies" was increased by $150 and the cash account was decreased by $150. Regardless of the type of transaction, the accounting equation must stay balanced.

The Expanded Accounting Formula

The expanded accounting equation shows the relationship between the income statement and the balance sheet. The Owner's Equity component of the accounting equation can be broken down into two parts - revenue and expenses. So far, the accounting equation has focused on the components of the balance sheet. Now, breaking the owner's equity part of the accounting equation into revenues and expenses shows the relationship between the balance sheet and the income statement since revenue and expenses are the key components of the firm's income statement.

Revenues, also called sales revenues, are what the business earns for providing its product or service to customers. Expenses are what it costs the business to provide the product or service to the customers. The relationship between revenues and expenses is simple. If revenues are greater than expenses, then the business generates a profit. If revenues are less than expenses, then the business sustains a loss.

The owner or owners of the company can also withdraw a salary or equity from the business. If the company is incorporated, then that salary may be in the form of dividends paid by the corporation. However, if the company is small and a sole proprietorship, partnership, or limited liability company, then the owner or owners will take a draw from the business as their salaries.

The expanded accounting equation, after you consider sales revenue and expenses, is:

Assets = Liabilities + Owner's Equity + Revenue - Expenses - Draws

where: Revenues increase Owner's Equity

Expenses decrease Owner's Equity

Draws or Dividends decrease Owner's Equity

It's important that your accounting equation balance because, if it does not, your financial reports will not make sense or enable you to keep track of your financial transactions.

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