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Concept
Accounting equation
Summary
The fundamental accounting equation, also called the balance sheet equation, represents the relationship between the assets, liabilities, and owner's equity of a person or business. It is the foundation for the double-entry bookkeeping system. For each transaction, the total debits equal the total credits. It can be expressed as furthermore:
In a corporation, capital represents the stockholders' equity. Since every business transaction affects at least two of a company's accounts, the accounting equation will always be "in balance", meaning the left side of its balance sheet should always equal the right side. Thus, the accounting formula essentially shows that what the firm owns (its assets) has been purchased with equity and/or liabilities. That is, with funds it has borrowed and therefore owes (its liabilities) plus funds invested by the founding shareholders (its shareholders' equity or capital); note that the profits earned by the company ultimately belong to its owners.
The formula can be rewritten:
Assets − Liabilities = (Shareholders' or Owners' Equity)
Now it shows owners' equity is equal to property (assets) minus debts (liabilities). Since in a corporation owners are shareholders, owner's equity is called shareholders' equity.
Every accounting transaction affects at least one element of the equation, but always balances. Simple transactions also include:
These are some simple examples, but even the most complicated transactions can be recorded in a similar way. This equation is behind debits, credits, and journal entries.
This equation is part of the transaction analysis model, for which we also write
Owner's equity = Contributed Capital + Retained Earnings
Retained Earnings = Net Income − Dividends
and
Net Income = Revenue − Expenses
The equation resulting from making these substitutions in the accounting equation may be referred to as the expanded accounting equation, because it yields the breakdown of the equity component of the equation.
Official source
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