The fundamental accounting equation forms the basis of the three statement financial projections model and can be stated as follows.
Assets = Liabilities + Equity
As can be seen the accounting equation is in effect a representation of the two sides of the balance sheet. Consequently for that reason is sometimes referred to as the balance sheet equation.
On one side of the equation are the assets (property, plant, equipment, accounts receivables, cash etc.). On the other side are the methods by which those assets are funded, which can either be liabilities (debt finance, accounts payable etc.) or equity (shareholder capital, and profits retained within the business).
Accounting Equation Examples
It is important to realize that since the accounting formula results from the process of double entry bookkeeping it holds true at any point in time and for every transaction.
A few examples will help to clarify its use.
Transaction Example 1
To illustrate suppose investors inject 20,000 cash into a business by way of new equity capital. This transaction, like all accounting transactions, has two sides and must satisfy the accounting equation as set out below.
The effect of the transaction on the accounting equation is explained as follows. As can be seen the business receives cash of 20,000 and the balance sheet asset of cash increases. On the other side the business issues new shares to the investor and the equity capital of the business increases. It is important to realize that there is no effect on the liabilities of the business from this transaction.
Effect on the Financial Projections Template
The effect of this transaction can be seen by inserting the additional equity in the financial projections template at line 57 (Proceeds from issue of share capital). Accordingly the balance sheet after this adjustment shows that cash at line 22 has increased by 20,000 and capital at line 37 has also increased by the same amount.
Accounting Equation Transaction Example 2
As a second example consider what happens when the business purchases equipment for 600 from a supplier on credit terms.
Again the transaction has two sides and must balance the accounting equation as set out below.
The business purchases equipment and the balance sheet asset of equipment increases by 600, on the other side the business still owes the supplier the amount of 600 for the equipment and the balance sheet liabilities of accounts payable increase by a similar amount. Furthermore this transaction has no impact on the equity of the business.
As a side note, the terms debit and credit used in double entry bookkeeping simply refer to which side of the accounting equation the transaction item is on. Debit means on the left hand side of the equation, credit means on the right hand side of the equation.
For example, equipment is an asset on the left hand side of the equation so is normally a debit, whereas accounts payable is a liability on the right hand side of the equation and is therefore normally a credit.
The Expanded Accounting Equation
The equity of the business has two components capital injected by investors (usually cash), and profits retained by the business, referred to as retained earnings. Accordingly using this fact the basic accounting equation shown above can be expanded as follows.
Assets = Liabilities + Capital + Retained Earnings
In addition the retained earnings is simply the cumulative net income of the business less any dividends. This leads to the fully expanded accounting equation shown below.
Assets = Liabilities + Capital + Net income - Dividends
It should also be noted that since the cumulative net income is equal to the cumulative revenue less expenses of the business, the equation can also be stated as follows.
Assets = Liabilities + Capital + Revenue - Expenses - Dividends
Additionally the diagram below summarizes the expanded accounting equation.
The expanded accounting equation is a fundamental concept that helps to explain the relationship between the assets, liabilities, and equity of a business. This equation provides a comprehensive view of a business’s financial position, making it an important tool for both the business owner and its investors.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. 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.