Accounting Equation
The Accounting Equation is the foundation on which the double entry bookkeeping system is built. Like ice cream is represented by many flavors, the accounting equation is expressed in different forms ranging from a summary to a detailed equation. We'll start our discussion with the summary equation or abbreviated version and then proceed to the fully expanded or detailed version of the accounting equation. The top most version of the equation is
Property = Property Rights.
This abbreviated equation states that the property of the business must equal the rights to the property or stated another way the claims against the property. In other words, we want to track not only the goodies (property) we get, but also how we acquired or got them and from whom (source).
Now, we'll move on to the expanded version of the accounting equation. The expanded version of the accounting equation is
Assets = Liabilities + Owner's Equity.
All we actuall did is replace the term Property with the term Assets and the term Property Rights with the terms Liabilities and Owner's Equity. Property and assets are both terms that define the same thing and property rights is an abbreviated term for liabilities and equity. In other words, since (1) Property = Assets and (2) Property Rights (Claims to the Property) = Liabilities + Equity, the abbreviated accounting equation Property = Property Rights expanded or restated now becomes
Assets = Liabilities + Owner's Equity.
Finally, let's develop our fully expanded accounting equation. All we're going to do in this step is to substitute the term Owner's Equity with all the components that actually make up Owner's Equity. Owner's Equity is the claim that the owners have to the property or assets of a business. The owner's claim is made up of (1) what they invested or put into the business, (2) what they took out, and (3) the operation of the business which is called a profit or loss. Preferably a profit.
The profit or loss is the the difference between the Revenues and Expenses ( Profit or Loss = Revenues - Expenses ). Profits increase the owner's claim to the assets while losses decrease the owner's claim to the business assets.The Owner's Equity Equation is
Current Owner's Equity (Capital) = Beginning Owner's Equity (Capital) + Owner's Investments + Revenues - Expenses - Draws.
This equation illustrates the relationships and effects investments, revenue, expense, and drawing have on Owner's Equity. These effects are - (1) Owner Investments increase Owner's Equity (2) Revenues increase Owner's Equity (3) Expenses decrease Owner's Equity, and (4) Owner's Draws decrease Owner's Equity. After including all the detailed components that make up Owner's Equity, the fully expanded accounting equation is
Assets = Liabilities + ( Beginning Owner's Equity + Owner's Investments + Revenues - Expenses - Draws ).
Our Last Thoughts About This Accounting Equation. In using the accounting equation, if two of the three components are known, the third can be easily calculated by rearranging the equation.
(1) You can Calculate Assets if Liabilities and Owner's Equity are known as follows-Assets = Liabilities + Owner's Equity.
(2) You can Calculate Owner's Equity if Assets and Liabilities are known as follows-Owner's Equity = Assets - Liabilities.
(3) You can Calculate Liabilitiesif Assets and Owner's Equity are known as follows-Liabilities = Assets - Owner's Equity.
Note- All these calculations assume that all the effects of investments, draws, and profits or losses are included in the Owner's Equity current balance.
Accounting Equation Videos