Accounting Equations

Financial statement elements (assets, liabilities, owners’ equity, revenue and expenses) are used as the inputs for the equations which feed into the preparation of a company’s financial statements. The balance sheet and income statement are two of the most popular financial statements that are prepared by a company.

Balance Sheet and the Basic Accounting Equation

The balance sheet provides a snapshot of a company’s financial position at a specific point in time. The equation which underlies the balance sheet is referred to as the “basic accounting equation”, and can be represented as follows:

Assets = Liabilities + Owners’ equity

The basic accounting equation tells us that the claims on a company’s assets are derived from its liabilities and owners’ equity.

If we make owners’ equity the subject of the equation, we see that:

Owners’ equity = Assets – Liabilities

This indicates that owners’ equity represents the residual claim on a company’s assets after its liabilities have been deducted.

Owners’ equity can also be classified according to its origin i.e. the capital that has been contributed by the owners of the company as well as the earnings that have been retained in the company up to a specified point in time. This can be expressed by the following equation:

Owners’ equity = Contributed capital + Retained earnings

Income Statement

The income statement tells the story of a company’s performance over a specified period of time. The equation that is associated with the income statement is:

Revenue – Expenses = Net income (loss)

The balance sheet and income statement are connected through the retained earnings component of owners’ equity. Retained earnings represent the earnings or net income of a company that is retained and not distributed as dividends. It has a balance at both the beginning and end of the accounting period, with the difference being due to activities which occur during the accounting period. The equation which underlies retained earnings may be represented as:

Ending retained earnings = Beginning retained earnings + Net income – Dividends

Or

Ending retained earnings = Beginning retained earnings + Revenues – Expenses – Dividends

Expanded Accounting Equation

The expanded accounting equation combines the equations for the balance sheet and income statement, and may be represented as:

Assets = Liabilities + Contributed capital + Ending retained earnings

Or

Assets = Liabilities + Contributed capital + Beginning retained earnings + Revenue – Expenses – Dividends

Question

The following information was compiled for company ABC.

Beginning retained earnings	$5,000
Liabilities at year-end	$10,000
Contributed capital at year-end	$5,000
Revenue for the year	$18,000
Expenses incurred	$15,500
Dividends	$1,500

The total assets of company ABC should be closest to:

A. $21,000

B. $12,000

C. $55,000

Solution

The correct answer is A.

Using the expanded accounting equation, assets = liabilities + contributed capital + beginning retained earnings + revenue – expenses – dividend, we see that company ABC’s assets = $10,000 + $5,000 + $5,000 + $18,000 – $15,500 – $1,500 = $21,000.

Reading 22 LOS 22c:

Explain the accounting equation in its basic and expanded forms