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
The income statement tells the story of how a company has performed 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
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
Assets = Liabilities + Contributed capital + Beginning retained earnings + Revenue – Expenses – Dividends
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:
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