- Solve the accounting equation
The Accounting Equation
Double entry bookkeeping and the reports it produces are based on a single, important concept called the accounting equation. The equation is self-balancing:
Assets = Liabilities + Equity.
In order to understand its importance, it’s best to see it in action in a simple form. Assets are what a company owns. For instance, assume you are starting a cab service. You buy an automobile for $60,000 by putting $10,000 down and financing the rest. Applying the accounting equation to your business, you would have the following:
$60,000 = $50,000 + $10,000
The cab is your asset, and the liability, which is the claim against it held by the bank, is $50,000, leaving you $10,000 in equity. Liabilities are claims held by non-owners, while equity are claims against the assets held by the owners. In short, assets are what a company owns, and liabilities and equity show who owns it.
Another way to look at the accounting equation is to solve it for equity:
Assets – Liabilities = Equity.
If you sold your assets for exactly what you paid for them and paid off the debt, equity is what you have left over. Equity then is the owner’s claim against the asset(s).
The Expanded Accounting Equation
The basic accounting equation can be expanded to include the four major subaccounts of equity as follows:
Equity = Owner Contributions – Owner Withdrawals + Revenues – Expenses.
This expanded equity portion of the equation allows the user of financial accounting information to see the changes in equity. In it’s entirety, the expanded equation looks like this:
Assets = Liabilities + Owner Contributions – Owner Withdrawals + Revenues – Expenses.
This equation is the basis for the entire set of financial statements. It shows what the company owns (assets), how much debt there is (liabilities) and the components of owners’ equity—how much have the owners invested and how much did the company add to the owners’ wealth.
The revenue and expense accounts can be further broken down into subaccounts for data collection and informational purposes. For instance, revenue is a broad category under the general heading of equity, but a particular company may want to summarize revenues in even greater detail, using accounts such as Service Revenue, Sales of Merchandise, Interest Income, and other accounts that roll up into the general category of revenue.
In addition, most companies capture expenses at a more detailed level, using accounts such as Rent Expense, Payroll Expense, Insurance Expense, and more.