In Practice
For example: A student buys a computer for $945. This student borrowed $500 from his best friend and spent another $445 earned from his part-time job. Now his assets are worth $945, liabilities are $500, and equity $445.
The formula can be rewritten:
- Assets - Liabilities = (Shareholders' or Owners' Equity)
Now it shows owners' interest is equal to property (assets) minus debts (liabilities). Since in a corporation owners are shareholders, owner's interest is called shareholders' equity. Every accounting transaction affects at least one element of the equation, but always balances. Simplest transactions also include:
| Transaction Number |
Assets | Liabilities | Shareholder's Equity |
Explanation | |||
|---|---|---|---|---|---|---|---|
| 1 | + | 6,000 | + | 6,000 | Issuing stocks for cash or other assets | ||
| 2 | + | 10,000 | + | 10,000 | Buying assets by borrowing money (taking a loan from a bank or simply buying on credit) | ||
| 3 | − | 900 | − | 900 | Selling assets for cash to pay off liabilities: both assets and liabilities are reduced | ||
| 4 | + | 1,000 | + | 400 | + | 600 | Buying assets by paying cash by shareholder's money (600) and by borrowing money (400) |
| 5 | + | 700 | + | 700 | Earning revenues | ||
| 6 | − | 200 | − | 200 | Paying expenses (e.g. rent or professional fees) or dividends | ||
| 7 | + | 100 | − | 100 | Recording expenses, but not paying them at the moment | ||
| 8 | − | 500 | − | 500 | Paying a debt that you owe | ||
| 9 | 0 | 0 | 0 | Receiving cash for sale of an asset: one asset is exchanged for another; no change in assets or liabilities | |||
These are some simple examples, but even the most complicated transactions can be recorded in a similar way. This equation is behind debits, credits, and journal entries.
This equation is part of the transaction analysis model, for which we also write
- Owners equity = Contributed Capital + Retained Earnings
- Retained Earnings = Net Income − Dividends
and
- Net Income = Income − Expenses
The equation resulting from making these substitutions in the accounting equation may be referred to as the expanded accounting equation, because it yields the breakdown of the equity component of the equation.
Read more about this topic: Accounting Equation
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