# 1.7: The Accounting Equation

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The accounting equation is the basis for all transactions in accounting. It provides the foundation for the rules of debit and credit in the journalizing process, where for each transaction total debits must equal total credits. As a result, theaccounting equation must be in balance at all times for a business’ financial records to be correct. It involves the three types of accounts that do not appear on the income statement.

Assets = Liabilities + Stockholders’ Equity

Businesses own assets. These may be partially owned by the owners (stockholders) and partially owned by outsiders (debtors).

When you purchase an asset, there are two ways to pay for it—with your own money and with other people’s money. This concept is a simple description of the accounting equation.

When you buy a truck, you can pay cash for it, as shown in the following journal entry:

 Date Account Debit Credit 1/1 Truck 30,000 Cash 30,000

If you pay in full, you own the entire vehicle and receive title to it.

Assets = Liabilities + Stockholders’ Equity

30,000 = 0 + 30,000

As an alternative, you may purchase the truck by making a down payment for part of its cost and taking out a loan for the remainder. This is summarized by the following journal entry.

 Date Account Debit Credit 1/1 Truck 30,000 Cash 30,000 Note Payable 20,000

Assets = Liabilities + Stockholders’ Equity

30,000 = 20,000 + 10,000

This second scenario is a good illustration of the accounting equation using just one asset. The buyer receives the entire asset – the truck. The buyer must pay for this asset. They do so with two forms of payment: their own money (equity) and other people’s money (the loan). The combined total of their down payment and the loan equal the cost of the truck.

The asset is the truck, the liability is the loan, and the down payment is the owner’s equity.

## 1.7.1 Accounting Equation Broken Out

Indirectly, revenue and expense accounts are part of this accounting equation since they impact the value of stockholders’ equity by affecting the value of Retained Earnings.

The Retained Earnings account normally has a credit balance. Closing entries move the credit balances of revenue accounts into Retained Earnings and cause that account to increase. Closing entries also transfer the debit balances of expense accounts into Retained Earnings, causing it to decrease.

##### EXPANDED ACCOUNTING EQUATION

Common Stock plus Retained Earnings equals total stockholders’ equity.

## 1.7.2 Accounting Transaction Grid

The following grid illustrates how familiar transactions for a new business fit into the accounting equation: ASSETS = LIABILITIES + STOCKHOLDERS’ EQUITY.

 Assets = Liabilities + Stockholders’ Equity Revenue Expenses Cash Accounts Receivable = Accounts Payable + Common Stock Retained Earnings Fees Earned Rent Expense Supplies Expense Issued stock for cash, $1,000 1,000 1,000 Paid cash for rent,$700 (700) (700) Sold to customers for cash, $900 900 900 Purchased supplies on account,$200 200 (200) Sold to customers on account, $500 500 500 Paid cash on account,$200 (200) (200) Purchased supplies on account, $100 100 400 (100) Sold to customers on account,$400 400 Received cash on account, $500 500 (500) Closed revenue account 1,800 (1,800) Closed expense accounts (1,000) 700 300 Ending balances 1,500 400 100 1,000 800 0 0 0 Each transaction in the first column impacts two accounts. For the asset, liability, and stockholders’ equity amounts, positive numbers represent increases and negative amounts indicate decreases. The ending balances prove that total assets of$1,900 (1,500 + 400) equal total liabilities and stockholders’ equity of $1,900 (100 +1,000 + 800). Revenue and expense accounts were used temporarily and were ultimately closed to Retained Earnings. As a result, the income statement account balances were set to zero and the Retained Earnings balance increased by the net income amount of$800.

## 1.7.3 Retained Earnings Statement

The retained earnings statement is a report that shows the change in the Retained Earnings account balance from the beginning of the month to the end of the month due to net income (or loss) and any cash dividends declared during the accounting period.

#3 The balance sheet is prepared last. It shows assets, liabilities, and stockholders’ equity as of the last day of the month. All amounts except retained earnings come from the ledger balances. The Retained Earnings amount comes from the ending amount on the retained earnings statement - in this case $40,000. The balance sheet is an exploded version of the accounting equation! ##### Jonick Company Balance Sheet June 30, 2018  Cash$15,000 Accounts receivable 10,000 Equipment 5,000 Truck 30,000 Total assets $60,000  Liabilities Accounts payable$5,000 Stockholders’ Equity Common stock $15,000 Retained earnings 40,000 $$\ \quad \quad$$Total stockholders’ equity 55,000 Total liabilities and stockholders’ equity$60,000

This page titled 1.7: The Accounting Equation is shared under a CC BY-SA 4.0 license and was authored, remixed, and/or curated by Christine Jonick (GALILEO Open Learning Materials) via source content that was edited to the style and standards of the LibreTexts platform.