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Accounting Equation

Accounting Equation is an accounting principle and rule which states that the business resources (assets) are attributable to the amount owed to creditors (liabilities) and capital invested by the owners (equity). When entrepreneurs start business, their business assets (such as office equipment, inventories, office buildings, cash, etc.) come from two sources: either they purchase them using the cash they invest in the business, or they raise loans and purchase the assets on credit terms in which they promise some third party to pay the price in future. This simple fact is expressed by the accounting equation as follows: Accounting equation is the most basic principle of financial accounting. It states that at a point of time, the value of assets of a business is equal to the sum of the value of its liabilities and its Owners equity.

Basic Accounting Equation:


Basic Accounting Equation is an accounting principle and rule which states that the business resources (assets) are attributable to the amount owed to creditors (liabilities) and capital invested by the owners (equity). It is formulated as follows:

ASSET = LIABILITY + EQUITY

Expanded Accounting Equation


Expanded accounting equation, as the name implies, is an expanded form of the standard accounting equation and it shows components of owner's equity such as paid-in capital, dividends, incomes, expenses etc. Expanded accounting equation does not expand assets and liabilities further. It helps to understand the relationship between balance sheet and income statement because it combines figures from both of the financial statements.

It is important to note that the components of equity differ between sole proprietorships, partnerships and companies. Therefore the expanded accounting equation is also different for different forms of business. For sole proprietorship, it will be:
Assets = Liabilities + Owner Capital + Incomes - Expenses - Withdrawals

For example, a corporation will use:


Assets = Liabilities + Paid-in Capital - Treasury Stock + Incomes - Expenses - Dividends

Discussion of Assets, Liabilities and Owners Equity:


The accounting equation (or basic accounting equation) offers us a simple way to understand how these three amounts relate to each other. The accounting equation for a organization is:

Asset Accounts:
Assets are the resources owned by a business which benefit its future operations and are convertible to cash (cash itself is also an asset). Examples are cash, land, building, vehicles, receivables, etc.

List of Asset Accounts:


Following are the common asset accounts:

Cash: In accounting, cash includes physical money such as bank notes and coins as well
as amount deposited in bank for current use.

Accounts Receivable: It includes the money owed to the business by outsiders such as
customers and other businesses. In most cases accounts receivable arise from sales or services provided on credit. There is no interest on accounts receivable.

Notes Receivable: Notes receivable includes the money owed to business by outsiders
for which there is a formal document for proof of debt. In most cases Notes receivable also involve interest.

Prepaid Insurance: The cost of insurance premium paid in advance. Inventory: These are goods and materials held by a business for the purpose of sale or
for the production process.

Supplies: Supplies include items held for use in miscellaneous activities by the business.
It may include items used by business staff (for example: stationary products) and items used in production process (for example nails used in production of furniture).

Equipment: Equipment having life more than a year. Examples are Vehicles,
Production Machinery, Computers etc.

Buildings: Buildings owned by the business. Examples are Office Building, Factory
Building, Godown, Garage etc.

Land: Includes cost of all the land owned by the business. Also includes cost of the land
with building on it.

Patents, Trade Mark, License: These are assets have no physical existence but have
properties of assets. The assets cash, accounts receivable, notes receivable, prepaid insurance, inventory and supplies are categorized as Current Assets. Equipment, buildings, land and patents are categorized as Non-Current Assets. Those assets which have no physical existence are called intangible assets.

Liability Accounts
Liabilities represent the obligation of the business towards creditors and their settlement is expected to result in an outflow of assets.

Liability Accounts List


Following are the common liability accounts: Accounts Payable: The amount that a business own to outsiders, which is unpaid yet. Notes Payable: Money which the business owes to third parties which is represented by a written promise to repay at specified date and often bearing interest. Unearned Revenue: The money received in advance for a certain service or goods to be provided in future. Unearned revenue is listed as liability up to the point when the service or goods are provided thus finishing the liability and it is converted to revenue. Salaries/Wages Payable: The salaries that are incurred but are not yet paid to employees.

Interest Expense: The amount of interest that is incurred on a note payable or bond is accumulated here and paid when due. Sales Tax Payable: Sales tax collected on sales but yet to be paid to tax collection authority. Other: Utilities Payable, Short-term Borrowings, Bonds Payable, etc.

Equity Accounts:
Equity accounts represent the owners' interest in the assets of a business. The owners' interest is the part of assets that is left after all liabilities are paid. Therefore equity is sometimes called Net Assets.

Types of Equity Accounts


Equity accounts may be divided into following important types: Contributed Capital: Contributed capital is the part of capital that directly comes from its owners. In case of sole-proprietorship and partnerships, it is the initial capital deposit by owner plus any additional capital deposits during the life of the business. In case of Corporations it is the value of Common Stock at par plus additional paid it capital plus any additional stock issuances. Gained Capital: Includes net income by the business less dividends. If the business is earning more than its dividend payments then gained capital accumulated over the years. Revenues: Revenue is the actual money that a business receives or recognizes for its services or sales during an accounting period before any deductions (discounts, sales returns, cost of goods sold, expenses) etc. are made. Expenses: Expenses actually reduce owners' equity so expenses are technically contra equity accounts. 5

Equity Accounts List


Following are the most common equity accounts for single owner businesses and partnerships: Capital: is the simplest equity account and it is used for sole proprietorships and partnerships. It includes both contributed capital and invested capital. Drawings: represents the money drawn by the owner of a small business for their personal use. Following are some of the equity accounts which are used by corporations:

Common Stock: is the basic account used for equity of corporations. It records the portion of contributed capital that relates to common stock issued at par value. Paid-in Capital Most often the amount that stockholders pay for a company stock is higher than par value per share. Since the common stock account only records the portion that relates to par value, therefore the extra amount is recorded and Paid-in Capital account. Treasury Stock Treasury Stock records those share of a company own common stock that are purchased back for some financial reasons. Dividends: Records the amount of money given to stockholders of a business in the form of income sharing. This has same function as of Drawings account of small businesses. Retained Earnings: Not all of the earnings of a corporation are distributed among the stockholders. Some are retained form future operations and are recorded in retained earnings account.

Revenue Accounts
Revenue is the total amount received by a business or recognized as earned when the business sells something, usually services and goods. In modern accountancy, revenue is recorded when it is earned not when the cash is received from customers. For example when a phone service provider records revenue when calls are made not at the time when you pay the bills. This principle is known as revenue recognition principle.

Types of Revenues:
Revenues can be classified as operating revenue and non-operating revenue.

Operating revenues are those that originate from main business operations. For example: Sales, etc. Non-operating revenues are earned from some side activity. For example: Interest Revenue, Rent Revenue (except in case where the business' main industry is renting industry).

Revenue Accounts List:


Following are the common revenue accounts:

Revenue/Sales/Fees: These accounts are used interchangeably to record the main revenue amounts. However most companies/businesses give their revenue account a more specific name like: fees earned, service revenue, etc. Interest Revenue: is used to record the interest earned by the business.

Rent Revenue: is the revenue from buildings or equipment of the business on rent. Dividend Revenue: is used to record the dividend earned on the stock of other companies which is owned by the business. Following accounts are called contra revenue accounts because they have exactly opposite characteristics of revenue accounts. Important contra revenue accounts are: Sales Returns: Sometimes goods are retuned by the customers for some defect or due to some other reason. These are recorded in sales returns account which is a contra sales account. Sales Discounts: This account records the discounts given to customer on the gross amount.

Expense Accounts
In financial accounting, expense is: The consumption of the business' own resources (assets). Examples: consumption of supplies, cash, materials inventory and deterioration of equipment etc. OR The creation of a liability against the business when it consumes resources from outside. Examples: use of electricity expense, interest expense etc.

Expense Accounts List


Few examples of expense accounts are: Supplies Expense Utilities Expense Salaries Expense 8

Depreciation Expense Insurance Expense Advertising Expense Bad Debts Expense Fuel Expense Rent Expense Interest Expense License Expense Telephone Expense Tax Expense Warranties Expense Miscellaneous Expense