The accounting equation can also be rearranged in several ways, including:
Assets = Capital + Liabilities
In this format, the formula more clearly shows how the assets controlled by the business have been funded. That is, through investment from the owners (capital) or by amounts owed to creditors (liabilities). You may also notice two other interesting points regarding the formula being laid out in this way:
- It reflects the format of the statement of financial position (ie assets are presented first and the total assets figure balances with the total amount of equity and liabilities); and
- It more clearly reflects the fact that total debits will always equal total credits (ie Assets (Dr) = Capital (Cr) + Liabilities (Cr))
What about drawings, income and expenses?
Drawings are amounts taken out of the business by the business owner. They will therefore result in a reduction in capital.
Income and expenses relate to the entity’s financial performance. Individual transactions which result in income and expenses being recorded will ultimately result in a profit or loss for the period. The term capital includes the capital introduced by the business owner plus or minus any profits or losses made by the business. Profits retained in the business will increase capital and losses will decrease capital. The accounting equation will always balance because the dual aspect of accounting for income and expenses will result in equal increases or decreases to assets or liabilities.
The accounting equation can be expanded to incorporate the impact of drawings and profit (ie income less expenses):
Assets = Capital introduced + (Income – Expenses) – Drawings + Liabilities
We will now consider an example with various transactions within a business to see how each has a dual aspect and to demonstrate the cumulative effect on the accounting equation.
Anushka began a sole trade business on 1 January 20X1. During the first month of trading, the following transactions took place:
- She started the business with $5,000 of cash
- She took out a loan from the bank of $10,000
- She purchased a van for $12,000 cash
- She purchased 100 units of inventory on credit at a total cost of $2,500 (ie $25 per unit)
- She sold 10 units of inventory to a customer on credit for a total of $400 (ie $40 per unit)
- She paid interest on the loan of $60
- She repaid $250 of the loan
- She took $10 from the business bank account to cover a personal expense
Explain how each of the above transactions impact the accounting equation and illustrate the cumulative effect that they have.
The impact of each of the above transactions has been outlined below, followed by a summary of the cumulative effect of these transactions on the accounting equation:
1. The cash (asset) of the business will increase by $5,000 as will the amount representing the investment from Anushka as the owner of the business (capital).