# Expanded Accounting Equation Principle Explained

There may be equal increases to both accounts, depending on what kind of accounts they are. Accordingly, the following rules of debit and credit in respect to the various categories of accounts can be obtained. There are two different approaches to the double entry system of bookkeeping. They are the Traditional Approach and the Accounting Equation Approach. Irrespective of the approach used, the effect on the books of accounts remain the same, with two aspects in each of the transactions. Most of the time these documents are external to the business, however, they can also be internal documents, such as inter-office sales.

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• To record capital contribution as the owners invest in the business.
• It is used in Double-Entry Accounting to record transactions for either a sole proprietorship or for a company with stockholders.
• Once the entries have all been posted, the Ledger accounts are added up in a process called Balancing.
• Additionally, changes is the accounting equation may occur on the same side of the equation.
• Personal accounts are liabilities and owners’ equity and represent people and entities that have invested in the business.
• In this way, the accounting equation offers a simple standard for retaining balance.

This process of transferring the values is known as posting. Once the entries have all been posted, the Ledger accounts are added up in a process called Balancing. For each transaction, the total debits equal the total credits. These three elements of the accounting equation are what constitute a balance sheet. As a result, the equation is sometimes referred to as the balance sheet equation. A company’s assets could include everything from cash to inventory.

## Accounting Equation Formulas

This consists of all equipment, prepaid expenses, receivables, and property – anything the business owns that reflects its value. Similarly, when a company takes out a business loan, the borrowed money leads to an increase in assets. At the same time, this increases the company’s liability in the form of debt. As you can see from the examples above, double-entry accounting keeps the books balanced. A particular working document called an unadjusted Trial balance is created.

The accounting equation varies slightly based on the type of capital structure and legal entity. This equation is kept in balance after every business transaction. Everything falls under these three elements ( assets, liability, owners’ equity ) in a business transaction. The accounting cycle includes analysis of transactions, transferring journal entries into a general ledger, revenue, and expense closed.

## The Accounting Equation

In the double-entry accounting system, each accounting entry records related pairs of financial transactions for asset, liability, income, expense, or capital accounts. Recording of a debit amount to one account and an equal credit amount to another account results in total debits being equal to total credits for all accounts in the general ledger. It is used in Double-Entry Accounting to record transactions for either a sole proprietorship or for a company with stockholders. Although the accounting equation appears to be only a balance sheet equation, the financial statements are interrelated. Net income from the income statement is included in the Equity account called retained earnings on the balance sheet.

If the funds are borrowed to purchase the asset, assets and liabilities both increase. If the company issues stock to obtain the funds for the purchase, then assets and equity both increase. To understand the purpose of the accounting equation, it’s first helpful to take a closer look at double-entry accounting. At the heart of this is the balance sheet, which shows a balance of total assets, total liabilities, and shareholder equity. Following this approach, accounts are classified as real, personal, or nominal accounts. Personal accounts are liabilities and owners’ equity and represent people and entities that have invested in the business.

## Accounting Equation Approach American

By making this an international standard, it’s easier for global corporations to keep track of their accounts. It’s also helpful on a lower level by keeping all transactions in balance, with a verifiable relationship between each expense and its source of financing. The two sides of the equation must always add up to equal value. The accounting equation ensures that all uses of capital remain equal to all sources of capital . The group of accounts is called ledger, or a book of accounts. This category includes the value of any investments made in the organisation, whether through the owners or shareholders.

For example, if a business buys raw materials using cash, it would first mark this in the inventory accounts. The raw materials would be an asset, leading to an increase in inventory. The transaction should also be marked as a reduction of capital due to the spending of cash. According to double-entry accounting, this single transaction would require two separate accounting entries. For example, when a company intends to purchase new equipment, its owner or board of directors has to choose how to raise funds for the purchase. Looking at the fundamental accounting equation, one can see how the equation stays is balance.

## Relationship To Double Entry Accounting

For example, if the company uses cash to purchase inventory, cash is decreased and inventory is increased ; thus, assets as a whole remain unchanged and the equation remains in balance. Likewise, as the company receives payment from its customers, accounts receivable is credited and cash is debited. Double-entry accounting requires that every business transaction be marked in at least two financial accounts.

### What are the four basic accounting equations?

The four basic financial statements are the income statement, balance sheet, statement of cash flows, and statement of retained earnings.

To record capital contribution as stockholders invest in the business. To record capital contribution as the owners invest in the business. In this article, we will discuss why it is essential for you to reconcile your bank statements. GoCardless is used by over 60,000 businesses around the world.