1.

2The Basic Accounting Equation and the Expanded Accounting Equation

As we just learned from topic 1.1, the basic accounting is
Assets = Liabilities + Shareholders Equity

Here, assets represent resources available for the business. It can be physical or
non-physical; it can be cash or non-cash. Liabilities represent future obligations.
Or you can think of it as resources that we owe to debtholders. Shareholders
equity represent the remaining (residual).
Shareholders equity comes from two sources. One source is contribution
from and distribution to shareholders. Imagine that you have a bank account and
you deposit $1000 dollars (contribution) to that account on 1/1/2011 and
withdraw $200 from that account (distribution) the next day. Immediately after
the withdrawal, your bank account shows a balance of $800. If you consider that
bank account a business, then that $800 will be shareholders equity. The second
source of shareholders equity is the gain or loss from operation of the business.
Lets say, at the end of 2011, you check your bank account and find the balance
equal to $810, $10 of which is interest received. This $10, together with the $800,
is considered part of the shareholders equity.
It is difficult to measure shareholders equity without measuring liabilities
first. For example, if a business is subject to a contingent liability due to a lawsuit,
both the liabilities and shareholders equity depend on the final settlement. In
this case, the higher the liability is, the lower the shareholders equity is.
Therefore, a direct way to calculate shareholders equity is to calculate liabilities
first, and then subtract liabilities from total assets. That is the reason we say
shareholders equity is the residual.

When does this equation hold?

Many people would say, this equation holds unconditionally. But be careful
with that statement. To be more precise, this equation holds after income
statement accounts are closed into the equity account. So you see that on all
balance sheets, assets is equal to liabilities plus shareholders equity. That is
because the balance sheet is prepared after all income statement accounts are

closed. Lets go back to the previous example with the bank account. On
12/31/2011, the asset has a balance equal to $810. Before the income statement
accounts are closed, the $10 would be reflected in interest revenue instead of
shareholders equity. Therefore, the shareholders equity balance is $800, which
is not equal to total assets. After the $10 revenue is closed to shareholders
equity, the equity account will have a balance equal to $810. In other words, the
basic accounting equation wont hold until then.

The basic accounting equation also implies that

Change in assets = change in liabilities + change in shareholders equity
This is the foundation for preparing journal entries. Journal entries reflect changes
in specific accounts. For example, when I debit cash and credit revenue, I am
showing a change (increase) in the cash account. Meanwhile, the revenue
account will eventually be reflected as a change (increase) in shareholders equity.

With the above said, which equation will hold even before the income
statement accounts are closed? I will introduce the second important equation
the expanded accounting equation.
Assets = Liabilities + Shareholders Equity + Revenues Expenses
Dividends
Or

A = L + E + R- Exp D

Here we are using revenues and expenses to loosely refer to

increase/decrease in assets resulting from business operation. Sometimes we
make distinctions between revenues and gains or between expenses and
losses, but here we do not. Dividends is a type of redistribution to shareholders
(Some people would simply combine S and D, but here we dont). Revenues,
expenses and dividends will be closed to the equity account at the end of the
fiscal year. While revenues add to shareholders equity, dividends and expenses
will reduce shareholders equity.

This equation holds all the time. That is, before income statement accounts
are closed or after (in the latter case, R=Exp=D=0). You can watch the following
video to get a better understanding of the expanded accounting equation.
https://www.youtube.com/watch?v=ip5HLUmgFBg
Notice that in this video, D (dividends) is missing from the expanded
accounting equation, because she considers D as subtracted from E (or SHE)
instead of a separate account of itself.