Equity is a residual, but it has moving parts. Owners' claims grow two ways and shrink two ways:
| Equity grows when… | Equity shrinks when… |
|---|---|
| Owners put money in (share capital / contributed capital) | Owners take money out (dividends / drawings) |
| The business earns profit (revenues exceed expenses) | The business loses money (expenses exceed revenues) |
Expanded accounting equation formula
Splitting equity into its parts gives the expanded accounting equation:
Assets = Liabilities + Share Capital + Retained Earnings
where retained earnings is itself a running total:
Retained Earnings (end) = Retained Earnings (start) + Revenues − Expenses − Dividends
Substitute and you get the fully expanded form. You'll use this line more than any other all week:
Assets = Liabilities + Share Capital + Retained Earnings (start) + Revenues − Expenses − Dividends
Three things in it are worth sitting with until they feel obvious.
- Revenue is a reason equity grew. It isn't an asset. When Meera sells cardamom for ₹1,40,000 on credit, her assets grow because a receivable appears. At the same moment the owners' claim grows by the same amount, since no outsider has a claim on that new asset. Revenue is the label for equity growth earned through operations, and an expense is the label for equity shrinkage incurred in operations. People sometimes call the income statement "a magnifying glass held over the retained-earnings line for one period," and now you can see why.
- Dividends are not an expense. An expense is a cost of earning revenue, such as salaries, rent or cardamom. A dividend is a distribution of the winnings to owners. It appears nowhere on the income statement and reduces retained earnings directly. A company with huge dividends and a company with none can have identical profits.
- Retained earnings is not cash. It's the cumulative history of profits kept in the business, and those profits were long ago reinvested into inventory, machines and acquisitions. Infosys's reserves aren't sitting in a vault. They're campuses and receivables. You'd be amazed how many working professionals believe a company with ₹50,000 crore of reserves can "spend its reserves." It can only spend assets.
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Worked example: four transactions
Every transaction preserves the equation. Watch four:
| Transaction | Assets | = | Liabilities | + Equity |
|---|---|---|---|---|
| Owner invests ₹10,00,000 cash | +10,00,000 (cash) | — | +10,00,000 (share capital) | |
| Buy ₹5,00,000 inventory on credit | +5,00,000 (inventory) | +5,00,000 (payable) | — | |
| Pay supplier ₹3,00,000 | −3,00,000 (cash) | −3,00,000 (payable) | — | |
| Sell goods costing ₹1,50,000 for ₹2,40,000 cash | +2,40,000 (cash) −1,50,000 (inventory) | — | +2,40,000 (revenue) −1,50,000 (expense) → net +90,000 |
Some transactions move only the left side: buy equipment for cash, and one asset goes up while another goes down. Some move both sides. None ever unbalance it.
If your books don't balance, you have made an arithmetic error. The world hasn't.