The Accounting Equation

Accounting is all about balance. Each time we engage in a transaction, there are at least two things that are happening. Usually, we give up something to receive something we need. For example, when you purchase supplies for school, you give up cash in order to get the supplies. When you take out a loan, you get cash today (or tuition or a car) by giving up the right to cash you will receive in the future so you can make your loan payments. Accounting principles work for individuals as well as businesses.

Note: As you progress through the course, think about transactions in your daily life and try to relate them to what you are doing in the course. Analyzing transactions in your own life will make the course easier to relate to and increase your understanding of the topic.

Because of this give and take, accounting is based on a double entry system. Whenever a transaction is recorded, at least two accounts must be effected. This allows us to remain in balance.

The accounting equation is the basis for all of accounting. The accounting equation states:

Assets = Liabilities + Equity

When recording transactions, the accounting equation must stay balanced.

Assets

An asset is something the business owns or has a right to, which can be used to generate future income. Examples of assets include cash, supplies, inventory, vehicles, machinery, equipment, and buildings. This is by no means an exhaustive list and you will spend most of any introductory financial accounting course studying assets.

Liabilities

A liability is an obligation that a business has to another person or entity. Typically, we think of liabilities as loans but there are many different types of liabilities a business can incur. For example, when the electric bill comes and the business has 30 days to pay it, that becomes a liability because the business used the electricity and is obligated to pay for it. If a business agrees to do work for a client and the client pays a deposit (puts money down) for work to be completed at a later date, the business has an obligation to complete the work or refund the money.

Equity

Equity is one of the most difficult concepts for most students to understand in accounting. Equity is the business’ worth to the owners. Let’s rearrange the accounting equation:

Assets – Liabilities = Equity

Now the equation tells us that what we own less what we owe others is equity. This is the value of the business to the owners, also called a business’s net worth. Equity has two main components: contributed capital and retained earnings.

Contributed capital is the value that the owners have contributed to the business. If you started a business tomorrow and put $1,000 cash plus a computer worth $500, the contributed capital in the business would be $1,500 because that is the amount the owner (you) have contributed.

Retained earnings is the amount of profit (earnings) the business has kept (retained) over the years. How is profit generated? When a business sells a product or service, the business generates revenue. When a business incurs costs associated with providing the product or service, the business generates an expense.

Revenue – Expenses = Profit

Once profits are generated the business can either keep those profits within the company to grow the business or protect against future downturns. The business can also choose to pay those profits out to the owners in the form of dividends or distributions. The profits that the business keeps are added to retained earnings.

Using the accounting equation to stay in balance

Let’s go back to the example we used above for contributed capital. You start a business by contributing $1,000 cash and a computer worth $500. Think about the exchange that is happening here. What is the business receiving? $1,000 cash and a computer. What are these? They are assets. The business is receiving $1,500 worth of assets. What is the business giving in exchange for these assets? It is giving you (the owner) $1,500 worth of capital (ownership) in the business. This value is considered contributed capital.

Our accounting equation is in balance. The business currently has $1,500 worth of assets and $1,500 worth of equity. There are currently no liabilities.

Let’s look at another transaction. The business takes out a loan for $10,000 to provide cash to purchase equipment and start operations. What is the business receiving? $10,000 cash. What is the business exchanging for that cash? The business is giving the bank a promise to pay in the future with assets generated from operations. This is a liability. A loan from the bank is more specifically called a note payable. Let’s add this to our existing balances.

The business now has $11,500 in assets, $10,000 in liabilities and $1,500 in equity. The equation still balances.

Let’s look at one more transaction. The business purchases a piece of equipment for $4,000 cash. Analyze the transaction to see what the business is receiving and exchanging. The business is receiving a piece of equipment worth $4,000 in exchange for $4,000 cash. Notice that both of these items are assets, therefore, we have one asset increasing and other decreasing.

*In accounting, a number in parenthesis indicates a negative number or a number that should be subtracted from the numbers around it. You will see this notation frequently.

Notice that the balances in our equation did not change. What did change was the makeup of the assets held by the business. In this part of the course, it is important to understand that the equation must be in balance at all times. As we progress through the course, we will look in greater detail at the individual accounts that make up total assets, liabilities, and equity.

You will also notice that we have not yet dealt with revenue or expenses. Let’s look at the effect those transactions will have on the equation. The business does $1,000 worth of work for a client and gets paid when the work is complete. Again, analyze the transaction and determine how the accounting equation will be affected. The business got paid. What does that mean? The business received cash. It does not matter if the business was paid by check, credit card or cash; the payment will end up in the business bank account and the cash can be spent to generate future revenue. Why did the business receive cash? Because it provided a service for a client. Providing goods or services for a customer is called revenue. You will see many different titles for revenue accounts. Because this revenue was generated because a service was provided, you might call it service revenue or fees earned. As you progress through the course, learn the terminology used in your course but also make sure to realize that other terminology can be used.

Let’s add this transaction to the equation. Clearly, an asset (cash) is increasing. How does the revenue effect the equation? We stated previously that profit increases equity. Profit is revenue less expenses, which means revenue increases profit and expenses decrease profit. Another way to look at the problem is to ask yourself if the revenue is increasing or decreasing the value of the business. Revenue coming in is good for the business and helps to increase its value. Therefore, revenue increases equity.

Still in balance! One more transaction to complete the lesson. We have looked at all the accounts except expenses. An expense is a cost of generating revenue. If the business rents an office, the cost of that office is an expense. How would we record the following transaction?

The business pays $400 cash for the current month’s office rent.

Analyze the transaction to determine the exchange. The business receives use of the office in exchange for $400 cash.

In this case, both sides of the equation decrease. An expense decreases equity because we are using up resources in the business which decreases the value of the business.

You’ll notice that we used three categories here because the accounting equation only has three: assets, liabilities, and equity. I tell my students to think as if there are five categories, the three above, plus revenue and expenses. Revenue makes equity go up and expenses make equity go down. As we start to discuss journal entries, it is important to think of revenue and expenses as separate categories.