The accounting equation
Every business can be described by one equation:
Assets = Liabilities + Equity
- Assets are resources the business owns (cash, receivables, inventory, equipment).
- Liabilities are what it owes to outsiders (accounts payable, loans).
- Equity is the owners' claim: what is left of the assets after liabilities are paid. Equity grows with owner investments and revenue, and shrinks with expenses and owner withdrawals or dividends.
The equation must balance after every transaction. That is the basis of double-entry bookkeeping: every transaction touches at least two accounts.
How transactions change the equation
- Owner invests $20,000 cash: assets +20,000, equity +20,000.
- Buy supplies for cash: one asset rises, another falls; total assets unchanged.
- Borrow $10,000 from a bank: assets +10,000, liabilities +10,000.
- Earn $3,000 of fees: assets +3,000 (cash or receivable), equity +3,000 through revenue.
- Pay $1,200 of rent: assets −1,200, equity −1,200 through an expense.
The four financial statements
- Income statement: revenues minus expenses over a period gives net income (or loss).
- Statement of changes in equity (retained earnings): beginning equity + net income − withdrawals/dividends = ending equity.
- Balance sheet: assets, liabilities and equity at a point in time.
- Statement of cash flows: cash in and out, grouped as operating, investing and financing.
They link: net income flows from the income statement into equity, and ending equity goes onto the balance sheet.
Basic principles
- Business entity: the firm's records are kept separate from its owner's personal finances.
- Revenue recognition: record revenue when it is earned, not necessarily when cash is received.
- Matching: record expenses in the same period as the revenue they helped earn.
- Going concern: assume the business will continue operating.
- Historical cost: record assets at what was paid.
Worked example
Maria starts a design firm. In its first month:
- She invests $20,000 cash.
- The firm borrows $5,000 from the bank.
- It buys $8,000 of equipment for cash.
- It earns $12,000 in fees, all in cash.
- It pays $7,000 of expenses.
- Maria withdraws $1,000.
Net income = 12,000 − 7,000 = 5,000.
Equity = 20,000 + 5,000 − 1,000 = 24,000.
Assets: cash = 20,000 + 5,000 − 8,000 + 12,000 − 7,000 − 1,000 = 21,000, plus equipment 8,000, so total assets = 29,000.
Check: liabilities (5,000) + equity (24,000) = 29,000. ✓ The equation balances.
Common mistakes
- Treating owner withdrawals as an expense. They reduce equity but do not appear on the income statement.
- Confusing cash received with revenue earned.
- Mixing up the balance sheet (a date) with the income statement (a period).