The accounting equation: assets, liabilities and equity
The accounting equation: assets, liabilities and equity
All the accounting of a business, however complex it may look, rests on a single formula: assets are equal to liabilities plus equity. That equality is called the accounting equation, and it is the foundation on which the recording of every transaction is built. Whoever understands this equation understands why every purchase, every sale and every payment is written down, and why the numbers of a business always end up in balance.
The idea behind it is simple. Everything a business has comes from two sources: what was lent to it or sold to it on credit, which is the liability, and what belongs to the owner, which is the equity. If you add up everything the business has and subtract what it owes, the result is exactly what the business is worth to its owner. That is why the equation is written Assets = Liabilities + Equity, and why it must always hold true, from the first day of operations to the last.
What is an asset
An asset is any good or right that the business owns and from which it expects to obtain a future benefit. In plain words, it is what the business has: the cash on hand, what customers owe, the merchandise on the shelves and even the counter of the shop. For something to count as an asset it is not enough for it to exist physically; it must represent value that the business can use or turn into money.
The most common assets of a commercial business are:
- Cash and bank accounts: the money in the drawer, in the cash register or deposited in the business account.
- Accounts receivable: the money that customers owe for purchases made on credit and that the business has the right to collect.
- Inventory or merchandise: the products bought to be sold, either in the warehouse or on the counter.
- Furniture and fixtures: desks, shelves, display cases, counters, the cash register and the other equipment the business works with.
Notice the detail: every asset is a good or a right. Cash is a good; an account receivable is a right; merchandise is a good expected to be sold; furniture is a good used to run the operation. In every case the business holds something of value that it will be able to use later on.
Why inventory is an asset
One question always comes up in the first days of an accounting course: why is the merchandise bought for resale an asset if the business already paid for it? The answer lies in the intention behind the purchase. Inventory is acquired in order to be sold; the business expects to recover its cost and, on top of that, earn a profit when the customer pays. That is why it is an asset and not an expense.
When a business buys merchandise, the money leaves the cash box, but it does not disappear: it becomes products ready for sale. The value stays inside the business; it only changed its form. Only when the merchandise is sold does it stop being inventory and become the cost of goods sold, which is compared with the revenue of the sale to measure the profit. In the meantime, while the products wait on the shelf, they remain an asset that appears in the equation.
What is a liability
A liability is a present obligation of the business: a debt that must be paid with money, with goods or with services. Liabilities are born when the business receives something today in exchange for the promise of paying for it later. They are an external source of resources: someone else, a supplier or a bank, is financing part of the operation.
The most frequent liabilities of a commercial business are:
- Accounts payable to suppliers: merchandise already received but not yet paid for, because it was bought on credit.
- Loans payable: money that a bank or an individual lent to the business and that must be returned within the agreed terms.
- Taxes payable: the levies that the business must remit to the government because of its sales or its activity.
The difference between a liability and equity is who has a claim on what the business owns. A liability belongs to outsiders: if the business were liquidated, those debts would be paid first. Equity, on the other hand, belongs to the owner: it is what remains after covering all the obligations.
What is equity
Equity is the interest of the owner in the business. It is built from two ingredients: the capital the owner contributed to start or strengthen the company, and the profits the business has earned and has not withdrawn. If the business loses money, or the owner withdraws part of the earnings, equity goes down; if the business earns and leaves the profits inside, equity grows.
Think of equity as the slice of the pie that belongs to the owner once everyone else has been paid. When opening a business, the owner delivers cash or other goods: that contribution is his or her capital. Over time, if sales exceed costs and expenses, the difference piles up and increases equity. That growth is not free money: it is the reward for having risked capital and for managing the business well.
Every account belongs to one side of the equation
To work with the equation in practice, businesses use accounts. An account is the name that groups transactions of the same kind: cash groups all the money on hand, and suppliers groups all the debts from credit purchases. Every account belongs to one of the three groups of the equation and, depending on the group, it behaves in a characteristic way. The following table classifies the typical accounts of a commercial business:
| Account | Type | Example in a business |
|---|---|---|
| Cash | Asset | The money in the drawer and in the cash register. |
| Accounts receivable | Asset | A credit sale that the customer will pay in fifteen days. |
| Inventory (merchandise) | Asset | The products that are on the shelf waiting to be sold. |
| Furniture and fixtures | Asset | The counter, the shelves and the display case of the store. |
| Accounts payable | Liability | Merchandise received that will be paid next week. |
| Loan payable | Liability | The credit granted by the bank to buy the store. |
| Owner's capital | Equity | The initial contribution with which the business was opened. |
The equation always balances
Now comes the most important part of the lesson: the accounting equation is not an ideal that the business should try to get close to; it is an equality that is satisfied after every single transaction. The reason is that every transaction touches at least two items at the same time, and those two effects offset each other in a way that keeps the equality alive. Let us see it with a commercial business that buys and sells merchandise.
Suppose a grocery store starts with nothing and buys merchandise on credit for 1,000. What happens to the equation? Inventory, an asset, goes up by 1,000 because the store now has products to sell. At the same time, the debt to the supplier, a liability, also goes up by 1,000 because the store must pay for that merchandise. Both sides of the equality grow by the same amount: Assets = Liabilities + Equity becomes 1,000 = 1,000 + 0. The equation balances.
Now the store sells all that merchandise for cash. Suppose the merchandise cost 1,000 and is sold for 1,500. Cash, an asset, goes up by 1,500 because the money from the sale comes in. Inventory, another asset, goes down by 1,000 because the products left the shelf. Net assets increased by 500. Where did that 500 come from? From the profit of the sale, and the profit belongs to the owner: equity goes up by 500. The equation now reads 1,500 = 1,000 + 500. It balances again.
Notice what happened: the sale did not only move cash and inventory; it also revealed a profit that increased equity. Accounting records all three effects and, because of that, the equation never goes out of balance. It is not magic: it is because every operation is always analyzed on its two sides.
A complete numerical example
To fix the idea once and for all, let us build the complete picture of a commercial business with several items. Maria opens a grocery store contributing 10,000 of her own money, which is her equity. Then she carries out three operations: she buys the counter and the shelves for 1,200 in cash; she buys merchandise for 4,000, of which 2,500 are paid in cash and 1,500 remain on credit with the supplier; and she takes a bank loan of 2,000 to have more working capital. After those operations, the business looks like this:
| Item | Assets | Liabilities | Equity |
|---|---|---|---|
| Cash | 8,300 | – | – |
| Inventory (merchandise) | 4,000 | – | – |
| Furniture and fixtures | 1,200 | – | – |
| Accounts payable | – | 1,500 | – |
| Loan payable | – | 2,000 | – |
| Owner's capital | – | – | 10,000 |
| Totals | 13,500 | 3,500 | 10,000 |
Check the equality: assets add up to 13,500, made of cash for 8,300, inventory for 4,000 and furniture for 1,200; liabilities add up to 3,500; and equity is 10,000. And 13,500 = 3,500 + 10,000. The equation holds. Notice as well that equity did not change because of the purchases or the loan: buying with cash only changed the form of the asset, and the credit and the loan created liabilities that offset the assets they financed.
What happens to the equation in three transactions
With that starting point, let us see what happens to the equation while the business operates during the day. We record three typical transactions: an additional credit purchase of merchandise, a cash sale with a profit and a partial payment to the supplier. The table shows the effect of each one on total assets and on the sum of liabilities plus equity:
| Transaction | Effect on assets | Effect on liabilities and equity | Result |
|---|---|---|---|
| Credit purchase of merchandise for 600 | Inventory +600; assets go from 13,500 to 14,100 | Accounts payable +600; liabilities go from 3,500 to 4,100 | Assets 14,100 = Liabilities 4,100 + Equity 10,000 |
| Cash sale with profit: cost 900, price 1,400 | Cash +1,400 and inventory −900; assets go from 14,100 to 14,600 | Profit +500; equity goes from 10,000 to 10,500 | Assets 14,600 = Liabilities 4,100 + Equity 10,500 |
| Payment to the supplier of 800 | Cash −800; assets go from 14,600 to 13,800 | Accounts payable −800; liabilities go from 4,100 to 3,300 | Assets 13,800 = Liabilities 3,300 + Equity 10,500 |
Look at the last column: in the three transactions total assets are exactly equal to the sum of liabilities and equity. The first transaction enlarged both sides equally; the second changed the mix of assets, with less inventory and more cash, and created profit, which is equity; the third reduced an asset and a liability at the same time. At no moment was the equality broken.
That is the beauty of the accounting equation: it does not need to be forced or adjusted. If every transaction is recorded properly, the balance appears on its own. When the numbers of a business do not balance, the cause is never that the equation stopped holding; it is that some transaction was recorded wrongly, omitted or miscalculated.
That is why every transaction is recorded twice
Here is the gateway to the rest of the course. If every transaction moves at least two items of the equation, then every transaction needs at least two entries: one that reflects an effect and another that reflects the opposite or complementary effect. That principle is called double entry, and it is the heart of accounting.
When the store bought merchandise on credit, it was not enough to note that products came in; the debt to the supplier also had to be noted. When it sold for cash, it was not enough to note the money coming in; the merchandise had to be removed from inventory and the profit had to be recognized. In the next lesson of the Kardex Tauro accounting course we will see how that double record is made with debits and credits, and how the journal is born from it. Before moving on, make sure you master the accounting equation: assets, liabilities and equity. Everything that follows, from double entry to the financial statements, is just a consequence of this equality.