The Accounting Equation
Assets = liabilities + equity, and how every transaction keeps it balanced.
Best in your head · no pen, no calculator why?
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the idea
Every business fits one line: assets = liabilities + equity. Assets are what the business owns, like cash, equipment and money customers owe it. Liabilities are what it owes, like loans and unpaid bills. Equity, or book equity, is what is left for the owners.
The two sides always stay equal. A loan adds cash and a debt of the same size. A cash sale adds cash and raises profit, which belongs to the owners, so equity rises. Buying equipment for cash swaps one asset for another.
Equity is a figure on paper. It is not the cash in the bank, and it is not what the business would sell for.
techniques
Rearrange the equation
- Missing assets: add liabilities and equity.
- Missing liabilities or equity: take the known one away from assets.
- Equity is negative when the debts are bigger than the assets.
worked example
A café has $40,000 of assets and $15,000 of equity. What are its liabilities?
- Liabilities = assets − equity.
- $40,000 − $15,000 = $25,000.
Answer: $25,000
Match every change
- Name the asset that went up or down.
- Then ask what matched it: a debt, the owners, or another asset.
- Borrowed money or work owed raises liabilities. Earnings and owner money raise equity; expenses and withdrawals lower it.
worked example
A bakery has $20,000 of assets and $8,000 of liabilities. A bank lends it $5,000 in cash. What is its equity now?
- Assets rise to $25,000; liabilities rise to $13,000.
- Equity: $25,000 − $13,000 = $12,000, the same as before.
Answer: $12,000
Roll equity forward
- Start with opening equity.
- Add what the owner put in and the net income, or subtract a net loss.
- Subtract what the owner took out, once.
worked example
Equity starts the year at $30,000. The owner invests $4,000, net income is $9,000, and the owner takes $6,000 in distributions. What is ending equity?
- $30,000 + $4,000 + $9,000 = $43,000.
- $43,000 − $6,000 = $37,000.
Answer: $37,000
watch out for
- Adding assets and liabilities to find equity. Equity is what is left after the debts, so subtract.
- Treating a loan as if it raised equity. Borrowed money is owed back, so liabilities rise.
- Adding distributions to equity, or taking them off twice as if they were also an expense.
practice
Find book equity
worked example
A business has $94,500 of assets and $64,000 of liabilities. What is its book equity? (Use a minus sign if negative.)
Answer: $30,500.00
- Assets = liabilities + equity, so equity = $94,500 − $64,000 = $30,500.
Solve for the missing piece
worked example
Assets are $31,500 and equity is $15,500. What are total liabilities?
Answer: $16,000.00
- Assets = liabilities + equity, so liabilities = $31,500 − $15,500 = $16,000.
Which way does the equation move?
worked example
A bank lends the business $14,800 in cash. What happens to the accounting equation?
- Assets up, equity up
- Assets down, equity down
- Assets down, liabilities down
- Assets up, liabilities up
Answer: Assets up, liabilities up
- Every transaction keeps assets = liabilities + equity.
- A loan raises cash and a debt of the same size, so nothing was earned.
Ending equity
worked example
Equity starts the year at $25,000. The owner invests $9,000, the business earns net income of $21,000, and the owner takes $15,000 in distributions. What is ending equity?
Answer: $40,000.00
- Ending equity = start + owner investment + net income − distributions
- = $25,000 + $9,000 + $21,000 − $15,000 = $40,000.