Accounting is built upon one fundamental rule known as the accounting equation:
Assets = Liabilities + Owner’s Equity
This equation must remain in balance at all times. For this reason, our modern accounting system is called a dual-entry system. This means that every transaction recorded in your accounting records must have at least two entries; if it only had one, the equation would immediately become unbalanced.
Understanding the Three Pillars
The equation’s three parts are defined as follows:
- Assets: What the business has or owns (e.g., equipment, supplies, cash, accounts receivable).
- Liabilities: What the business owes to outsiders (e.g., bank loans, accounts payable).
- Owner’s Equity: What the owner owns (e.g., initial investment and business profit).
From the equation, we can see that what the business owns (Assets) always equals what it owes to both creditors (Liabilities) and the owners (Equity).
- The business owes creditors for loans made and obligations to pay for goods or services.
- The business owes the owner for any money or assets the owner invests in the business.
- The business also owes the owner the profit realized from business operations.
Alternative Expressions of the Equation: If you know any two of the amounts, you can always calculate the third:
- Assets = Liabilities + Owners’ Equity
- Liabilities = Assets – Owners’ Equity
- Owners’ Equity = Assets – Liabilities
How Business Transactions Affect the Equation
Business transactions occur on a daily basis. Items are purchased or sold, credit is extended or borrowed, income is made, or expenses are assumed. These transactions result in changes to the elements of the basic accounting equation.
To keep the equation balanced, the following rules apply:
- A transaction that increases total assets must also increase total liabilities or owner’s equity.
- A transaction that decreases total assets must also decrease total liabilities or owner’s equity.
- Some transactions may increase one account and decrease another on the same side of the equation (e.g., one asset increases while another asset decreases, resulting in no net change to total assets).
Regardless of the nature of the specific transaction, the accounting equation must stay in balance.
Basic Transaction Analysis: Examples
Transaction Analysis is the process of reconciling the differences made to each side of the equation when a financial transaction occurs. Let’s look at some sample transactions for a brand new company.
Starting Balance:
Assets ($0) = Liabilities ($0) + Owner’s Equity ($0)
Transaction 1: The owner deposits $5,000 in the checking account to begin operations.
- Impact: The asset “Cash” increases by $5,000, and Owner’s Equity increases by $5,000. (The business now owes the owner $5,000).
- Equation: Assets (+$5,000) = Liabilities ($0) + Owner’s Equity (+$5,000)
Transaction 2: The business purchases a computer, on credit, for $2,500.
- Impact: The asset “Computers” increases by $2,500, and the liability “Accounts Payable” increases by $2,500 because the business now owes the store money.
- Equation: Assets (+$2,500) = Liabilities (+$2,500) + Owner’s Equity ($0)
Transaction 3: The business purchases office supplies using $550 cash.
- Impact: The asset “Office Supplies” increases by $550, and the asset “Cash” decreases by $550. Both changes happen on the Assets side.
- Equation: Assets (+$550 and -$550) = Liabilities ($0) + Owner’s Equity ($0)
Transaction 4: A business purchases a building for $100,000 with a $25,000 cash down payment and a bank loan for the remaining $75,000.
- Impact: More than two accounts are affected here. The asset “Building” increases by $100,000, the asset “Cash” decreases by $25,000, and the liability “Bank Loan” increases by $75,000. The net result is that both sides of the equation increase by $75,000.
- Equation: Assets (+$100,000 and -$25,000) = Liabilities (+$75,000) + Owner’s Equity ($0)
The Expanded Accounting Equation
The Expanded Accounting Equation breaks the Owner’s Equity section out into additional components: Revenues, Expenses, and Drawings/Dividends.
- Revenues: What the business earns for providing goods or services. (Increases Equity)
- Expenses: The cost of assets the business uses to generate revenues (e.g., payroll, rent, utilities, taxes). (Decreases Equity)
- Drawings / Dividends: Equity withdrawn by the owner for personal use. (Decreases Equity)
The business’s Profit or Loss equals Revenues – Expenses. If Revenues are higher, there is a Profit. If Expenses are higher, there is a Loss.
The Expanded Equation:
Assets = Liabilities + Owner’s Equity + Revenues – Expenses – Drawings
Expanded Transaction Analysis: Examples
Transaction 5: The business sells goods for $1,200 cash.
- Impact: The asset “Cash” increases by $1,200, and Revenue increases Owner’s Equity by $1,200.
- Equation: Assets (+$1,200) = Liabilities ($0) + Owner’s Equity (+$1,200)
Transaction 6: The business pays its monthly rent of $950 using a company check.
- Impact: The asset “Cash” decreases by $950, and the rent Expense decreases Owner’s Equity by $950.
- Equation: Assets (-$950) = Liabilities ($0) + Owner’s Equity (-$950)
Transaction 7: The business owner withdraws $2,000 for personal use.
- Impact: The asset “Cash” decreases by $2,000, and the Drawing decreases Owner’s Equity by $2,000.
- Equation: Assets (-$2,000) = Liabilities ($0) + Owner’s Equity (-$2,000)
Summary
The accounting cycle is the sequence of procedures used to keep track of what has happened in the business and to report the financial effect of those events. Financial reports will only make sense if the accounts have been analyzed correctly and the accounting equation remains balanced. This is the fundamental building block of accounting, and mastering transaction analysis is your essential first step.
