The accounting equation and business transactions

Every accounting system rests on one simple equation. A business has resources, called assets, and every asset was provided by someone: either by creditors, who expect to be repaid, or by owners, who have a residual claim on whatever is left. So at every moment, assets equal liabilities plus equity. This lesson defines each element, shows how ordinary business transactions change the equation while keeping it in balance, and introduces revenues, expenses and dividends as the parts of equity that change through operations. By the end you will be able to analyse a month of transactions for a small business and produce a simple balance sheet from the result.

Assets

An asset is a resource controlled by the business as a result of past events, from which future economic benefits are expected. In plain terms, assets are things the business owns or controls that will help it earn money or that can be turned into cash. Cash is the most obvious asset. Accounts receivable are amounts customers owe for goods or services already provided. Inventory is goods held for sale. Prepaid expenses, such as insurance paid in advance, are assets because the business has paid for benefits it has not yet used. Equipment, vehicles, buildings and land are long-lived assets used in operations. Intangible assets such as patents, trademarks and software licences have no physical form but still provide future benefits.

Note what is not an asset. A loyal customer base, a talented team or a good reputation may be valuable, but they are not controlled through a past transaction and cannot be measured reliably, so they do not appear on the balance sheet unless they were purchased as part of buying another business. This is one reason a company's market value often differs from the total equity on its balance sheet.

Liabilities

A liability is a present obligation of the business to transfer economic resources as a result of past events. Accounts payable are amounts owed to suppliers for goods or services bought on credit. Wages payable are amounts earned by employees but not yet paid. Notes payable and loans payable are formal borrowings, usually with interest. Unearned revenue, sometimes called deferred revenue or contract liabilities, arises when a customer pays in advance: the business owes the customer goods or services, or a refund. Sales taxes collected from customers and not yet sent to the government are also liabilities, as lesson 8 explains.

Equity

Equity is the owners' residual interest in the assets after deducting liabilities. For a corporation, equity has two main parts. Share capital (often called common shares) records what shareholders paid the corporation for its shares. Retained earnings record the profits the corporation has earned over its life, less the dividends it has paid to shareholders. For a sole proprietorship, equity is a single owner's capital account, increased by the owner's investments and the business's profits and decreased by losses and by the owner's withdrawals, called drawings.

Retained earnings change through operations, and it helps to break the change into parts. Revenues are increases in equity from delivering goods or services to customers: sales revenue, service revenue, rent revenue, interest revenue. Expenses are decreases in equity from the costs of earning revenue: wages, rent, utilities, advertising, the cost of goods sold, depreciation. Dividends are distributions of profits to owners; they reduce retained earnings but are not expenses, because they are not a cost of earning revenue. Putting it together gives the expanded accounting equation.

Here 'share capital' plus 'revenues minus expenses minus dividends' (accumulated over the business's life, starting from opening retained earnings) is total equity. When revenues exceed expenses for a period, the result is net income, also called profit; when expenses exceed revenues, the result is a net loss.

What counts as a transaction

An accounting transaction is an event that changes the financial position of the business and can be measured reliably in money. Buying supplies, selling a bicycle, paying wages and borrowing from a bank are transactions. Signing a contract to buy equipment next month, receiving a purchase order from a customer, or hiring an employee who starts next week are not yet transactions, because nothing has been exchanged; they may be important, and some must be disclosed, but they do not change the equation today. Each transaction is supported by a source document such as an invoice, receipt, bank statement, contract or payroll record, which provides evidence of what happened and the amount.

Every transaction affects at least two items in the equation. If one asset increases, either another asset decreases, a liability or equity increases, or both. This dual effect is the foundation of double-entry bookkeeping in lesson 3. Before learning debits and credits, it is useful to analyse transactions directly in the equation, writing a plus or minus under each element.

Analysing a month of transactions

Birchwood Bikes Inc. is a small corporation that sells and repairs bicycles in Guelph, Ontario. Its owner, Maya Okafor, incorporated the business on 1 May. The transactions for May are below. To keep the focus on the equation, sales taxes are ignored until lesson 8.

Work through them one at a time. Transaction 1 increases cash (an asset) by $40,000 and share capital (equity) by $40,000. Transaction 2 increases cash by $20,000 and notes payable (a liability) by $20,000. Transaction 3 exchanges one asset for another: equipment rises by $18,000 and cash falls by $18,000, with no change in the totals. Transaction 4 is similar: prepaid insurance, an asset, rises by $3,600 and cash falls by $3,600. The insurance is not an expense yet, because the benefit covers the next 12 months; lesson 5 shows how one month is moved to expense at month end.

Transaction 5 increases supplies (an asset) and accounts payable (a liability) by $1,500. Transaction 6 increases cash and service revenue by $4,200; revenue increases equity because the business has earned it by doing the work. Transaction 7 also earns $2,800 of revenue, but the customer has not paid, so the asset that increases is accounts receivable. Transaction 8 decreases cash and accounts payable by $1,000. Transaction 9 exchanges one asset for another: cash up $1,800, accounts receivable down $1,800. Collecting a receivable is not revenue; the revenue was recorded when the work was done in transaction 7.

Transaction 10 decreases cash by $5,100 and records rent expense of $2,000 and wages expense of $3,100, each reducing equity. Transaction 11 records an expense even though no cash has been paid: the shop used the electricity in May, so utilities expense increases by $350 and accounts payable (or utilities payable) increases by $350. Transaction 12 reduces cash and retained earnings by $500. The dividend is not an expense; it is a distribution of profits.

# Transaction analysis for Birchwood Bikes, May (illustrative)
cols = ["Cash", "A/R", "Supplies", "Prepaid", "Equipment",
        "A/P", "Note", "ShareCap", "Revenue", "Expenses", "Dividends"]
tx = [
    (1,  {"Cash": 40000, "ShareCap": 40000}),
    (2,  {"Cash": 20000, "Note": 20000}),
    (3,  {"Cash": -18000, "Equipment": 18000}),
    (4,  {"Cash": -3600, "Prepaid": 3600}),
    (5,  {"Supplies": 1500, "A/P": 1500}),
    (6,  {"Cash": 4200, "Revenue": 4200}),
    (7,  {"A/R": 2800, "Revenue": 2800}),
    (8,  {"Cash": -1000, "A/P": -1000}),
    (9,  {"Cash": 1800, "A/R": -1800}),
    (10, {"Cash": -5100, "Expenses": 5100}),
    (11, {"A/P": 350, "Expenses": 350}),
    (12, {"Cash": -500, "Dividends": 500}),
]
bal = dict.fromkeys(cols, 0)
for n, eff in tx:
    for k, v in eff.items():
        bal[k] += v
    assets = sum(bal[c] for c in cols[:5])
    claims = (bal["A/P"] + bal["Note"] + bal["ShareCap"]
              + bal["Revenue"] - bal["Expenses"] - bal["Dividends"])
    assert assets == claims, n
for c in cols:
    print(f"{c:<10}{bal[c]:>9,}")
assets = sum(bal[c] for c in cols[:5])
print(f"Total assets {assets:,}; liabilities + equity {claims:,}")

Cash         37,800
A/R           1,000
Supplies      1,500
Prepaid       3,600
Equipment    18,000
A/P             850
Note         20,000
ShareCap     40,000
Revenue       7,000
Expenses      5,450
Dividends       500
Total assets 61,900; liabilities + equity 61,900

The program applies each transaction and checks after every one that assets still equal liabilities plus equity. At the end of May, total assets are $61,900, and the claims on them are the same: $20,850 of liabilities and $41,050 of equity. If any transaction had been entered with only one side, the check would fail at that line, which is exactly how accountants locate many errors.

From the equation to the statements

The ending balances produce simple financial statements. Revenue for May was $4,200 + $2,800 = $7,000, and expenses were $2,000 + $3,100 + $350 = $5,450, so net income was $1,550. Retained earnings started at zero, increased by net income of $1,550 and decreased by the $500 dividend, ending at $1,050. The balance sheet then lists the assets, the liabilities, and equity made up of share capital and retained earnings.

It is worth tying the statements back to the analysis. Cash is 40,000 + 20,000 − 18,000 − 3,600 + 4,200 − 1,000 + 1,800 − 5,100 − 500 = $37,800, matching the program. Accounts payable is 1,500 − 1,000 + 350 = $850. Total liabilities are therefore $20,850 and total equity is $40,000 + $1,050 = $41,050, giving $61,900, the same as total assets. Recomputing a key figure two different ways is a habit worth building; it catches slips that a single calculation hides.

Errors the equation cannot catch

The equation guarantees that every transaction is recorded with equal effects on both sides, but it cannot guarantee that the right accounts were used or that the amounts are correct. If the $2,000 rent payment were recorded as a purchase of equipment, the equation would still balance, but assets would be overstated by $2,000 and expenses understated by $2,000, so net income would look $2,000 better than it really was. If a $4,200 sale were recorded as $2,400 on both sides, the equation would balance but revenue and cash would both be wrong. Lesson 4 discusses errors that a trial balance does and does not reveal, and lesson 10 covers internal controls that reduce them.