The Accounting Equation: Assets, Liabilities and Equity, with Examples

What you'll learn

The accounting equation: Assets = Liabilities + Owner's Equity.
How to classify assets and liabilities as current or long-term.
How revenue, expenses and owner's draws change equity.
How to analyze any transaction with three questions, using Brightside Coffee's first month.

All of accounting rests on one formula with three parts. Once you understand it, you'll know why a balance sheet always "balances," and you'll be able to analyze any transaction without memorizing rules. It's called the accounting equation:

ASSETS = LIABILITIES + OWNER'S EQUITY

The three elements

Assets

Resources the business owns or controls that should bring future benefits: cash, accounts receivable (money customers owe you), inventory, equipment, vehicles, buildings, software.

Think: what the money is invested in.

Liabilities

What the business owes to outsiders: accounts payable to suppliers, bank loans, credit card balances, wages payable, sales tax collected but not yet sent to the state.

Think: money that came from creditors.

Owner's equity

The owners' claim on the business: what they invested plus profits kept in the business, minus losses and minus what they took out. A corporation calls it stockholders' equity.

Think: money that came from the owners.

Another way to read the equation

The left side shows where the money is invested. The right side shows where it came from: creditors (liabilities) or owners (equity). Every resource has a source, so both sides are always equal. That's not a coincidence or a rule someone invented; it's arithmetic.

Rearrange the formula and you get the version investors and lenders care about most:

OWNER'S EQUITY = ASSETS − LIABILITIES

In other words, what truly belongs to the owners is what's left after every debt is paid. This is also called net assets or book value, and it's the business version of personal net worth.

1. A landscaping company has assets of $85,000 and liabilities of $30,000. What is its owner's equity?

$115,000
$30,000
$55,000

Assets = Liabilities + Equity, so Equity = $85,000 − $30,000 = $55,000.

Current vs. long-term

Knowing how much a business owns and owes isn't enough; when matters too. A bank wants to know whether the bills due next month can be paid with assets that turn into cash soon. That's why both sides are split by time horizon, usually one year:

	Current (within 12 months)	Long-term or noncurrent (beyond 12 months)
Assets	Cash, accounts receivable, inventory, prepaid expenses such as insurance paid in advance.	Equipment, furniture, vehicles, buildings, land, software and other intangibles.
Liabilities	Accounts payable, wages payable, sales tax payable, credit card balances, the principal on a loan due within the next year.	The rest of a loan's principal, a mortgage, a multiyear equipment note.

2. An invoice from a coffee bean supplier, due in 30 days, is…

A current asset
A current liability
A long-term liability

It's money owed to an outsider (a liability) and it's due within a year (current). It's recorded as accounts payable.

The equation never breaks: Brightside's first transactions

Let's run Brightside Coffee's opening transactions from lesson 1 through the equation. After each one, both sides still match.

Transaction	Effect	Assets	=	Liabilities	+	Equity
1. Maya invests $40,000	+ Cash / + Owner's capital	$40,000	=	$0	+	$40,000
2. Espresso machine, $12,000 cash	+ Equipment / − Cash	$40,000	=	$0	+	$40,000
3. Supplies on account, $6,000	+ Inventory / + Accounts payable	$46,000	=	$6,000	+	$40,000
4. Bank loan, $10,000	+ Cash / + Notes payable	$56,000	=	$16,000	+	$40,000

Look at transaction 2: total assets didn't change. Only their mix did, with less cash and more equipment. That's an asset swap, and it creates no profit or loss. Buying a $12,000 espresso machine doesn't make Brightside poorer; it changes the form of its wealth.

What about revenue and expenses?

Revenue and expenses also move the equation, but indirectly: they change equity. Revenue increases what belongs to the owner; expenses reduce it. Owner's draws (money the owner takes out) also reduce equity, though they aren't expenses. The expanded equation looks like this:

ASSETS = LIABILITIES + OWNER'S CAPITAL − OWNER'S DRAWS + REVENUE − EXPENSES

Let's continue with Brightside's month:

Transaction	Effect	Assets	=	Liabilities	+	Equity
Balance so far		$56,000	=	$16,000	+	$40,000
5. Sales, $18,000	+ Cash / + Revenue	$74,000	=	$16,000	+	$58,000
6. Rent, $3,500	− Cash / + Expense	$70,500	=	$16,000	+	$54,500
7. Wages, $7,000	− Cash / + Expense	$63,500	=	$16,000	+	$47,500
8. Supplies used, $5,000	− Inventory / + Expense (cost of goods sold)	$58,500	=	$16,000	+	$42,500

Here's how Brightside's total assets moved, transaction by transaction:

1. Investment$40,000

2. Espresso machine$40,000

3. Supplies on account$46,000

4. Bank loan$56,000

5. Sales$74,000

6. Rent$70,500

7. Wages$63,500

8. Supplies used$58,500

At month-end, equity went from $40,000 to $42,500: the business earned $2,500. That's exactly revenue ($18,000) minus expenses ($5,000 + $3,500 + $7,000 = $15,500). In lesson 5 you'll add one more month-end item, $200 of depreciation on the espresso machine, which brings the profit to $2,300, the figure you'll see on Brightside's income statement in lesson 8.

And this is how the $58,500 of assets is financed at month-end:

Liabilities $16,000 (27.4%) and owner's equity $42,500 (72.6%). Most of Brightside is financed by Maya, not by lenders.

Only four things move equity

Notice how few events actually change what the owner has in the business. Equity goes up when the owner invests more money or the business earns a profit. It goes down when the business has a loss or the owner takes money out. Everything else, from borrowing to buying equipment to paying suppliers, just rearranges assets and liabilities.

That's why lenders watch equity so closely. Picture a food truck with $60,000 of assets and $75,000 of debts: its equity is −$15,000. On paper, even if it sold everything at book value, it couldn't pay off its creditors. Negative equity doesn't mean the business closes tomorrow, but it does mean the owners have nothing at stake and the creditors are carrying all the risk, so getting new credit becomes hard. Steady profits kept in the business are the healthiest way to build equity back up.

A common mistake

Thinking that buying supplies is an expense the moment you buy them. It isn't: while they sit on the shelf, they're an asset (inventory). They become an expense, cost of goods sold, when they're used or sold. That's why equity didn't change in transaction 3 but did in transaction 8. (For tax purposes, some very small businesses can simplify how they treat supplies; your CPA can tell you whether that applies to you. The economics don't change.)

How to analyze any transaction: three questions

Which accounts are affected? Cash, accounts payable, sales revenue… There are always at least two.
Which element does each belong to? Asset, liability, owner's equity, revenue or expense.
Does each go up or down? Then check that the equation still balances.

Try it on an owner's draw. Maya transfers $1,500 from the business account to her personal account: cash (an asset) goes down $1,500 and owner's equity goes down $1,500. Both sides fall by the same amount, so the equation holds. No expense is involved, so profit is unchanged; as the owner of a single-member LLC, Maya pays herself through draws, not wages.

3. A business buys $2,000 of inventory and pays cash. What happens to the accounting equation?

Equity falls by $2,000 because it's an expense
One asset goes up (inventory) and another goes down (cash); the total doesn't change
Liabilities rise by $2,000

Buying inventory isn't an expense; you trade one asset for another. The expense appears when the inventory is sold, as cost of goods sold.

Common misreadings of the equation

"A loan is income because cash went up."

A loan raises assets and liabilities equally. Equity doesn't change; only interest becomes an expense.

"Paying a supplier is an expense."

Paying a bill you already recorded lowers cash and accounts payable. The expense was recognized earlier.

"An owner's draw is the owner's salary expense."

For a sole proprietor or single-member LLC, a draw reduces equity directly. It never touches the income statement.

"Equity is the cash the owner could take out today."

Equity is a claim on all assets, including equipment and inventory, not a pile of cash.

4. Maya takes a $1,500 owner's draw. Which statement is correct?

Expenses rise by $1,500 and profit falls
Liabilities rise by $1,500
Cash and owner's equity both fall by $1,500; profit is unchanged

A draw moves money from the business to the owner. It reduces assets and equity equally and doesn't appear on the income statement.

Practice exercise

Start from Brightside's month-end position (Assets $58,500 = Liabilities $16,000 + Equity $42,500). Analyze these transactions from the following month and show the equation after each one:

Brightside pays $4,000 to the coffee supplier.
It caters a tech company's team meeting for $1,200 and sends an invoice due in 30 days.
Maya takes a $1,500 owner's draw.

See solution

− Cash $4,000 / − Accounts payable $4,000 → $54,500 = $12,000 + $42,500. Equity doesn't change: paying a debt isn't an expense.
+ Accounts receivable $1,200 / + Revenue $1,200 → $55,700 = $12,000 + $43,700. It's revenue even though no cash arrived yet: that's the accrual basis.
− Cash $1,500 / − Owner's equity (draws) $1,500 → $54,200 = $12,000 + $42,200. Equity falls, but profit doesn't.

Summary

Assets = Liabilities + Owner's Equity, always, after every transaction.
Assets are what the business owns; liabilities are what it owes outsiders; equity is the owners' claim.
Revenue increases equity; expenses and owner's draws decrease it, but only expenses reduce profit.
Buying inventory, borrowing money or paying a bill isn't an expense.
Split assets and liabilities into current and long-term to judge short-term health.

Next lesson: Accounts and the Chart of Accounts. You'll see the accounts every small business uses, how to number them and how depreciation spreads the cost of equipment over time.