The Accounting Equation

The resources owned by a business are its assets. Examples of assets include cash, land, buildings, and equipment. The rights or claims to the properties are normally divided into two principal types:
 (1) the rights of creditors and
 (2) the rights of owners.

The Accounting Equation

The rights of creditors represent debts of the business and are called liabilities. The rights of the owners are called owner’s equity. The relationship between the two may be stated in the form of an equation, as follows:

The accounting system reflects two basic aspects of a company: what it owns and what it owes. Assets are resources a company owns or controls. Examples are cash, supplies, equipment, and land,
where each carries expected benefits. The claims on a company’s assets—what it owes—are separated into owner and nonowner claims. Liabilities are what a company owes its nonowners (creditors) in future payments, products, or services. Equity (also called owner’s equity or capital) refers to the claims of its owner(s). Together, liabilities and equity are the source of funds to acquire assets.

The relation of assets, liabilities, and equity is reflected in the following accounting equation:

Assets = Liabilities+Owner’s Equity
This equation is known as the accounting equation. Liabilities usually are shown before owner’s equity in the accounting equation because creditors have first rights to the assets. The claim of the owners is sometimes given greater emphasis by transposing liabilities to the other side of the equation, which yields:
Assets - Liabilities= Owner’s Equity
To illustrate, if the assets owned by a business amount to $100,000 and the liabilities amount to $30,000, the owner’s equity is equal to $70,000, as shown below.
Assets - Liabilities= Owner’s Equity

Liabilities are usually shown before equity in this equation because creditors’ claims must be paid before the claims of owners. (The terms in this equation can be rearranged; for example,Assets 2 Liabilities 5 Equity.) The accounting equation applies to all transactions and events, to all companies and forms of organization, and to all points in time. For example, Research In Motion’s assets equal $10,204,409, its liabilities equal $2,601,746, and its equity equals $7,602,663 ($ in thousands). Let’s now look at the accounting equation in more detail.


Assets are resources a company owns or controls. These resources are expected to yield future benefits. Examples are Web servers for an online services company, musical instruments for a rock band, and land for a vegetable grower. The term receivable is used to refer to an asset that promises a future inflow of resources. A company that provides a service or product on credit is said to have an account receivable from that customer.


Liabilities are creditors’ claims on assets. These claims reflect company obligations to provide assets, products or services to others. The term payable refers to a liability that promises a future outflow of resources. Examples are wages payable to workers, accounts payable to suppliers, notes payable to banks, and taxes payable to the government.

Equity Equity

 is the owner’s claim on assets. Equity is equal to assets minus liabilities. This is the reason equity is also called net assets or residual equity.

Equity for a noncorporate entity—commonly called owner’s equity—increases and decreases as follows: owner investments and revenues increase equity, whereas owner withdrawals and expenses decrease equity. Owner investments are assets an owner puts into the company and are included under the generic account Owner, Capital. Revenues are sales of products or services to customers.

Revenues increase equity (via net income) and result from a company’s earnings activities.

Examples are consulting services provided, sales of products, facilities rented to others, and commissions from services. Owner withdrawals are assets an owner takes from the company for personal use. Expenses are the costs necessary to earn revenues. Expenses decrease equity. Examples are costs of employee time, use of supplies, and advertising, utilities, and insurance services from others. In sum, equity is the accumulated revenues and owner investments less the accumulated

expenses and withdrawals since the company began. This breakdown of equity yields the following
Assets = Liabilities+Owner’s Equity "Owner,capital - Owner,Withdrawals + Revenues - Expenses"
Net income occurs when revenues exceed expenses. Net income increases equity. A net loss occurs when expenses exceed revenues, which decreases equity.
Previous Post Next Post