The accounting equation

The equation

assets = liabilities + capital

Read it as: everything the business owns was paid for either by someone it owes (liabilities) or by the owner (capital).

Rearranged, capital = assets − liabilities, and this version has a name. Capital is the owner's claim on the business, which is what is left after everyone else has been paid.

The equation always balances, after every transaction, because every transaction has two effects that keep it balanced. That is why the system is called double entry.

The terms

Assets are resources owned by the business.

• Non-current assets are kept for more than one year and are used to run the business rather than to be resold: premises, machinery, motor vehicles, fixtures and fittings.
• Current assets are held for a short time and change constantly: inventory, trade receivables, other receivables, bank, cash.

Liabilities are amounts owed by the business.

• Non-current liabilities are repayable after more than a year: a long-term bank loan, a mortgage.
• Current liabilities are repayable within a year: trade payables, other payables, a bank overdraft.

Capital is the amount the owner has put into the business. It rises with profit and with more capital introduced, and it falls with drawings and with a loss.

Note where a bank loan repayable in 8 months sits. It is a current liability, because the classification is about when it is due, not what kind of debt it is.

Every transaction, three possible shapes

Every transaction fits one of these, and naming the shape makes the entry obvious.

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Work through a short sequence, starting from nothing.

1. The owner pays in $20 000. Assets (bank) $20 000, capital $20 000.
2. Buys equipment for $8 000 by cheque. Assets are now equipment $8 000 and bank $12 000, still $20 000 in total. Capital is unchanged.
3. Buys inventory on credit for $3 000. Assets $23 000, liabilities $3 000, capital $20 000.
4. Pays the supplier $1 000. Assets $22 000, liabilities $2 000, capital $20 000.

At every step, assets equal liabilities plus capital. Notice that steps 2 and 4 changed nothing about the owner's stake at all.

Profit and drawings

Two things move capital during the year.

closing capital = opening capital + capital introduced + profit − drawings

Drawings are anything the owner takes out for personal use: cash, goods, or the business paying a private bill. Drawings are not an expense, and goods taken by the owner are not a sale. They reduce capital.

The statement of financial position

The statement lists the equation at a date. A simple layout:

Check it: assets of 23 500 equal capital of 21 500 plus liabilities of 2 000. If the two totals disagree, something has been left out or put on the wrong side, and it is worth finding before going further.

Common mistakes

• Writing the equation as assets = liabilities − capital.
• Classifying a loan repayable in six months as non-current.
• Putting inventory among non-current assets because it is "goods".
• Treating drawings as an expense in the income statement.
• Forgetting that buying an asset for cash leaves total assets unchanged.
• Saying capital is the cash in the business. Capital is the owner's claim, and it is rarely held as cash.

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