The accounting equation is a simple expression of the fact that, at any point in time, the assets of a business will be equal to its liabilities plus capital , where capital is the residual interest in the assets after all liabilities have been settled and which is due to the owner(s).
Note that, like any equation, it can be rearranged and presented in a different way as illustrated below
Note that any gains or losses made by a business are due to the business owner(s). Using this simplified approach, losses or expenses incurred will reduce capital and profits or gains made will increase capital.
Over time, the assets, liabilities and capital of a business change continually, but the relationship between the components of the accounting equation is always true. This is because of the way assets, liabilities and capital are defined and because of the way in which changes in the three elements are recorded. The reason this equality is maintained is that the assets controlled by the business had to be financed in some way, either by the owner and/or lenders. Conversely, input of finance from the owner and/or lenders must be represented by an asset or assets to the same monetary value. Note that all transactions are always recorded from the perspective of the business, rather than the owner(s).
Situation
Day 1
Sam Green (a sole proprietor) invests $5,000 of own funds to set up a garden design business. The $5,000 contributed to the business becomes the business's capital and the $5,000 in the business bank account represents the only asset of the business.
This situation has two effects - assets (cash at bank) increase by $5,000 and capital increases by $5,000. The business has $5,000 more cash than before and the owner is owed $5,000 from the business. There are no liabilities. The resulting accounting equation is as follows:
Day 2
The business pays cash for inventory of plants, flowers and seeds (goods for resale) costing $2,000. The capital remains the same, but there are now two assets.
The purchase of inventory results in two effects assets (cash at bank) decreases by $2,000 and a new asset, (inventory), increases by $2,000. There are no liabilities. The resulting accounting equation is:
Day 3
So far, all finance has come from the owner in the form of capital. In the next step, the business will borrow $4,000 from a bank to buy a van at a cost of $4.000. The capital remains the same, but there are now three assets and a liability.
Capital $5,000 = Assets $9,000-Liabilities $4,000 (loan) The assets are $3,000 (cash at bank) + $2,000 (inventory) + $4,000 (van)
Day 4
So far, capital has remained unchanged. This means that neither a profit nor a loss has been made. As soon as trading starts, profits (or losses) will be generated which will increase (or decrease) capital.
We will now assume that all inventory of plants, flowers and seeds, is sold for $3,500 cash, generating a profit of $1,500 ($3,500-$2,000 cost of inventory).
Capital + Profit $6,500 = Assets $10,500-Liabilities $4,000 (loan) Capital is $5,000 (capital introduced) + $1,500 (profit).
The assets are Cash at bank $3,000 + Cash $3,500 + $4,000 (van)
Day 5
The business paid $480 cash to meet sundry expenses, reducing its profit to $1,020. The sundry expenses could be for casual labour, equipment hire, motor expenses and so on.
The accounting equation now becomes:
Capital + Profit $6,020 = Assets $10,020-Liabilities $4,000 (loan)
Capital is $5,000 (capital introduced) + $1,500 (profit) - $480 sundry expenses.
The assets are Cash at bank $3,000, Cash of $3,020 (3,500-480) + $4,000 (van)
Day 6
Owners must obviously withdraw some cash from the business in order to pay their daily living expenses. All cash withdrawn from a business by its owner is referred to as drawings. This will decrease the amount of capital due to the owner. (Any other asset taken out of the business by the owner, such as inventory, will also be classified as drawings.) We will end this example with Sam Green withdrawing $350 from the business bank account for personal use.
Capital + Profit-Drawings $5,670 = Assets $9,670-Liabilities $4,000
Capital is $6,020 (as before) - $350 (drawings).
The assets are $10,020 (as before) - $350 withdrawn from the bank as drawings.
The accounting equation helps you to understand the basic nature of accounting transactions. The accounting equation can be expanded to provide additional information and understanding as follows:
Capital Assets - Liabilities, or rearranged as: Assets = Capital + Liabilities
Capital can be expanded to show more detail of any increases or decreases:
Capital = Opening net assets + Profit - Drawings
In a similar manner:
Assets - Liabilities = Capital introduced + Revenue - Expenses - Drawings
From this, it follows that:
if a business makes a profit its capital and net assets increase
if a business makes a loss its capital and net assets decrease