The amount of assets a business owns at a point in time must equal the amount of financing the business has at that point in time. In other words, assets must equal liabilities plus stockholders’ equity. This concept can be expressed as an equation, referred to as the fundamental accounting equation which is expressed as follows:
\[\text{Assets = Liabilities + Shareholder }\!\!’\!\!\text{ s Equity}\]
Liability
A liability is ‘a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits’. Most common liabilities are accounts payable, taxes payable.
Assets
A definition of assets is ‘a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity’. Typical examples of assets include land, building, motor vehicles, and computers.
Shareholder’s Equity
Shareholders’ equity is the phrase used to describe owners’ equity in a corporation. The shareholders’ equity section of the equation can be broken down into smaller subcategories:
- Common stock is used to reflect shareholders’ equity that is the result of the owners of the business investing money (or other assets) into the business.
- Retained earnings are used to reflect stockholders’ equity that is the result of the business having a net income, or net earnings, that have been retained in the business.
Accountants prepare a key summary, known as a statement of financial position, which lists the values of the three components at a specific date. Assets and liabilities are split between those that are ‘non-current’ and those that are ‘current’. The accounting equation might be rewritten as:
\[\text{Shareholder }\!\!’\!\!\text{ s Equity=Assets-Liabilities }\]
Example
For each of the following transactions, show the effect (as pluses and minuses) on assets, liabilities, and equity.
| Assets | Liabilities | Equity | ||
| $ | $ | $ | ||
| 1 | The owner starts the business with $3,000 paid into a business bank account on 1 April | + 3,000 (bank) | + 3,000 (equity) | |
| 2 | The business buys machinery with a bank payment of $800 on 2 April | + 800 (machinery) – 800 (bank) | ||
| 3 | The business buys an office computer for $800 from Dart Tech on 4 April and agrees to pay in May | + 800 (computer) | +800 (trade payable: Dart Tech) | |
| 4 | On 5 April, a bank lends the business $10,000 which is paid into the bank account on the same day | + 10,000 (bank) | + 10,000 (loan) | |
| 5 | The business pays Dart Tech $800 by bank transfer on 1 May | -800 (bank) | -800 (trade payable: Dart Tech) | |
| 6 | The owner takes $100 from the bank for personal spending money | -100 (bank) | -100 (equity) | |
| Summary (overall change) | + 12,900 | + 10,000 | +2,900 | |
Applying the accounting equation formula, Assets – Liabilities = Equity, we see that the overall increase in assets (10,000) is matched by the overall increase in equity ($2,900).
How Does the Value of Equity Change?
The owner’s investment will change for a number of reasons, most obvious of which is if more equity is contributed by the owner, or equity is withdrawn by the owner. However, the other main reason is the business making either a profit or a loss over a specific period.
We calculate profit or loss by comparing a business’s income with its expenses.
- If income exceeds expenses, the business makes a profit and the owner’s equity increases.
- If expenses exceed income, the business makes a loss and the owner’s equity decreases.
The comparison of income and expenses leads us to the equation shown below:
If income > Expenses, then:
\[\text{Income-Expenses=Profit}\]
Similarly, If income < Expenses, then:
\[\text{Income-Expenses=Loss}\]