The Accounting Equation
A Lens for Understanding Business Transactions
Imagine you’re looking at a business through a special lens—a lens that helps you see how every financial decision impacts the company’s resources, obligations, and ownership. This lens is the accounting equation, and it’s at the heart of understanding a business’s financial health.
The equation is simple but powerful:
Assets – Liabilities = Equity
- Assets are what the business owns, like cash, equipment, or inventory.
- Liabilities are what the business owes, like loans or unpaid bills.
- Equity is the owner’s share of the business, which includes any money they’ve invested and the profit the business makes.
Through this lens, every transaction a business makes will affect at least two of these categories, and the equation always stays balanced. Now, let’s meet Jim, who is starting a sweet shop, and follow along as he takes steps to build his business. Each of Jim’s actions will show us how the accounting equation works in real life.
Jim’s Sweet Shop
A Journey Through the Accounting Equation
Jim’s Initial Capital Investment
Jim decides to open a sweet shop in his local town. He starts by investing EUR 50,000 of his savings into the business.
Journal Entry:
- Debit: Bank (EUR 50,000)
- Credit: Capital (EUR 50,000)
This is Jim’s first step in making his dream come true. By putting EUR 50,000 into the shop’s bank account, Jim increases the business’s assets (cash in the bank). At the same time, this creates equity because Jim now owns that amount in the business. The capital account represents Jim’s ownership stake, and this investment is the foundation of his sweet shop.
Getting Ready to Open
Jim uses EUR 15,000 to buy equipment for the shop and EUR 20,000 to purchase stock (sweets) to sell.
Journal Entry:
- Debit: Equipment (EUR 15,000)
- Debit: Stock (EUR 20,000)
- Credit: Bank (EUR 35,000)
Now Jim’s sweet shop is taking shape. He buys shelves, a cash register, and sweets to sell, all essential for getting the shop ready for customers. These purchases decrease his cash (an asset) but increase two new assets: equipment and stock. The total assets stay the same, but now they’re distributed between cash, equipment, and stock. Jim is almost ready to open his doors!
The First Day of Sales
Jim opens his shop and makes EUR 4,000 in cash sales and EUR 2,500 from customers paying by card.
Journal Entry:
- Debit: Cash (EUR 4,000)
- Debit: Bank (EUR 2,500)
- Credit: Sales (EUR 6,500)
On his first day of trading, Jim’s sweet shop is buzzing with customers! The shop’s assets grow as Jim receives EUR 4,000 in cash and EUR 2,500 in card payments that go straight into the bank. The “Sales” entry reflects the value of the goods sold, which increases Jim’s equity in the business. He’s off to a great start, with more money coming in and his business growing stronger.
Taking Out a Loan for a Freezer
Jim needs a large freezer for ice cream, so he takes out a EUR 5,000 loan from the bank.
Journal Entry:
- Debit: Bank (EUR 5,000)
- Credit: Bank Loan (EUR 5,000)
Jim’s next step is to invest in a freezer to keep ice cream—a popular item in his shop. The loan gives Jim an extra EUR 5,000 in cash, increasing his assets. However, this also creates a new liability because he now owes the bank EUR 5,000. This loan helps Jim expand his shop, but it also means he has a financial obligation to meet.
Buying the Freezer
Jim uses the EUR 5,000 loan to buy the freezer.
Journal Entry:
- Debit: Equipment (EUR 5,000)
- Credit: Bank (EUR 5,000)
Now that Jim has the freezer, his equipment assets go up while his cash balance (in the bank) goes down by the same amount. This transaction doesn’t change the total value of his assets but shifts some of it from cash to equipment. Jim’s sweet shop is now even better equipped to serve his customers!
The Plumbing Emergency
Jim’s shop has a small leak, and he hires a plumber to fix it. The plumber’s bill is EUR 500, which Jim agrees to pay at the end of the month.
Journal Entry:
- Debit: Maintenance Expense (EUR 500)
- Credit: Accrued Expenses (EUR 500)
Every business faces the occasional hiccup, and for Jim, it’s a plumbing issue. The plumber fixes the leak, but Jim doesn’t pay right away. Instead, he records the service as a maintenance expense, which reduces his equity because expenses lower profits. The unpaid bill becomes a liability (accrued expense), reflecting the amount Jim owes the plumber. Running a business has its challenges, but Jim handles them with a smile.
Paying Rent
At the end of the month, Jim pays EUR 600 for his shop’s rent.
Journal Entry:
- Debit: Rent Expense (EUR 600)
- Credit: Bank (EUR 600)
Paying rent is part of the everyday running of Jim’s sweet shop. His cash balance decreases, and the rent expense reduces equity since it’s a necessary cost of operating the business. This transaction reflects the steady, ongoing expenses that come with keeping the shop open.
Paying the Plumber
At the end of the month, Jim pays the plumber EUR 500 for the work done earlier.
Journal Entry:
- Debit: Accrued Expenses (EUR 500)
- Credit: Bank (EUR 500)
Now that Jim is paying his plumber, the liability for the unpaid bill (accrued expense) decreases, and so does the cash in his bank account. It’s important for Jim to stay on top of payments like this, ensuring that his business obligations are met and his finances stay in order.
Interest on the Loan
Jim’s loan from the bank accrues EUR 21 of interest for the first month.
Journal Entry:
- Debit: Interest Expense (EUR 21)
- Credit: Bank Loan (EUR 21)
Interest is the cost of borrowing money, and this EUR 21 represents the cost of using the loan for a month. The interest expense reduces Jim’s equity, while the amount owed to the bank increases. Jim knows that managing loans carefully is part of running a successful business.
Jim Takes Money Out for Himself
After a month of hard work, Jim withdraws EUR 500 from the business for personal use.
Journal Entry:
- Debit: Drawings (EUR 500)
- Credit: Cash (EUR 500)
Jim decides to reward himself by taking EUR 500 for personal use. This is known as “drawings,” and it reduces both the cash in the business and Jim’s equity. Unlike an expense, drawings represent money Jim takes out for himself, but they don’t affect the business’s overall profit.
Summary of Transactions Through the Accounting Equation
Here’s how all of Jim’s efforts have impacted the accounting equation over the course of his first month:
| Journal No. | Assets | Liabilities | Equity | Note | ||
|---|---|---|---|---|---|---|
| 1 | 50,000 | - | 0 | = | 50,000 | Initial capital investment by Jim |
| 2 | 50,000 | - | 0 | = | 50,000 | Buying stock and equipment (no change) |
| 3 | 56,500 | - | 0 | = | 56,500 | First day of sales (assets increase) |
| 4 | 61,500 | - | 5,000 | = | 56,500 | Loan from bank (assets and liabilities) |
| 5 | 61,500 | - | 5,000 | = | 56,500 | Buying the freezer (no net change) |
| 6 | 61,500 | - | 5,500 | = | 56,500 | Plumbing services (expense + liability) |
| 7 | 60,900 | - | 5,500 | = | 55,400 | Paying rent (expense + asset decrease) |
| 8 | 60,400 | - | 5,000 | = | 55,400 | Paying the plumber (liability decreases) |
| 9 | 60,400 | - | 5,021 | = | 55,379 | Interest accrues on the loan |
| 10 | 59,900 | - | 5,021 | = | 54,879 | Jim’s drawings for personal use |
As you can see, with each transaction, the accounting equation changes, but it always stays balanced. Jim’s assets, liabilities, and equity are constantly shifting as he grows his sweet shop, but every decision he makes, from paying bills to taking out loans, fits into this equation. It’s a wonderful way to track his progress and ensure that his shop remains financially healthy.
Jim’s journey to running a successful sweet shop is just beginning, and with the accounting equation as his guide, he can make smart, informed decisions that help his business thrive.
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Course Outline
- Concepts and Accounting
- The Three Different Natures of Accounts
- The Accounting Equation
- Accrual Accounting
- Debits and Credits
- The Journal
- Bank Reconciliation
- Adjusting Entries
- Chart of Accounts
- Accounting Principles
- Financial Accounting
- Financial Statements
- Balance Sheet
- Working Capital and Liquidity
- Income Statement
- Cash Flow Statement
- Financial Ratios
- Accounts Receivable and Bad Debts Expense
- Accounts Payable
- Inventory and Cost of Goods Sold
- Depreciation
- Payroll Accounting
- Bonds Payable
- Stockholders’ Equity
- Present Value of a Single Amount
- Present Value of an Ordinary Annuity
- Future Value of a Single Amount
- Nonprofit Accounting
- Break-even Point
- Improving Profits
- Evaluating Business Investments
- Manufacturing Overhead
- Nonmanufacturing Overhead
- Activity Based Costing
- Standard Costing