The equation and what each part means
Assets are things the business owns, such as cash, money customers owe, supplies and equipment. Liabilities are amounts the business owes to others, such as unpaid bills and loans. Owner's equity is the owner's share, which is what is left after liabilities are taken from assets.
Written as a formula: Assets = Liabilities + Owner's Equity. If you know any two parts, you can find the third. Equity rises when the owner invests and when the business earns revenue. It falls with expenses and with owner withdrawals.
Each transaction affects at least two items, and the equation stays balanced afterward. Some transactions only move value within assets, such as swapping cash for equipment. Others change both sides at once, such as buying on credit.
The eight transactions
Summit Tutoring Services is an invented one-owner business. It begins with nothing. For each transaction, say what happens to total assets, total liabilities and total equity, then write the new totals.
Transaction 1. The owner invests 15,000 in cash.
Transaction 2. The business buys equipment for 5,000 in cash.
Transaction 3. The business buys supplies for 600 on credit.
Transaction 4. The business earns 4,000 in tutoring fees and is paid in cash.
Transaction 5. The business tutors clients and bills 2,500, to be paid later.
Transaction 6. The business pays 1,000 in cash for rent.
Transaction 7. The business pays 400 of the 600 owed for supplies.
Transaction 8. The owner withdraws 1,200 in cash.
Answers: the running table
After each line, the totals are written as Assets = Liabilities + Equity.
Transaction 1: Cash up 15,000 and Owner's Capital up 15,000. Totals: 15,000 = 0 + 15,000.
Transaction 2: Equipment up 5,000, Cash down 5,000. Total assets do not change. Totals: 15,000 = 0 + 15,000.
Transaction 3: Supplies up 600, Accounts Payable up 600. Totals: 15,600 = 600 + 15,000.
Transaction 4: Cash up 4,000, equity up 4,000 through revenue. Totals: 19,600 = 600 + 19,000.
Transaction 5: Accounts Receivable up 2,500, equity up 2,500 through revenue. Totals: 22,100 = 600 + 21,500.
Transaction 6: Cash down 1,000, equity down 1,000 through rent expense. Totals: 21,100 = 600 + 20,500.
Transaction 7: Cash down 400, Accounts Payable down 400. Totals: 20,700 = 200 + 20,500.
Transaction 8: Cash down 1,200, equity down 1,200 through withdrawals. Totals: 19,500 = 200 + 19,300.
What the final position looks like
Assets at the end: Cash 11,400 (15,000 less 5,000, less 1,000, less 400, less 1,200, plus 4,000), Accounts Receivable 2,500, Supplies 600 and Equipment 5,000. Together they come to 19,500.
Liabilities at the end: Accounts Payable 200, which is 600 less 400.
Equity at the end: Owner's Capital 15,000, plus revenue of 6,500 (4,000 and 2,500), less rent expense of 1,000, less withdrawals of 1,200. That is 19,300.
Check the equation: 200 plus 19,300 equals 19,500, which matches total assets.
Five quick-check questions
Question 1. A business has assets of 40,000 and liabilities of 12,000. What is the owner's equity?
Question 2. A business has liabilities of 9,000 and owner's equity of 21,000. What are its total assets?
Question 3. A business buys 800 of supplies for cash. What happens to total assets?
Question 4. A business has assets of 50,000, liabilities of 15,000 and equity of 35,000. It borrows 10,000 in cash from a bank. What are the new totals?
Question 5. A business starts the month with equity of 18,000. During the month it earns revenue of 7,000, has expenses of 4,500 and the owner withdraws 1,000. What is the equity at the end of the month?
Quick-check answers
Answer 1: Equity equals assets less liabilities, so 40,000 less 12,000 equals 28,000.
Answer 2: Assets equal liabilities plus equity, so 9,000 plus 21,000 equals 30,000.
Answer 3: Total assets do not change. Supplies rise by 800 and Cash falls by 800.
Answer 4: Assets become 60,000, liabilities become 25,000 and equity stays at 35,000. Check: 25,000 plus 35,000 equals 60,000.
Answer 5: Ending equity is 18,000 plus 7,000 less 4,500 less 1,000, which equals 19,500.
How to check your work
After every transaction, add the assets and compare them with liabilities plus equity. If the two sides are not equal, the last step is where the error is.
Ask which of three patterns the transaction follows. Both sides rise by the same amount (investment, buying on credit, earning revenue). Both sides fall by the same amount (paying a bill, withdrawals, expenses). Or one asset replaces another and nothing else changes (buying equipment for cash).
Remember that revenue is recorded when it is earned, so transaction 5 raises equity even though no cash arrived.
Remember that paying a bill you already recorded does not change equity. In transaction 7 only cash and the payable move.
Finally, recompute the ending position from scratch. Assets of 19,500 must equal liabilities of 200 plus equity of 19,300.
Where this leads
The accounting equation is the foundation for debits and credits. Once you can see what each transaction does to the equation, journal entries are the same facts written in a standard format. For a spreadsheet to practice with, the Accounting Student Study Workbook toolkit on this site walks through entries, the trial balance and statements.
Common questions
Is owner's equity the same as profit?
No. Profit is revenue less expenses for a period. Owner's equity also includes what the owner invested and is reduced by withdrawals.
Can a transaction affect only one side of the equation?
A transaction can affect only the asset side, such as buying equipment for cash, because one asset replaces another. The equation still balances.
Why is paying a bill not an expense?
If the cost was already recorded when the bill arrived, paying it only reduces cash and the payable. The expense happened earlier.
This guide is general information, not tax, legal or accounting advice. Rules, fees and due dates change; check with the IRS, the NJ Division of Taxation or a licensed professional for your situation.