The Accounting Equation
Build your mental model
Everything a business has must have been financed somehow.
A business can finance its resources with money from owners or money owed to others. The accounting equation is simply the permanent check that both sides still match after every event.
- 1Identify what the business has
- 2Identify who financed it
- 3Check that both sides remain equal
Now meet the key accounting terms.
You already know the basic idea. These cards connect it to the professional vocabulary. Each card starts with a plain explanation; its detail page adds the definition, example and visual.
Everything a business owns was financed either by creditors or by its owners.
Learn more →Working capitalAccounts payableSupplier invoices the business has received but has not paid yet.
Learn more →Balance sheetAssetSomething useful the business controls, such as cash, a customer receivable or a machine.
Learn more →Balance sheetEquityWhat would remain for the owners after all obligations were deducted from the assets.
Learn more →Balance sheetLiabilityAn amount or obligation the business still owes to somebody else.
Learn more →Economic resources and claims under IFRS
An asset is a present economic resource controlled by the entity as a result of past events.
A liability is a present obligation to transfer an economic resource as a result of past events.
Equity is the residual interest after deducting liabilities.
Assets are present resources controlled because of past events; liabilities are present obligations; equity is the residual. Classification depends on substance, not merely on an account's label.
Classify cash, an unpaid supplier invoice, owner capital, customer receivable, and revenue earned this month.
Every transaction has a dual effect
Borrowing cash increases both cash and a loan.
Buying equipment for cash swaps one asset for another.
Earning revenue on account increases receivables and equity.
Paying an expense reduces cash and equity.
Every recorded transaction preserves Assets = Liabilities + Equity. Some change total resources; others exchange one resource for another or settle one claim with another.
Equity is not the company’s bank balance. It is the residual claim after liabilities.
An example company borrows $10,000 and immediately uses $4,000 to buy equipment. Show both equation effects.
Current versus non-current under IAS 1
An asset is current when it meets an IAS 1 current-classification criterion, including realization in the normal operating cycle, trading, expected realization within twelve months, or qualifying cash.
A liability is current when it is expected to be settled in the operating cycle, held for trading, due within twelve months, or the entity lacks the reporting-date right to defer settlement for at least twelve months.
Current classification is based on the operating cycle or roughly twelve months. Liquidity depends on timing and quality, not simply on the current label.
Classify a 30-day receivable, a five-year bank loan with $2,000 due next year, office supplies, and equipment.
Cash and cash equivalents
Cash includes money available for immediate use.
Cash equivalents are highly liquid, short-term investments with little value risk.
Restricted cash may exist but cannot be freely spent, so readers need to understand both the amount and its availability.
Cash includes funds available on demand; cash equivalents are highly liquid, short-term investments with insignificant value risk. Restricted amounts may require separate presentation.
Decide whether petty cash, a 90-day treasury bill bought at issue, a two-year bond, and customer IOUs are cash or cash equivalents.
Receivables, supplies and prepayments
Receivables represent claims against customers or payers.
Supplies are resources waiting to be consumed.
Prepayments are future benefits already paid for, such as insurance.
All are assets, but they differ greatly in liquidity and uncertainty.
Receivables represent claims, supplies represent unconsumed resources, and prepayments represent future services already paid for. Each becomes cash or expense through a different path.
An example company has $3,000 receivables, $700 unused supplies, and $1,200 unexpired insurance. Explain the future event that removes each asset.
Property, equipment and intangible assets
Long-lived assets support activity across several periods.
Tangible examples include buildings and diagnostic machines; intangible examples may include purchased software or licenses.
Their costs are allocated over time rather than immediately treated as one period’s expense.
Long-lived tangible assets provide capacity over several periods; identifiable intangibles provide rights or advantages without physical form. Purchase cost and subsequent allocation are separate questions.
Equation questions test classification and dual effects before debit–credit mechanics hide the logic.
Classify a computer, purchased software license, internally trained workforce, and office lease deposit.
Payables, accruals and borrowings
Accounts payable usually arise from supplier credit.
Accrued liabilities arise when an expense has occurred without an invoice or payment.
Borrowings arise from financing contracts.
Each is a liability, but its origin, timing and risk differ.
Payables arise from purchases on credit, accruals from expenses incurred before invoicing or payment, and borrowings from financing contracts. Their settlement may have different income effects.
Separate these: supplier invoice $600; wages earned but unpaid $900; bank loan $8,000.
Contributed capital and retained earnings
Owners may contribute resources directly, creating contributed capital.
Profitable operations increase retained earnings, while losses and distributions reduce it.
Retained earnings is not a cash reserve; it is a cumulative equity account.
Contributed capital records owner investment. Retained earnings accumulate profits less distributions. Owner withdrawals are not business expenses because they do not create revenue-producing benefit.
Beginning retained earnings are $4,000, profit is $7,500, and dividends are $2,000. Find ending retained earnings.
Revenue and expenses expand the equation
Revenue increases equity by increasing net assets through earned activity.
Expenses decrease equity as resources are consumed.
The expanded equation connects everyday performance with the balance sheet: Assets = Liabilities + Contributed Capital + Revenue − Expenses − Distributions.
Revenues increase equity through earned value; expenses decrease equity through consumed resources or incurred obligations. Cash can move before, with, or after either item.
Show the equation effect of earning $1,500 on account and incurring $400 wages to be paid later.
Transaction map workshop
Build a table with one row per transaction and columns for assets, liabilities and equity.
Enter pluses and minuses, then total every row.
This method slows you down at first but creates a reliable mental model before journal-entry rules are introduced.
A transaction map prevents premature debit-credit guessing. First identify accounts, classify them, state increases or decreases, and verify the equation.
Map: collect $900 from a customer who was invoiced last month; pay $300 of an existing supplier payable.
Map Northstar's first month
Continue with the January events introduced in Lesson 1. Enter the owner contribution 20,000; computer equipment 3,000 cash; supplies 800 on account; service revenue 4,500, including 3,000 on credit; receivable collection 2,000; customer advance 1,200; supplier payment 600; and annual insurance payment 1,200.
Now make it stick.
A business receives a $20,000 bank loan. State the equation effect.
It buys $4,000 of equipment for cash. State the effect.
Quick check.
Which is a liability?
Assets are $90,000 and liabilities $25,000. Equity is…
Buying supplies for cash causes…
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