Key Concepts
The accounting equation is:
This equation always balances. Every transaction affects at least two elements, but the equation remains in balance.
This also means Total Debits = Total Credits — assets normally carry a debit balance, while liabilities and equity normally carry a credit balance. When the equation balances, debits equal credits.
Put simply: every asset a business owns is funded by either money borrowed from others (liabilities) or what the owner puts into the business (equity).
Tip:Exam questions often give two values and ask you to find the third — just rearrange:
Rearranging the accounting equationAssets = Liabilities + EquityRearranges toEquity = Assets − LiabilitiesLiabilities = Assets − Equity
The Extended Accounting Equation
Equity is made up of capital, income, expenses, and drawings. Substituting these in gives the extended accounting equation:
Note:Equity and capital refer to the same thing and can be used interchangeably — both represent the owner's interest in the business.
Income and expenses are part of equity — they are not separate categories.
- When profit is earned, equity rises.
- When expenses are incurred or drawings are taken, equity falls.
ALE — the equation always runs left to right in this order: Assets = Liabilities + Equity.
Effects of Common Transactions
| Transaction | Assets | Liabilities | Equity |
|---|---|---|---|
| Owner invests cash | + (Cash in hand) | — | + (Capital) |
| Borrow from bank | + (Cash at bank) | + (Bank loan) | — |
| Buy goods on credit | + (Inventory) | + (Trade payables) | — |
| Buy goods for cash | + (Inventory) − (Cash in hand) = no net change | — | — |
| Sell goods on credit (revenue) | + (Trade receivables) | — | + (Sales revenue) |
| Sell goods on credit (cost) | − (Inventory) | — | − (Cost of sales) |
| Sell goods for cash (revenue) | + (Cash in hand) | — | + (Sales revenue) |
| Sell goods for cash (cost) | − (Inventory) | — | − (Cost of sales) |
| Pay expense by cash | − (Cash in hand) | — | − (Expense) |
| Pay trade payable by cheque | − (Cash at bank) | − (Trade payables) | — |
| Receive cash from trade receivable | + (Cash in hand) − (Trade receivables) = no net change | — | — |
| Owner withdraws cash for personal use | − (Cash in hand) | — | − (Drawings) |
| Owner takes goods for personal use | − (Inventory) | — | − (Drawings) |
| Owner pays for trade payables using personal cheque | — | − (Trade payables) | + (Capital) |
| Customer returns goods — sold on credit (revenue reversal) | − (Trade receivables) | — | − (Sales returns) |
| Customer returns goods (cost reversal) | + (Inventory) | — | + (Cost of sales reversal) |
| Return goods previously bought on credit | − (Inventory) | − (Trade payables) | — |
Why does equity show a minus for expenses and drawings?Cost of sales, expenses, and drawings reduce what the owner gets to keep — so when they go up, the owner's share of the business goes down. These are debit accounts, but equity normally carries a credit balance, so an increase in these accounts means a decrease in equity — hence the minus.
Sales returns is a contra income account — it does not reduce Sales revenue directly, but it sits alongside it and offsets it. When a customer returns goods, the business issues a credit note: Sales returns increases (reducing net revenue) and Inventory comes back in.
Purchase returns are different.When you return goods to a supplier, Sales returns does not appear — only Inventory decreases and Trade payables decreases (see row above).
- Nur Aina invested an additional $2,000 cash into the business bank account.
- Bought inventory on credit from Arjun for $1,500.
- Paid salaries of $800 by cheque.
Opening position: Assets $12,000 = Liabilities $3,000 + Equity $9,000 ✓
- Assets: + $2,000 (Cash at bank)
- Liabilities: no change
- Equity: + $2,000 (Capital)
- Check: $14,000 = $3,000 + $11,000 ✓
- Assets: + $1,500 (Inventory)
- Liabilities: + $1,500 (Trade payables — Arjun)
- Equity: no change
- Check: $15,500 = $4,500 + $11,000 ✓
- Assets: − $800 (Cash at bank)
- Liabilities: no change
- Equity: − $800 (Salaries expense reduces equity)
- Check: $14,700 = $4,500 + $10,200 ✓
Adding expenses or drawings to equity instead of subtracting. Expenses and drawings normally carry a debit balance, but equity normally carries a credit balance — so when they increase, equity goes down. In the extended equation, they are subtracted from equity, not added.