Assets = Liabilities + Equity

This equation is what is called the balance sheet. Let me give you an example:

Your business has some money in the bank (an Asset) of $100.  You owe your mom (a Liability) $20 and you contributed $80 of your own money to the business (Equity) of $80  The equation known as the balance sheet would look like this:  $100 = $20 + $80 (Assets = Liability + Equity)

What is an Asset?

An Asset is something that can be used in the future to make you more money or prevent you from paying money. Let’s look at some examples:

Cash – Cash is money. Money can be invested into other things that can make you more money.

Accounts Receivable – Accounts Receivable is money you will receive from your customers. Once you receive it you can invest the money in other things that can make you more money.

Prepaid Expenses – Prepaid Expenses are expenses that you have paid ahead of time and, therefore, you do not have to pay them in the future.

There are many more assets than this list, but those are some of the most popular ones and for most companies, you really only need to know about cash.

What is a liability?

A Liability is something you owe someone and has to be paid to someone else in the future. Let’s look at some examples:

Accounts Payable – Accounts payable is money that you owe to your vendors and will have to be paid to them in the future.

Loan Payable – A loan is money you borrowed from someone or the bank that will have to be paid to them in the future.

Credit Card Payable – When you spend money on your credit card you have to pay off the credit card in the future.

There are many more liabilities than this list, but those are some of the most popular ones and most companies don’t need to know about liabilities at all for accounting.

What is Equity?

The most important thing to remember at this point is that Assets = Liabilities + Equity. This means that the equation has to balance. So what is equity? Equity consists of Assets that didn’t get into your business by owing it to someone else. Here is an example:

Remember the $80 that you contributed to your company in the example up above. This would be considered equity because you contributed it on your own without borrowing it from your mom.

There you go. You now know the balance sheet. Not too bad. There is just a little more that you have to learn.

This is the fun part. Keeping track of the money you make on the Income Statement. There is also an equation for this known as the Income Statement:

Revenue – Expense = Income

Let’s say that you sold a car in your car dealership business for $100(Revenue).  The car costed (Expense) $80.  The difference between what you sold if for of $100 and what it costed $80 is Income of $20.

The Income Statement would look like this:  $100 – $80 = $20 (Revenue – Expense = Income)

What is revenue?

Revenue is what you earn from your customers. Here are some examples:

You sell 20 T-shirts for $10 each. Revenue earned would be $200.
You sell 40 cars for $1,000 each. Revenue earned would be $40,000
You have 3 houses rented for $800 a month. Revenue earned would be $2,400 per month.
Your bank pays you $3 of interest. Revenue earned would be $3.

What is an expense?

Expense is what you have to pay to earn your revenue. Here are some examples:
The 20 T-shirts you sold cost $5 each. Expense would be $100.
The 40 cars you sold cost $500 each. Expense would be $20,000.
The property taxes on the 3 houses you have rented are $100 each per month. Expense would be $300 per month.

What is Income?

Net Income is what remains after you subtract your Expenses from your Revenue.

For the 20 T-shirts you sold your net income would be $100 ($200 – $100 = $100)
For the 40 cars you sold your net income would be $20,000 ($40,000 – $20,000 = $20,000)
For the 3 houses you have rented your net income would be $2,100 ($2,400 – $300 = $2,100)
The net income from the bank interest would be $3 ($3 – $0 = $3)

Putting it all together

The Balance Sheet and Income Statement are connected by Debits and Credits and Debits have to equal Credits.

Assets = Liabilities + Equity  It is the same equation as Debits = Credits.  Here is why.

Remember the example asset accounts we went over before? Cash, Accounts Receivable, Prepaid Expenses? Just know that these generally have debit balances. For instance, if you have $100 of cash in your bank account. The way you would say that in accounting is you have a debit balance of $100 in your bank account.

Remember the example Liability account we went over before? Accounts Payable, Notes Payable, Credit Card Payable? Just know that these generally have credit balances. For instance, the $20 you borrowed from your mom would be said as you have a credit balance of $20 in Notes Payable.

Remember that $80 you contributed to your company. You have a credit balance of $80 in Equity.

See, I told you it was the same. $100 = 20 + $80 (Assets = Liabilities + Equity) or $100 = $100 (Debits = Credits)

So here is where it gets a little tricky. Let’s say that your mom gives you another $20. That increases your cash by $20 and also increases your Note Payable by $20. Now your balance sheet equation looks like this:

$120 = $40 + $80

To get your equation to look like you need it to, use the debits and credits. Remember, Assets are naturally debits and Liabilities and Equity are naturally credits. So to increase your Asset you need to debit and to increase your Liability you need to credit in what is called a journal entry. Here it is:

Debit Cash $20
Credit Note Payable $20

See how everything is balanced? Assets = Liabilities + Equity and Debits = Credits.

Ok. Now the Income Statement.

Just know that Revenue is usually a credit. For example, you earn the $200 on your T-shirts. You would have a credit of $200 to Revenue.  So you have a credit to Revenue, what do you debit? Let’s assume that you collected the $200 from your T-shirt sale. It would increase your cash right?  That is how the balance sheet and income statement are connected. Your journal entry would be:

Debit Cash $200
Credit Revenue $200

What would the Expense be? Just know that Expense is usually a Debit. Your expense for the T-shirts in the example was $100 and you paid cash to buy them. Remember what the entry was for Revenue where you increased cash. In this instance you are decreasing cash or crediting cash:

Debit Expense $100
Credit Cash $100

Whenever you start accounting for your business all of the balances from Assets, Liabilities, Equity, Revenue, and Expense are tracked by a trial balance. The trial balance should always equal to zero if you sum up all of the accounts. If it doesn’t, it means that you have made a mistake that resulted in debits not equaling credits.