Lesson 2 of 9
Assets, liabilities, equity
The identity that cannot break, why equity is a residual rather than a pot of money, and what it means when a balance sheet appears not to balance.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- Assets equal liabilities plus equity, and the identity holds because equity is defined as whatever is left over.
- Every transaction keeps the identity true, which is the first check a bookkeeper has.
- Equity is a claim, not a pot of money. A company with large equity and no cash is ordinary, not contradictory.
There is one equation in bookkeeping and everything else follows from it.
Assets equal liabilities plus equity. What the business controls equals what others can claim from it plus what the owners can claim from it.
Fen Street Bindery on 2 January, after three transactions
What it controls
- Cash, $52,000.
- Equipment, $48,000.
Who can claim it
- The bank, $40,000.
- The owner, $60,000.
Both columns total $100,000, and they will keep matching through every transaction in this course.
The left column is the assets: the cash left after buying the machine, plus the machine. The right column is every claim on those assets, ranked later by who gets paid first. Neither column was measured independently of the other.
Why the equation cannot break
Equity is not measured independently. It is defined as assets minus liabilities, which means the equation is true by construction rather than by discovery.
That sounds like a trick and it is not. What it guarantees is a check: if you record both sides of every event, the identity survives, and if it fails, you recorded something wrongly. The equation cannot tell you that a number is correct, but it can tell you that a pair of numbers is inconsistent.
Four shapes a transaction can take
That last observation is the bridge between the balance sheet and the income statement, and it is the reason the two are not separate systems. Profit is a change in equity that did not come from the owners.
Equity is a claim, not cash
The most common misreading of a balance sheet is treating equity as money sitting somewhere. It is not. It is a number arrived at by subtraction, and the assets it corresponds to are whatever the business actually holds.
Fen Street Bindery will finish its first year with equity of $121,600 and cash of $88,200. Those are different numbers describing different things. The equity is the owners' claim on everything the business has. The cash is one of the things it has.
This is also why retained earnings is not a fund. It is the running total of profit that was never paid out, and the money it represents was long ago spent on machines, materials and wages.
When a balance sheet appears not to balance
In a real published balance sheet, three things most often explain an apparent failure to balance, and none of them is a broken identity.
Some line was missed, most often a minority interest in a subsidiary or an accumulated other comprehensive income figure that is sitting inside equity but printed separately. Or the figures came from different dates. Or a subtotal was read as a total, which happens constantly with current against total liabilities.
The identity itself is enforced by every accounting system in existence. If it appears to fail, the reading is wrong before the accounts are.
Check yourself
Why does the accounting equation always hold?
- Because accountants check it carefully
- Because equity is defined as assets minus liabilities, so the identity is true by construction
- Because regulators require it
Show the answer
Answer: B.
Equity is a residual rather than an independently measured quantity. That is what makes the equation a check on recording rather than a discovery about the business.A business buys $30,000 of materials on credit. What happens to the two sides of the equation?
- Assets rise, and the other side is unchanged
- Assets rise by $30,000 and liabilities rise by $30,000
- Equity falls by $30,000
Show the answer
Answer: B.
Materials arrive and an obligation to the supplier arrives with them. Nothing has been earned or consumed yet, so equity does not move.A company reports equity of $121,600 and cash of $88,200. What does the difference mean?
- Some of the equity is missing
- Nothing is wrong. Equity is a claim on all the assets, and cash is only one of them
- The company owes $33,400
Show the answer
Answer: B.
Equity is a residual claim, not a balance of money. The rest of the assets here are receivables, materials, prepaid rent and the machine.Sources
- This lesson is taught from first principles. No external source is cited, because no claim here depends on one.
What this leaves out
- Fen Street Bindery and every figure in this course are invented, and chosen so the arithmetic can be checked by hand.
- The four transaction shapes here cover a simple trading business. Share issues at a premium, treasury stock, revaluations and other comprehensive income all sit inside equity and are not covered.
- A published balance sheet for a bank, an insurer or a real estate investment trust is not presented in this form, though the identity still holds.
- Nothing here is advice about any security.