Week 2 · Chapter

Chapter 2 — The Accounting Equation and Transaction Analysis

Financial Accounting Free sample edition

The module's primary reading · ~35–45 minutes · Objective 2 (analyze business transactions with the accounting equation and record them in a journal using double-entry bookkeeping, post them to the ledger, and prepare a trial balance), with Objective 1 (explain the purpose of financial accounting, its users, the forms of business organization, the roles of GAAP, the FASB, the SEC, and IFRS, and the ethical principles that guide accountants) recalled · Read it first this week; the lecture, the slide deck, the tutorial, the quiz, and the Accounting Workshop all build on it.

In plain language

Every business has things it owns and bills it owes. This week you learn the one line accountants use to keep track of both, the accounting equation (a balance that says everything a business has was supplied either by people it owes or by its owners). You will sort a business's belongings into assets (what it has), liabilities (what it owes), and stockholders' equity (the owners' share of what is left). Then you will follow a small bicycle shop through its first month, from a $30,000 investment on Day 1 to a $500 dividend on Day 30, across 12 events, and watch the equation stay balanced after every single one. By the end, you will be able to read any simple business event and say what it changed.

Why you already care about this

Picture two friends who open a bicycle repair shop. On Day 1 they each put money in, $30,000 between them, and the shop gives them 30,000 shares of stock in return. By Day 30 the shop has run through 12 transactions: it has bought tools, paid rent, fixed bikes, and paid its mechanic. Now somebody asks a fair question: how is the shop doing?

You could count the cash in the drawer. But the drawer does not tell you about the delivery company that still owes the shop money, or the supplier the shop still owes. It also does not tell you how much of the shop belongs to the two founders. You have probably felt this yourself if you have ever split rent, lent a friend money, or saved up for a car while paying off a phone. What you have and what you owe are two different lists, and you need both.

This chapter gives you a way to keep both lists at once and check that they agree.

By the end of this chapter you will be able to:

sort a business's accounts into assets, liabilities, and stockholders' equity;
state the accounting equation and show that it balances;
name the three things that change retained earnings;
analyze a transaction with a four-question routine;
read a month's totals in one plain sentence.

Carry this sentence with you: equity is a claim on the shop — not money in the drawer.

Where we are

Already covered: Week 1 set out what financial accounting is for, who uses it, who sets its rules, and the three forms of business, and it introduced the running case.
This week: the accounting equation and transaction analysis, worked on the running case's first twelve transactions.
How they connect: Week 1 said a corporation is an entity separate from its owners; this week that separation decides what goes into the shop's books.
Where we're going next: Week 3 records these same twelve transactions with debits and credits in a journal and checks them with a trial balance.

Week 1 gave you the setting. You met the running case: an illustrative, unnamed bicycle repair and sales shop, organized as a corporation by two founders. You also learned the economic entity idea: the shop's records hold the shop's resources and the shop's debts, not the founders' personal ones. If a founder buys groceries, that is not a shop event. Keep that rule close, because it decides which events you analyze this week and which you ignore.

1. Assets and liabilities: list what the shop has and what it owes

Think about your own life for a moment. You might own a laptop, a bike, and some money in a checking account. You might also owe a friend for concert tickets and owe your phone company for this month's bill. Your belongings and your bills are two lists. A business keeps the same two lists, with more care.

The things on the first list are the business's assets.

An asset is a resource the business controls that is expected to provide future benefits.

The words "future benefits" matter. Cash can pay future bills. Equipment can fix bikes for years. Supplies will be used on future repairs. Even a promise from a customer to pay later is an asset, because it will turn into cash. In the bicycle shop this month, the assets are:

Cash — money the shop holds in its bank account and its cash drawer, ready to spend.
Accounts Receivable — amounts customers owe the shop for work it has already done on account ("on account" means the customer will pay later).
Supplies — small items such as cables, tubes, and grease that the shop will use up on repairs.
Prepaid Insurance — an insurance policy the shop has paid for in advance; the coverage it has not used yet is still there to protect it.
Equipment — work stands, a wheel-truing station, and tools.

The things on the second list are the business's liabilities.

A liability is an obligation to transfer resources to others.

Usually that means the business owes cash, but it can also owe work. In the bicycle shop this month, the liabilities are:

Accounts Payable — what the shop owes a supplier for things it bought on account.
Unearned Revenue — cash a customer has paid for work the shop has not done yet, which the shop owes until it does the work.

Unearned Revenue surprises many students. The shop has the cash, so why is it a debt? Because the shop now owes the customer something: either the work or the money back. Until the shop does the tune-ups, the cash comes with a string attached.

Worked example — sorting the shop's accounts. Take the shop's seven accounts this month and sort them.

Cash: a resource the shop controls, which can pay future bills. Asset.
Accounts Receivable: the delivery company's promise to pay, which will become cash. Asset.
Supplies: items the shop will use on future repairs. Asset.
Prepaid Insurance: coverage the shop has paid for and has not used up. Asset.
Equipment: tools the shop will use for years. Asset.
Accounts Payable: money the shop must send a supplier. Liability.
Unearned Revenue: tune-ups the shop must perform, or money it must return. Liability.

So the shop has five asset accounts and two liability accounts. In words: everything the shop can use to earn money is on the first list, and everything it must hand over to someone else is on the second.

Misconception check — buying equipment is an expense. Students often think that when the shop spends $12,000 on repair equipment, that money is "gone," so it must be an expense. It is tempting, because the cash really does leave. But the equipment is still sitting in the shop, ready to fix bikes for years. The shop has traded one asset, Cash, for another, Equipment. Nothing was used up yet, so nothing is an expense yet.

2. Stockholders' equity: separate the owners' claim from cash

Now go back to your own two lists. Suppose your laptop, bike, and checking account add up to more than your bills. The difference is yours, free and clear. If you sold everything and paid every bill, that difference is what you would walk away with.

A business has the same leftover amount. In a corporation, the owners are called stockholders, so the leftover is called stockholders' equity.

Stockholders' equity is the owners' residual claim: what is left of the assets after the liabilities.

"Residual" means left over. Creditors, the people the business owes, get paid first. The owners' claim is whatever remains after that.

Stockholders' equity has two parts, and you can tell them apart by where the money came from:

Contributed capital is what the owners paid into the business in exchange for shares. In the bicycle shop, it sits in an account called Common Stock. On Day 1 the founders put in $30,000 for 30,000 shares of $1-par common stock, so Common Stock is $30,000. (Par value is a legal amount per share that Week 14 explains; for now, the $30,000 the founders paid is what Common Stock records.)
Retained earnings is the part of equity that comes from the business's own profits and has not been paid out to the owners. The shop starts the month with none, and you will watch it grow and shrink in Section 4.

Misconception check — stockholders' equity is cash. Students often read "$31,700 of equity" and picture $31,700 of cash in the bank. It is tempting, because equity is measured in dollars. But equity is a claim, not a pile of cash. The founders' $30,000 went into Cash on Day 1, and then the shop spent some of that cash on equipment and insurance. The claim stayed the same while the cash moved. At the end of this month the shop's equity and its cash are two different amounts, and Section 7 shows you both.

3. The accounting equation: keep both sides equal

Here is the big idea of the week. Every resource a business has came from somewhere. Either someone lent it, or the owners supplied it. There is no third source. So the total of what the business has must equal the total of the claims on it.

The accounting equation is Assets = Liabilities + Stockholders' Equity. Every transaction keeps the two sides equal, because every resource the shop has came from a creditor or an owner.

The left side lists what the business has. The right side lists who has a claim on it. You can think of the equation as a scale with the assets in one pan and the claims in the other. Every event that adds weight to one side adds the same weight somewhere on the scale, so it never tips.

Worked example — the shop's first day. On Day 1 the founders invest $30,000 cash in exchange for 30,000 shares of $1-par common stock.

What the shop has: Cash of $30,000. Total assets are $30,000.
What the shop owes: nothing yet. Total liabilities are $0.
The owners' claim: Common Stock of $30,000. Total stockholders' equity is $30,000.
The check: $30,000 = $0 + $30,000.

In words: on its first day the shop has $30,000, and all of it is the owners' claim, because nobody has lent the shop anything yet.

Misconception check — the equation only balances at month's end. Students sometimes think a business adds everything up at the end of the month and then makes it balance. It is tempting, because the totals get reported at the end. But the equation is true after every single transaction, not only at the end. If it ever fails to balance in the middle of the month, an analysis is wrong right there, and you can find it.

4. Retained earnings: see what raises it and what lowers it

Retained earnings is the part of equity that the business earns for its owners. Three things move it.

Revenues increase it. Revenue is the amount a business earns by providing goods or services to customers. When the shop fixes a bike, it earns revenue, and the owners' claim grows.
Expenses decrease it. An expense is the cost of the resources a business uses up to earn its revenue, such as rent or a mechanic's wages. When the shop pays this month's rent, the owners' claim shrinks.
Dividends decrease it. A dividend is a distribution of the corporation's assets, usually cash, to its owners. When the shop pays its stockholders a dividend, the owners take some of their claim home, so the claim left in the business shrinks.

Notice that revenue raises retained earnings whether the customer pays now or later. Revenue is about doing the work, not about when the cash arrives.

Worked example — the shop's retained earnings this month. Over Month 1 the shop has two revenue events, two expense events, and one dividend.

Revenues: $3,500 of repairs for walk-in customers, paid in cash, plus $1,800 of repairs for a delivery company on account. Revenues are 3,500 + 1,800 = $5,300.
Expenses: $1,500 of rent plus $1,600 of wages. Expenses are 1,500 + 1,600 = $3,100.
Dividends: $500.
Retained earnings effects: $5,300 − $3,100 − $500 = $1,700.

In words: the shop's work raised the owners' claim by $5,300, and the costs of that work lowered it by $3,100. The $500 dividend handed part of the rest to the owners, which leaves $1,700 of new retained earnings.

Misconception check — a dividend is an expense. Students often file a dividend next to rent and wages, because all three send cash out the door. It is tempting. But an expense is a cost of earning revenue, and a dividend earns nothing: it pays the owners. A dividend is a distribution to owners, never an expense: it pays the owners rather than helping to earn revenue. Both lower retained earnings, but for different reasons, and they are kept apart.

5. Transaction analysis: run the four questions

A transaction is an event that changes a business's assets, liabilities, or equity, which is why it belongs in the books. Signing a lease for next year is a promise, not yet a transaction; paying this month's rent is a transaction. Analyzing a transaction means deciding exactly what it changed.

Transaction analysis is the routine of asking four questions about every event:

What happened? Say it in plain words.
Which accounts change? Name them, using the account titles exactly.
In which direction? Each account goes up or down, and by how much.
Does the equation still balance? Add up the changes on each side and check.

You run the same four questions on every event, whether it is a $500 dividend or a $30,000 investment. The routine is the habit; the numbers change.

Worked example — collecting from a customer. On Day 25 the delivery company pays the shop $1,000 of what it owes.

What happened: a customer paid part of a bill for work the shop did earlier.
Which accounts change: Cash and Accounts Receivable.
Which direction: Cash goes up $1,000 (+$1,000). Accounts Receivable goes down $1,000 (−$1,000), because the customer owes $1,000 less.
Does it balance: the asset side changes by +$1,000 and −$1,000, a net change of zero. Liabilities and equity do not change. The equation still balances.

In words: the shop swapped one asset for another; it now holds $1,000 as cash instead of as a promise.

Misconception check — a collection is revenue. Students often see cash arriving from a customer and record revenue. It is tempting, because "the customer paid us" sounds like earning. But the shop earned that money on Day 18, when it did the repairs, and it counted the revenue then. On Day 25 nothing new was earned; a promise turned into cash. Counting revenue again would count the same work twice.

6. Walk the twelve transactions of Month 1

Now you can run the routine on the whole month. The running case's first month has twelve transactions, and they are illustrative: the shop and its numbers describe no real business. The table below follows them in order. After each one, it gives the running totals, so you can check the equation line by line.

The bicycle shop's twelve Month 1 transactions (illustrative), each account change, and the running totals after each one, in dollars
#	Day	What happened	Accounts that change	Total assets	Total liabilities	Total equity
1	1	Founders invest $30,000 cash for 30,000 shares	Cash +$30,000; Common Stock +$30,000	$30,000	$0	$30,000
2	2	Pays $12,000 cash for repair equipment	Cash −$12,000; Equipment +$12,000	$30,000	$0	$30,000
3	3	Buys $900 of shop supplies on account	Supplies +$900; Accounts Payable +$900	$30,900	$900	$30,000
4	4	Pays $2,400 for a 12-month insurance policy that begins on Day 1	Cash −$2,400; Prepaid Insurance +$2,400	$30,900	$900	$30,000
5	6	A cycling club pays $1,200 in advance for tune-ups not yet performed	Cash +$1,200; Unearned Revenue +$1,200	$32,100	$2,100	$30,000
6	15	Repairs for walk-in customers, $3,500 collected in cash	Cash +$3,500; retained earnings +$3,500 (service revenue)	$35,600	$2,100	$33,500
7	18	$1,800 of repairs for a delivery company on account	Accounts Receivable +$1,800; retained earnings +$1,800 (service revenue)	$37,400	$2,100	$35,300
8	20	Pays $1,500 rent for the month	Cash −$1,500; retained earnings −$1,500 (rent expense)	$35,900	$2,100	$33,800
9	22	Pays $600 of the $900 owed for supplies	Cash −$600; Accounts Payable −$600	$35,300	$1,500	$33,800
10	25	Collects $1,000 from the delivery company	Cash +$1,000; Accounts Receivable −$1,000	$35,300	$1,500	$33,800
11	28	Pays $1,600 wages to the part-time mechanic	Cash −$1,600; retained earnings −$1,600 (wages expense)	$33,700	$1,500	$32,200
12	30	Pays a $500 cash dividend to the shareholders	Cash −$500; retained earnings −$500 (dividends)	$33,200	$1,500	$31,700

Worked example — three lines checked by hand. You do not have to trust the table. Check any line by adding.

After transaction 3: assets $30,000 + $900 = $30,900. Liabilities $0 + $900 = $900. Equity stays $30,000. The check: $30,900 = $900 + $30,000.
After transaction 6: assets $32,100 + $3,500 = $35,600. Liabilities stay $2,100. Equity $30,000 + $3,500 = $33,500. The check: $35,600 = $2,100 + $33,500.
After transaction 9: assets $35,900 − $600 = $35,300. Liabilities $2,100 − $600 = $1,500. Equity stays $33,800. The check: $35,300 = $1,500 + $33,800.

In words: every row in the table balances on its own, so by Day 30 the month as a whole balances too.

Two rows deserve a closer look. In transaction 5, the club's $1,200 raises Cash, but the shop has not done the tune-ups, so the claim it creates is a liability, Unearned Revenue, not revenue. In transaction 9, the shop pays $600 of its $900 supplier bill, so Accounts Payable falls to $900 − $600 = $300.

In practice (your tools). In a free spreadsheet such as Google Sheets, you can rebuild this table with one column per account. Put each change in its row, then let formulas add the columns: for example, =SUM(C2:C13) totals the Cash column, and a check cell such as =F14-(G14+H14) should show 0 when assets equal liabilities plus equity. If the check cell ever shows anything else, the row where it first goes wrong is the row to fix.

Misconception check — every cash payment lowers equity. Students often assume that whenever cash goes out, the owners lose something. It is tempting, because cash leaving feels like a loss. But look at transactions 2, 4, and 9. Equity stays the same in all three, because the shop either got another asset back or paid down a debt. Only expenses and dividends lower equity.

7. Sort the transactions into five patterns

Twelve transactions can feel like twelve separate puzzles. They are not. Every one of them fits one of five patterns, and once you know the patterns, a new event usually takes seconds.

The five patterns of change in the accounting equation, with the Month 1 transactions that follow each one
Pattern	What happens to the equation	Month 1 transactions
An asset swapped for another asset	One asset up, another down by the same amount; totals unchanged	2, 4, and 10
An asset and a liability both up	Both sides grow by the same amount	3 and 5
An asset and a liability both down	Both sides shrink by the same amount	9
An asset and equity both up	Both sides grow; equity grows through Common Stock or revenue	1, 6, and 7
An asset and equity both down	Both sides shrink; equity shrinks through an expense or a dividend	8, 11, and 12

The patterns work for any business, not only a bicycle shop. Here are two fresh ones, described without dollar amounts so you can focus on the direction of each change.

Worked example — a tutoring business's first week. One client pays cash for a session. That is an asset and equity both up: Cash goes up, and retained earnings goes up through revenue. Another client has a session and will pay later. That is also an asset and equity both up, but the asset is different: Accounts Receivable goes up, and retained earnings goes up through revenue. In words: the tutor earned revenue both times, because the tutor did the work both times; only the asset that came in was different.

Worked example — a dog-grooming service. The service buys a grooming table on account. That is an asset and a liability both up: Equipment goes up, and Accounts Payable goes up by the same amount. Equity does not change. In words: the groomer has a new table and a new bill, and the owners' claim is exactly where it was.

Misconception check — a purchase on account changes equity. Students often think buying something on credit makes the owners poorer, because the business now has a bill. It is tempting. But the business also has the thing it bought, worth the same amount as the bill. Assets and liabilities rise together, and the owners' claim does not move. In Month 1, transaction 3 shows this: $900 of supplies and $900 of Accounts Payable, with equity unchanged at $30,000.

Pause and reflect. Choose one of these two and write two or three sentences in your notes:

(a) Think of a purchase you or your family made on credit or on a payment plan. Which of the five patterns did it follow for you, and what happened to what you "really owned" that day?
(b) Think of a time someone paid you before you did the work, such as a deposit for babysitting or a ticket for an event. Which pattern did it follow for the person you owed, and why was the cash not yet fully theirs?

8. Read the month's totals in one plain sentence

At the end of Month 1, each account has a balance. Add them up by group.

Worked example — the end-of-month check. Add each group, then compare the two sides.

Assets: Cash $17,100 + Accounts Receivable $800 + Supplies $900 + Prepaid Insurance $2,400 + Equipment $12,000 = total assets $33,200.
Liabilities: Accounts Payable $300 + Unearned Revenue $1,200 = total liabilities $1,500.
Equity: Common Stock $30,000 + retained earnings effects $1,700 = total stockholders' equity $31,700.
The check: $33,200 = $1,500 + $31,700.

The bicycle shop's account balances at the end of Month 1's twelve transactions (illustrative), in dollars, grouped by side of the equation
Assets	Amount	Liabilities and stockholders' equity	Amount
Cash	$17,100	Accounts Payable	$300
Accounts Receivable	$800	Unearned Revenue	$1,200
Supplies	$900	Common Stock	$30,000
Prepaid Insurance	$2,400	Retained earnings effects	$1,700
Equipment	$12,000
Total assets	$33,200	Total liabilities and stockholders' equity	$33,200

Now say it in one plain sentence. After its first twelve transactions the shop controls $33,200 of assets, and $1,500 of them are claimed by creditors while the other $31,700 is the owners' claim, which is not the same as the $17,100 of cash the shop holds.

That last clause is the payoff of the week. If you only looked at the cash drawer, you would see $17,100 and miss more than half the picture.

Honesty note. These are the totals after the twelve transactions, before any month-end updates. A real shop would also note at month's end that some supplies were used, some insurance expired, and some of the club's tune-ups were done. Those updates are real, and Week 4 teaches them; this week you take the twelve transactions as they happened.

A second caveat. The equation proves that the analysis is balanced, not that it is right. If you recorded rent as Equipment, the equation would still balance, and the books would still be wrong. Week 3 comes back to this limitation when it introduces the trial balance.

Misconception check — a balanced equation means the shop made $33,200. Students sometimes read total assets as profit. It is tempting, because $33,200 is the biggest number on the page. But most of those assets came from the founders' $30,000 and from creditors' $1,500. The shop's own earnings for the month, after the dividend, account for $1,700 of the owners' claim.

Key terms

Asset — a resource a business controls that is expected to provide future benefits, such as cash, amounts customers owe it, supplies, insurance paid in advance, or equipment. (first used: 1. Assets and liabilities: list what the shop has and what it owes)
Accounts Receivable — the asset account for amounts customers owe a business for goods or services it has already provided on account. (first used: 1. Assets and liabilities: list what the shop has and what it owes)
Liability — an obligation of a business to transfer resources, such as cash or services, to others; what the business owes its creditors. (first used: 1. Assets and liabilities: list what the shop has and what it owes)
Accounts Payable — the liability account for amounts a business owes its suppliers for goods or services it bought on account. (first used: 1. Assets and liabilities: list what the shop has and what it owes)
Stockholders' equity — the owners' residual claim on a corporation's assets, equal to total assets minus total liabilities; a claim on the business, not a sum of cash. (first used: 2. Stockholders' equity: separate the owners' claim from cash)
Contributed capital — the part of stockholders' equity that owners paid into the corporation in exchange for its shares, recorded in an account such as Common Stock. (first used: 2. Stockholders' equity: separate the owners' claim from cash)
Common Stock — the account that records the amount the owners invested in a corporation in exchange for its common shares. (first used: 2. Stockholders' equity: separate the owners' claim from cash)
Retained earnings — the part of stockholders' equity that comes from the business's own profits and has not been paid out to the owners. (first used: 2. Stockholders' equity: separate the owners' claim from cash)
Accounting equation — Assets = Liabilities + Stockholders' Equity, the relationship that says every resource a business has was supplied by its creditors or its owners. (first used: 3. The accounting equation: keep both sides equal)
Revenue — the amount a business earns by providing goods or services to customers in its ordinary operations, whether the customer pays in cash or on account. (first used: 4. Retained earnings: see what raises it and what lowers it)
Expense — the cost of the resources a business uses up to earn its revenue, such as rent or wages. (first used: 4. Retained earnings: see what raises it and what lowers it)
Dividend — a distribution of a corporation's assets, usually cash, to its owners, which lowers retained earnings but is not an expense. (first used: 4. Retained earnings: see what raises it and what lowers it)
Transaction analysis — the routine of deciding which accounts an event changes, in which direction, and whether the accounting equation still balances. (first used: 5. Transaction analysis: run the four questions)

Summary

Assets are what a business has; liabilities are what it owes; stockholders' equity is the owners' leftover claim.
Assets = Liabilities + Stockholders' Equity, after every transaction, not only at month's end.
Equity has two parts: contributed capital (Common Stock) and retained earnings.
Revenues raise retained earnings; expenses and dividends lower it; a dividend is never an expense.
Run four questions on every event: what happened, which accounts, which direction, does it balance.
Most events fit one of five patterns, so a new event is usually a pattern you already know.
The shop ends Month 1 with $33,200 = $1,500 + $31,700, and its $17,100 of cash is a different number from its equity.

Check your understanding

Work these before looking at the answers — they are ungraded, and the answers (with reasoning) are at the bottom of the page.

A landscaping company pays cash for a new lawn mower. Which accounts change, in which direction, and does stockholders' equity change?
A food truck caters an office lunch and sends the office a bill to pay next month. Which accounts change, and which of the five patterns is it?
A small software firm receives cash from a client for a year of support it will provide later. A classmate says, "The firm earned revenue, so equity went up." Explain what is wrong with that reading.
A farmers' market stall, organized as a corporation, pays its owners a cash dividend. Which accounts change, which pattern is it, and why is the dividend not an expense?

Answers (worked reasoning — read after attempting)

Equipment goes up and Cash goes down by the same amount. This is an asset swapped for another asset, so total assets do not change, and neither liabilities nor stockholders' equity change. The mower is an asset because the company will use it for many seasons; it is not an expense on the day it is bought.
Accounts Receivable goes up, and retained earnings goes up through revenue. It is the pattern "an asset and equity both up." The truck earned the revenue when it served the lunch, even though the cash comes next month; when the office pays, Cash will go up and Accounts Receivable will go down, with no new revenue.
The firm has not done the work yet, so it has not earned revenue. Cash goes up and Unearned Revenue, a liability, goes up by the same amount: the pattern "an asset and a liability both up." Equity does not change. The firm owes the client a year of support, or the money back, until it does the work.
Cash goes down, and retained earnings goes down through dividends. It is the pattern "an asset and equity both down." The dividend is not an expense because it does not help the stall earn revenue; it hands part of the owners' claim to the owners themselves.

Next up in this module: the Readings & Resources page, the lecture tutorial, the practice set, the quiz, the discussion, the assignment, and the Accounting Workshop. Next week, the debit-and-credit rule turns these same twelve transactions into journal entries.

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