Every number in the financial statements belongs to one of five elements only: an asset, a liability, equity, revenue or an expense. Know these five and you know how to read any financial statement.
1 Assets: what the business owns
An asset is a resource controlled by the business as a result of past events, from which economic benefits are expected to flow to it. Assets are split by how quickly they turn into cash:
- Current assets: expected to convert into cash within a year — cash, receivables, inventory, prepaid expenses.
- Non-current assets: held for long-term use — land, buildings, machinery, vehicles, and intangibles such as software and trademarks.
The test that separates them
Ask: will this thing bring me a benefit in the future? If yes it is an asset; if its benefit is already used up it is an expense.
2 Liabilities: what the business owes others
A liability is a present obligation of the business arising from a past event, whose settlement will transfer resources out of it. It is split the same way:
- Current liabilities: settled within a year — payables, accrued expenses, the current portion of loans, tax payable.
- Non-current liabilities: settled after more than a year — long-term loans and end-of-service benefits.
3 Equity: what belongs to the owners
Equity is what remains of the assets after all liabilities are settled, which is why it is sometimes called net assets. Its main components are:
- Capital: what the owners contributed at formation or afterwards.
- Retained earnings: accumulated profits that were not distributed and stayed in the business.
- Drawings or distributions: what the owners took out — these reduce equity.
4 Revenue and expenses: the drivers of equity
Revenue is an increase in benefits during the period arising from the main activity — selling goods or providing a service. An expense is a decrease in benefits incurred to earn that revenue — salaries, rent, electricity. The difference between them is the result for the period, profit or loss, and it ultimately flows into equity.
Assets
What the business owns
Liabilities
What it owes others
Equity
The owners’ share
Revenue
Increases equity
Expenses
Decrease equity
The five elements: three in the statement of financial position, two in the income statement
5 The expanded accounting equation
If we bring revenue, expenses and drawings inside equity, the equation takes its full form:
The expanded form
- Assets = Liabilities + Capital + Revenue − Expenses − Drawings
- Every transaction touches at least two items, and yet both sides stay equal.
- If the equation does not balance, the fault is in the recording — not in the equation.
6 How transactions affect the equation
Take a business that started with capital of 100,000 and follow four transactions and the effect of each:
| Transaction | Assets | Liabilities | Equity |
|---|---|---|---|
| Capital deposited in cash 100,000 | +100,000 cash | — | +100,000 capital |
| Goods purchased on credit 30,000 | +30,000 inventory | +30,000 payables | — |
| Service sold for cash 15,000 | +15,000 cash | — | +15,000 revenue |
| Salaries paid 6,000 | −6,000 cash | — | −6,000 expense |
| Total | 139,000 | 30,000 | 109,000 |
Check: 139,000 = 30,000 + 109,000. The equation did not break at any step.
A common mistake
Treating a loan as revenue. A loan is a liability that increases cash and increases liabilities; it does not increase equity and never enters the income statement.
7 Where does each element appear?
| Element | Statement it appears in | Example |
|---|---|---|
| Assets | Statement of financial position | Cash, inventory, buildings |
| Liabilities | Statement of financial position | Payables, loans |
| Equity | Statement of financial position | Capital, retained earnings |
| Revenue | Income statement | Sales, service revenue |
| Expenses | Income statement | Salaries, rent, depreciation |
Lesson summary
- There are five elements: assets, liabilities, equity, revenue and expenses.
- Assets and liabilities split into current and non-current at the one-year line.
- Equity is what remains for the owners after all liabilities are settled.
- Revenue increases equity; expenses and drawings reduce it.
- However many transactions occur, the equation stays in balance.
8 Test yourself
Three quick questions
Choose the answer you think is correct — the result appears immediately.
1. “Rent paid in advance for next year” is classified as:
Its benefit has not been consumed yet, so it is a right of the business against another party — a current asset that turns into an expense gradually as time passes.
2. The business takes a bank loan of 50,000. What is the effect?
Cash rose by 50,000 (an asset) and an obligation to the bank arose for the same amount. Equity is unaffected.
3. If assets are 400,000 and liabilities are 150,000, equity equals:
Equity = Assets − Liabilities = 400,000 − 150,000 = 250,000.