The accounting profession is full of equations, but only one accounting equation is so important that they call it "the accounting equation." That equation goes like this: Assets = Liabilities + Equity. Since liabilities and equity live on the same side of the equation, it might be natural to assume that an increase in liabilities will result in a decrease in equity. But in accounting, few things are ever so simple, which is why people have accountants.
The accounting equation holds true no matter what kind of business is involved -- whether it’s a small business you’re looking to start, or a giant corporation you’re looking to invest in by buying stock. Each part of the equation has a specific meaning in the language of business, which sometimes, but not always, resembles English. An asset is anything the company owns that holds future economic value. A liability is a future obligation, usually financial. Equity is the difference between them. Think of it as what the owners of the company would walk away with if they sold all the assets and settled all the liabilities.
About Those Liabilities
So liabilities are obligations. But those obligations don’t drop out of thin air onto a company’s balance sheet; the business gets something in exchange for them. Think about your own finances. If you take out a car loan, the amount you owe is a liability. But you get something in return for that liability: your car, which is an asset. Similarly, if a company takes out a $100,000 loan, it assumes a liability. But it gets something in return: $100,000 in cash (perhaps the best asset of all). Most of the major liabilities on a business’ balance sheet actually have the effect of increasing assets on the other side of the accounting equation, not reducing equity. When a company pays off a liability, it typically does so with cash. The liability shrinks, and so does the cash asset on the other side of the equation. Equity is unaffected by any of this.
Expenses are what really reduce equity. An expense is an instance in which value leaves the company. Your wages, for example, are an expense for your employer, because in paying them, it’s letting go of money without getting a hard asset in return. Expenses directly reduce a company’s net income, also called its profit. Profit flows directly into equity; if a company reports $100,000 in net income, for example, then its equity grows by $100,000. Therefore, an increase in expenses means a reduction in equity -- although, for profitable companies, this reduction really just translates into a smaller increase. Not all costs are expenses, though. If your employer buys a plot of land, or a major piece of equipment, or even a bunch of inventory, the cost isn’t an expense because no value has left the company. The company has merely traded one asset for another -- cash for land, or equipment, or inventory.
When Liabilities Become Expenses
By their very nature, some liabilities generate expenses. Interest on borrowed money is a prime example. When a company takes out a $100,000 loan, it agrees to pay the money back with interest. Repaying the $100,000 itself isn’t an expense, because the company (hopefully) still has $100,000 worth of whatever it used the loan for. But the interest is an expense, since the company is saying goodbaye to the value of that money. As anyone who’s ever run up a big credit card bill can attest, interest can mean saying goodbye to a lot of money.
- "Financial Accounting for MBAs," Fourth Edition; Peter Easton, et al; 2010