Mistaken idea “Equity is the cash a company has”

Correction

Equity equals total assets minus total liabilities. Cash is only one asset, so its balance does not measure the company's equity.

Calculate equity from all assets and liabilities

Use all reported assets and liabilities in the calculation:

Equity = Total assets - Total liabilities

Cash is one asset account. It is not a measure of equity.

Why the wrong answer seems reasonable

Harbor Design is a new design-services corporation. Cash and equity can be equal when a company begins. Its shareholders contribute $40,000 cash, so Harbor Design initially has $40,000 of Cash, no liabilities, and $40,000 of equity. The mistake turns that temporary match into a general rule.

Where it goes wrong

Harbor Design then pays $18,000 cash for equipment. Its accounts now show $22,000 of Cash and $18,000 of Equipment. Harbor Design still has $40,000 of total assets and no liabilities:

Equity = ($22,000 Cash + $18,000 Equipment) - $0 liabilities
       = $40,000

Setting equity equal to $22,000 would ignore the equipment. The cash purchase changed the mix of assets, not the amount of equity.

Check your answer

If your equity amount always matches Cash, check whether the company has other assets or any liabilities. Also check whether you changed equity when one asset was exchanged for another.

What to do instead

1. Add all reported asset balances, including Cash.
2. Add all reported liability balances.
3. Subtract total liabilities from total assets.
4. Use the separate account balances to explain why equity differs from Cash.