Last reviewed: July 2026.
The accounting equation expresses the relationship between the economic resources controlled by a business and the claims against those resources:
Assets = Liabilities + Equity
Every valid transaction keeps the equation in balance. Double-entry bookkeeping is the system used to record the changes.
What each element means
- Assets: present economic resources controlled by the entity because of past events.
- Liabilities: present obligations to transfer economic resources because of past events.
- Equity: the residual interest in assets after deducting liabilities.
These definitions connect basic bookkeeping with the IFRS Conceptual Framework.
Expanded accounting equation
For learning and analysis, equity can be expanded:
Assets = Liabilities + Owner capital + Income − Expenses − Drawings
For a company, owner capital and drawings are replaced by share capital, reserves and distributions. Income increases equity; expenses and distributions reduce it.
Transaction examples
| Transaction | Assets | Liabilities | Equity |
|---|---|---|---|
| Owner invests 50,000 CU cash | +50,000 | — | +50,000 |
| Buy equipment for 20,000 CU cash | Equipment +20,000; cash −20,000 | — | — |
| Buy inventory on credit for 8,000 CU | +8,000 | +8,000 | — |
| Earn 12,000 CU cash revenue | +12,000 | — | +12,000 |
| Pay 3,000 CU rent | −3,000 | — | −3,000 |
| Repay 2,000 CU supplier balance | −2,000 | −2,000 | — |
Owner investment
An owner contributes 50,000 CU cash. Cash increases and owner capital increases by the same amount:
- Debit cash 50,000 CU
- Credit owner capital 50,000 CU
The equation becomes assets 50,000 CU = liabilities 0 + equity 50,000 CU.
Credit purchase
Inventory of 8,000 CU is bought on credit:
- Debit inventory 8,000 CU
- Credit trade payables 8,000 CU
Assets and liabilities both rise. Equity is unchanged until inventory is sold or written down.
Revenue and expense effects
When revenue is earned, equity increases through profit. When an expense is incurred, equity decreases. Cash timing can differ because revenue may create a receivable and expenses may create a payable.
Read the revenue recognition guide and the related accrual-accounting articles.
Cash withdrawal by the owner
A sole trader withdraws 4,000 CU cash for personal use:
- Debit drawings 4,000 CU
- Credit cash 4,000 CU
Drawings reduce equity but are not a business expense. For a company, distributions such as dividends are also transactions with owners rather than operating expenses.
Link to debits and credits
Assets and expenses normally increase with debits. Liabilities, equity and income normally increase with credits. The rule is not “debit means increase”; the effect depends on the account type.
See the ledger accounts guide and double-entry bookkeeping article.
Worked multi-transaction example
A new business completes these transactions:
- Owner invests 100,000 CU cash.
- Business borrows 40,000 CU from a bank.
- Equipment costing 60,000 CU is bought for cash.
- Services of 25,000 CU are provided, of which 15,000 CU is collected and 10,000 CU remains receivable.
- Expenses of 9,000 CU are paid.
Closing assets are cash 86,000 CU, equipment 60,000 CU and receivables 10,000 CU: total 156,000 CU. Liabilities are 40,000 CU. Equity is owner capital 100,000 CU plus profit of 16,000 CU: total 116,000 CU.
156,000 = 40,000 + 116,000.
Transactions that change composition but not totals
Some transactions change the composition of assets without changing total assets. Buying equipment for cash exchanges one asset for another. Collecting a receivable increases cash and decreases receivables by the same amount.
Other transactions change both sides equally, such as borrowing cash or repaying a supplier. Understanding the pattern makes journal analysis faster and reduces classification errors.
Contra accounts and net amounts
Accumulated depreciation reduces the carrying amount of property, plant and equipment, and an expected credit loss allowance reduces receivables. These contra balances do not break the equation; they reduce the net asset reported.
For example, equipment cost of 100,000 CU less accumulated depreciation of 30,000 CU gives a net asset of 70,000 CU.
Profit, retained earnings and distributions
Profit increases equity through retained earnings. Losses and owner distributions reduce equity. The equation therefore links the income statement, statement of changes in equity and statement of financial position.
Review the updated purpose of accounting guide for how these statements support decisions and accountability.
Equation and the statement of financial position
The statement of financial position is a structured presentation of the accounting equation. Assets are reported alongside liabilities and equity, with classifications and disclosures determined by applicable requirements.
Review the protected financial statements and balance sheet guide.
Equation and the trial balance
The trial balance lists debit and credit ledger balances. Equal totals support the equation, but a balanced trial balance can still contain omissions, classification errors and reversals.
The trial balance worked example shows the flow into financial statements.
Negative equity and complex transactions
The equation remains valid when equity is negative. If liabilities exceed assets, the residual is a deficit. Complex transactions such as leases, provisions, derivatives and deferred tax still affect the same basic relationship, even though measurement is more advanced.
Common mistakes
- treating every cash receipt as income;
- treating a loan as revenue;
- recording owner drawings as an expense;
- forgetting the cost-of-sales entry when inventory is sold;
- assuming debit always means increase;
- ignoring receivables and payables because cash has not moved;
- believing a balanced equation proves every classification is correct.
Key takeaway
The accounting equation is the foundation of financial reporting. Analyse each transaction by the resources, obligations and equity effects it creates, then record equal debits and credits.
Official learning references: IFRS Conceptual Framework and ACCA FA1 technical articles, including the accounting equation.