What it means
The equation is a statement of ownership. On the left are the resources the business controls: cash, receivables, stock, equipment, property.
On the right are the claims on those resources: liabilities are the claims of lenders, suppliers, employees and the tax authority; equity is the residual claim of the owners after everyone else is paid. Since every resource must have been financed by someone, the claims add up to the resources.
There is no third possibility. Every transaction touches the equation in one of a few ways.
Buying equipment with cash swaps one asset for another; the left side is unchanged. Buying equipment on credit raises assets and raises liabilities by the same amount.
Taking out a loan raises cash and raises liabilities. Owners investing raises cash and raises equity.
Earning revenue raises assets (cash or receivables) and raises equity through profit. Paying an expense reduces cash and reduces equity.
Repaying a loan reduces cash and reduces liabilities. In every case the two sides move together or one side has offsetting changes, and the equation holds.
The expanded form makes profit explicit: Assets = Liabilities + Share Capital + Retained Earnings, where retained earnings are the cumulative revenues minus expenses minus dividends. This is why the income statement and balance sheet are linked: the period's profit is the change in retained earnings, and it is the mechanism by which trading activity ends up in the owners' equity.
The equation is also a diagnostic tool. If a bookkeeping system does not balance, an entry has been made on only one side.
If a company's liabilities exceed its assets, equity is negative and the business is balance-sheet insolvent. If assets are growing but equity is not, the growth is being funded by debt.
Reading a balance sheet is, at bottom, reading the equation and asking which side has been doing the work.
In practice
Real-world examples.
Example
A company with $2 million of assets and $1.2 million of liabilities has equity of $800,000, whatever its shares are trading at.
Example
A business that borrows $500,000 to buy a building sees both sides of its equation rise by $500,000; its equity is unchanged but its leverage has increased.
Example
A company that loses $300,000 in a year sees its assets (cash) fall and its equity fall by the same amount, with liabilities unchanged.
Think of it
“The accounting equation: what you own = what you owe + what belongs to owners. Always in balance.
Formula
Calculation
Assets = Liabilities + Equity
Expanded: Assets = Liabilities + Share Capital + Retained Earnings
Rearranged: Equity = Assets minus Liabilities
Worked example. A new catering business goes through its first month:
1. Owner invests $30,000 cash. Assets $30,000 (cash) = Liabilities $0 + Equity $30,000.
2. Buys a van for $18,000, paying $8,000 cash and financing $10,000. Assets: cash $22,000 + van $18,000 = $40,000. Liabilities: van loan $10,000. Equity $30,000. Check: $40,000 = $10,000 + $30,000.
3. Buys $3,000 of supplies on credit. Assets $43,000 (adds supplies $3,000). Liabilities $13,000 (adds payables $3,000). Equity $30,000. Check: $43,000 = $13,000 + $30,000.
4. Caters an event for $9,000, paid in cash, using $2,500 of supplies. Assets: cash $31,000, van $18,000, supplies $500 = $49,500. Liabilities $13,000. Equity: $30,000 + revenue $9,000 minus expense $2,500 = $36,500. Check: $49,500 = $13,000 + $36,500.
5. Pays $1,200 rent and $2,000 wages in cash. Assets $46,300. Liabilities $13,000. Equity $36,500 minus $3,200 = $33,300. Check: $46,300 = $13,000 + $33,300.
6. Pays the $3,000 supplier. Assets $43,300. Liabilities $10,000. Equity $33,300. Check: $43,300 = $10,000 + $33,300.
Month-end position: assets $43,300 (cash $24,800, van $18,000, supplies $500); liabilities $10,000; equity $33,300, made up of $30,000 capital and $3,300 retained profit. The profit of $3,300 ($9,000 minus $2,500 minus $3,200) is exactly the increase in equity.Case study
Seen in the real world.
A start-up founder preparing for an investor meeting produced a balance sheet in a spreadsheet that showed assets of $410,000 and liabilities plus equity of $385,000. She assumed the $25,000 difference was rounding and adjusted equity to make it balance. The investor's accountant, reviewing the figures, refused to accept a balance sheet that had been forced and asked for the underlying ledger.
The $25,000 turned out to be a customer deposit that had been recorded as cash received but not as a liability; the founder had, in effect, counted the customer's money as her own. Once recorded correctly, liabilities rose by $25,000, equity fell by $25,000, and the equation balanced without adjustment. The investor proceeded, but the accountant's advice stayed with the founder: the equation is not a formatting rule, it is a check, and a balance sheet that does not balance is telling you something is missing.
Watch out
Common mistakes.
- Forcing a balance sheet to balance with a plug figure. An imbalance means a transaction has been recorded on one side only; find it.
- Thinking equity is money in the bank. Equity is a claim on all the assets, most of which are not cash.
- Reading growth in assets as success without checking which side of the equation funded it.
Questions
People also ask.
Why must the accounting equation always balance?
Because every asset was paid for with either borrowed money (a liability) or owners' money (equity), and double-entry bookkeeping records both sides of every transaction.
How does profit fit into the equation?
Profit increases equity through retained earnings; losses decrease it. Revenue and expenses are temporary accounts that feed into equity at the period end.
What does it mean if liabilities exceed assets?
Equity is negative. The business owes more than it owns and is insolvent on a balance sheet basis, though it may continue if it can pay its debts as they fall due.
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