What is the accounting equation?
The accounting equation states that a business's assets always equal its liabilities plus its equity, which is why every balance sheet balances.
What the accounting equation means
The equation is: Assets = Liabilities + Equity. Assets are what the business owns or is owed. Liabilities are what it owes to others. Equity is what belongs to the owners. Rearranged, equity equals assets minus liabilities, which is why it is also called net assets.
Every transaction changes at least two items in a way that keeps the equation balanced. This is the basis of double-entry bookkeeping.
Example
A new company makes five transactions.
| Transaction | Assets | Liabilities | Equity |
|---|---|---|---|
| Shareholder invests £10,000 | Cash +£10,000 | Share capital +£10,000 | |
| Buys a laptop for £1,500 | Laptop +£1,500, cash −£1,500 | ||
| Takes a £5,000 bank loan | Cash +£5,000 | Loan +£5,000 | |
| Invoices a client £3,000 | Debtors +£3,000 | Profit +£3,000 | |
| Pays rent of £800 | Cash −£800 | Profit −£800 | |
| Totals | £17,200 | £5,000 | £12,200 |
Assets of £17,200 (cash £12,700, laptop £1,500 and debtors £3,000) equal liabilities of £5,000 plus equity of £12,200.
How it links to double-entry bookkeeping
In double-entry bookkeeping, every transaction is recorded as a debit in one account and a credit in another, for the same amount. Debits increase assets and expenses; credits increase liabilities, equity and income. Because each entry has two equal sides, the accounting equation always stays in balance, and the trial balance shows total debits equal to total credits.
Profit is part of equity. When the business earns income, equity rises; when it incurs expenses, equity falls. At the year end, the profit or loss for the year moves into retained earnings on the balance sheet, which is how the profit and loss account and the balance sheet connect.
Lenders often look at the equation in reverse, checking how much of the assets are funded by debt rather than by the owners.
Why it matters for your business
The equation is a built-in check. If your records do not balance, something has been entered on one side only. It also shows how the business is funded: by the owners, through equity, or by others, through liabilities. A business whose liabilities exceed its assets has negative equity, a warning sign that lenders and suppliers will notice. Cloudkeepers reviews clients' balance sheets as part of their regular accounts.
Common questions
It means there is an error in the records, such as a transaction entered once instead of twice, an amount keyed in wrongly, or a missing opening balance. Accounting software enforces double entry, so in practice an imbalance usually points to a problem with imported data or a suspense account.
Yes. For a sole trader, equity is the owner's capital account: money put in, plus profits, less drawings. The same check applies to their records, even though sole traders are not required to publish a balance sheet.