Track 1 · What accounting does
The accounting equation
Assets = liabilities + equity: see how every transaction keeps the accounting equation in balance, with an interactive simulator.
You will be able to
- Define assets, liabilities and equity.
- Show the effect of a transaction on the accounting equation.
- Use the equation to find a missing figure, including profit for a period.
Builds on
Related standards
Conceptual Framework ch. 4
Everything a business controls was financed by someone. Either it was borrowed — the business owes it to lenders or suppliers — or it came from the owners. That gives the accounting equation:
Assets = Liabilities + Equity
- Assets are resources the business controls that can bring future economic benefits: cash, amounts customers owe, inventory, equipment.
- Liabilities are present obligations to transfer resources: amounts owed to suppliers, loans, wages not yet paid, work customers have paid for but not yet received.
- Equity is what is left for the owners after liabilities: the money they invested plus the profits kept in the business.
Read the equation two ways. The left side lists what the business has; the right side lists who has a claim on it. Lenders and suppliers have first claim; the owners own whatever remains. That's why equity is sometimes called the residual interest: Equity = Assets − Liabilities.
Every transaction keeps it balanced
Each transaction changes at least two things, and the changes always keep both sides equal. There are only four patterns:
- Both sides up — e.g. borrow from a bank (cash up, loan up), or shareholders invest (cash up, equity up).
- Both sides down — e.g. repay a supplier (cash down, payable down), or pay an expense (cash down, equity down).
- Swap within assets — e.g. buy equipment for cash, or collect from a customer. Total assets don't change.
- Swap within claims — e.g. a supplier agrees to turn an overdue bill into a loan. Total liabilities and equity don't change.
Interactive
Try it: build a business's equation one transaction at a time
Record transactions and watch assets, liabilities and equity stay in balance.
0 = 0 + 0 — balanced
| Transaction | Assets | Liabilities | Equity | Pattern |
|---|---|---|---|---|
| 1 Apr — Maya and Theo pay 20,000 for shares | 20,000 | 0 | 20,000 | Both sides up |
| 1 Apr — Northgate Bank lends 18,000 | 38,000 | 18,000 | 20,000 | Both sides up |
| 1 Apr — pay April's studio rent, 800 | 37,200 | 18,000 | 19,200 | Both sides down (expense) |
| 1 Apr — pay a year's insurance in advance, 2,400 | 37,200 | 18,000 | 19,200 | Swap within assets |
| 2 Apr — buy a laptop by debit card, 2,880 | 37,200 | 18,000 | 19,200 | Swap within assets |
| 3 Apr — buy supplies on 30-day credit, 500 | 37,700 | 18,500 | 19,200 | Both sides up |
| 3 Apr — buy desks and chairs on 30-day credit, 720 | 38,420 | 19,220 | 19,200 | Both sides up |
| 7 Apr — design a café menu, paid on the spot, 650 | 39,070 | 19,220 | 19,850 | Both sides up (revenue) |
Each row shows the running totals after the transaction, taken from Lumen's ledger. Assets equal liabilities plus equity on every line. Paying for a year's insurance in advance is a swap: cash becomes another asset, prepaid insurance — cover Lumen will use month by month.
Practice
Practising as a guest — attempts aren't saved.
Exercise 1 · Accounting equation
On 1 April Lumen borrows 18,000 from Northgate Bank, repayable over three years. How does this affect the accounting equation?
Exercise 2 · Accounting equation
On Friday 17 April Lumen pays Maya and Theo 3,900 of salaries for the 13 working days they have worked since 1 April. How does this affect the equation?
Exercise 3 · Accounting equation
On 7 May Kiln & Co. Ceramics pays Lumen the 1,200 it owed for a logo invoiced on 8 April. How does this affect the equation?
Exercise 4 · Accounting equation
On 18 December Lumen's board declares a dividend of 3,000 and pays it to Maya and Theo the same day. How does this affect the equation?
Exercise 5 · Calculate
A company has total assets of 85,000 and total liabilities of 32,000. What is its equity?
Exercise 6 · Worksheet
Marigold Bakery Ltd starts trading in May. Complete the totals after each transaction. The first row is done for you.
Exercise 7 · Calculate
On 1 March a company's equity was 25,000. During March it earned a profit of 4,000 and paid dividends of 1,500; it issued no shares. Its liabilities on 31 March were 18,000. What were its total assets on 31 March?
Exercise 8 · Calculate
Fernway Bikes Ltd lost its income statement, but the owners kept these figures. Using the accounting equation, what profit did Fernway make for the year?
Key points
- Assets = liabilities + equity, always — what the business has equals who has a claim on it.
- Every transaction affects at least two items and keeps the equation balanced.
- Revenue increases equity; expenses and dividends decrease it; borrowing and collecting from customers do neither.
- Closing equity = opening equity + new shares + profit − dividends.
Content review: answers and figures are checked by automated tests against the accounting engine, and the text has had an internal review against the standards; independent review by a qualified accountant is pending.