Accounting equation

The accounting equation is the fundamental relationship underlying all financial accounting: assets = liabilities + equity. Assets are the resources a business controls (cash, inventory, equipment, receivables), liabilities are claims held by outsiders (loans, accounts payable), and equity is the residual claim belonging to the owners. Because every resource must be financed by someone, the two sides always balance.

The equation is the engine of double-entry bookkeeping. Every transaction affects at least two accounts and leaves the equation in balance. If a company borrows $50,000, cash (an asset) rises by $50,000 and loans payable (a liability) rises by $50,000. If it buys $10,000 of equipment with cash, one asset increases while another decreases — the totals never move out of balance.

Rearranging the equation makes it a practical problem-solving tool. Equity equals assets minus liabilities, which is why equity is also called net assets. Accountants use this to reconstruct missing figures from incomplete records: if you know opening equity, closing equity, owner drawings, and any capital introduced during the year, you can back into profit for the period. The balance sheet itself is simply the accounting equation presented as a formal statement.

The accounting equation is tested directly on the ACCA Financial Accounting (FA) exam and the CMA Part 1 exam, both of which build double-entry bookkeeping and the statement of financial position on top of it. Expect questions that give two elements of the equation and ask for the third.