# The accounting equation

> Assets = liabilities + equity is not a formula you apply at period end. It is true after every single entry, and that is what makes the books provable.

Source: https://lopifi.com/learn/the-accounting-equation
Part of: Lopifi — US GAAP books on autopilot, checked by a CPA (https://lopifi.com)

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**What is the accounting equation and why does it always balance?** Assets = liabilities + equity is not a formula you apply at period end. It is true after every single entry, and that is what makes the books provable.

Everything a business has came from somewhere. That sentence, taken literally, is the whole of accounting: the things it holds must equal the claims on those things. Someone lent it, someone invested it, or the business earned it.

*[The accounting equation]*

Day zero. Nothing on either side, and the equation still holds.

An [Asset](https://lopifi.com/md/glossary/asset) is a present right of the business to an economic benefit — cash, a receivable, stock on a shelf, a van. A [Liability](https://lopifi.com/md/glossary/liability) is an obligation to hand something over — a supplier's bill, an accrued cost, a deposit taken for goods not yet delivered. [Equity](https://lopifi.com/md/glossary/equity) is what is left over for the owners after every obligation is met. Not "the money in the bank", and not "what the company is worth" — the residual.

So on 1 September, the founders pay in $60,000. Assets go up by $60,000 in cash. Nobody outside is owed anything, so the whole claim belongs to the owners.

> “An asset is a present right of an entity to an economic benefit.”

© Financial Accounting Foundation. All rights reserved.

— [CON 8, Ch. 4, ¶E16](https://www.fasb.org/concepts-statements), Definition of an asset

> “A liability is a present obligation of an entity to transfer an economic benefit.”

© Financial Accounting Foundation. All rights reserved.

— [CON 8, Ch. 4, ¶E37](https://www.fasb.org/concepts-statements), Definition of a liability

Those two definitions are narrower than the everyday words. "A present right to an economic benefit" excludes something you hope to get; "a present obligation to transfer an economic benefit" excludes something you intend to spend. Equity is defined last and defined as the leftover, which is why the equation is a definition rather than a discovery.

> “The terms equity or net assets represent the residual interest in the assets of an entity that remains after deducting its liabilities.”

© Financial Accounting Foundation. All rights reserved.

— [CON 8, Ch. 4, ¶E61](https://www.fasb.org/concepts-statements), Definition of equity

*[The accounting equation]*

After JE-1: $60,000 of assets, $60,000 of equity.

Now watch what the van does. Northwind buys it for $24,000 in cash. Assets fall by $24,000 and rise by $24,000 — cash became a van. Nothing on the right-hand side moves at all, because nothing about who has a claim changed. This is why an entry has two sides even when only one side of the equation is involved.

> **The equation holds after every entry, not just at month end. A transaction that breaks it has been recorded wrong — there is no third possibility.**

## Six shapes, one rule

| Shape | Example from September | Effect on the equation |
| --- | --- | --- |
| Asset up, asset down | Buy the van for cash | Both sides unchanged |
| Asset up, liability up | Take $18,000 of stock on 30-day terms | Both sides up |
| Asset up, equity up | Founders pay in $60,000; a sale is made | Both sides up |
| Asset down, liability down | Pay the supplier $12,000 | Both sides down |
| Asset down, equity down | Pay September's rent; goods leave inventory as a cost | Both sides down |
| Liability up, equity down | Accrue the power used but not yet billed | Liabilities up, equity down |

Every entry in September is one of these shapes, and every one keeps the equation balanced. Others exist — a loan converted to shares moves a liability into equity — and they obey the same rule.

Revenue and expenses are not a fourth category — they are equity, moving. Revenue increases the owners' claim, expenses decrease it, and the reason they get their own accounts is that "equity went up by $2,550" is a useless sentence compared to "we sold $31,500 and it cost us $28,950". Written out in full, the equation a bookkeeper actually works with is `assets = liabilities + contributed capital + opening retained earnings + revenue − expenses − dividends` — revenue, expenses and dividends folded into retained earnings when the year is closed. (Northwind pays no dividends and has no retained earnings yet, so for September the last terms are zero.)

*[The accounting equation]*

Where September ends. The same equation, with a month of trading inside it.

**Check yourself.** Northwind pays $12,000 to its supplier. What happens to equity?

- It falls by $12,000 — money left the business. — Money leaving is not the test. Ask what claim changed: the supplier's claim shrank by exactly as much as the cash did.

- Nothing. Assets and liabilities both fall by $12,000. — Both sides fall together. Paying a bill settles someone else's claim; the owners' residual is untouched.

- It rises — the company owes less. — Owing less and owning less happen at the same instant here, and they cancel exactly.

- **Lesson:** 2 of 13 — 7 min
- **Terms taught:** [Accounting equation](https://lopifi.com/md/glossary/accounting-equation), [Asset](https://lopifi.com/md/glossary/asset), [Liability](https://lopifi.com/md/glossary/liability), [Equity](https://lopifi.com/md/glossary/equity), [Balance sheet](https://lopifi.com/md/glossary/balance-sheet)
- **Previous:** [Why the books exist](https://lopifi.com/md/learn/why-the-books-exist)
- **Next:** [Accounts, and the five types](https://lopifi.com/md/learn/accounts-and-the-chart)
- **The course:** https://lopifi.com/learn