The Accounting Equation

The equation

Everything in bookkeeping rests on one identity:

Assets = Liabilities + Equity

• Assets — what the business controls and expects to benefit from: cash, bank balances, money owed by customers, inventory, equipment, vehicles, property.
• Liabilities — what the business owes: suppliers, loans, tax due, wages payable.
• Equity — the owners’ residual interest: capital introduced, plus accumulated profits, less drawings or dividends.

The equation always holds because equity is defined as the remainder. Expanding it to include trading:

Assets = Liabilities + Capital + Income − Expenses − Drawings

Why two sides

Every transaction affects at least two accounts, because every transaction has a source and a destination. Buying a machine for cash converts one asset into another. Buying it on credit increases an asset and increases a liability. Paying a supplier reduces an asset and reduces a liability. There is no transaction with only one effect, which is why the books balance — and why an imbalance is proof of an error.

The five account types

• Assets — increased by debits.
• Expenses — increased by debits.
• Liabilities — increased by credits.
• Income — increased by credits.
• Equity — increased by credits.

A memory aid in wide use is DEAD CLIC: Debits increase Expenses, Assets and Drawings; Credits increase Liabilities, Income and Capital.

Debit and credit mean position, not value

A debit is the left side of an account and a credit is the right. Neither means good or bad, and neither means increase or decrease on its own — it depends entirely on the account type. This is the single point that confuses newcomers, and it is worth settling before going further. The everyday banking usage, where a credit to your account is money in, is from the bank’s books: your deposit is a liability of theirs, and liabilities increase with credits.

Worked examples

• Owner introduces 10,000 cash. Debit Bank 10,000 (asset up); Credit Capital 10,000 (equity up).
• Buy inventory for 2,000 on credit. Debit Inventory 2,000 (asset up); Credit Trade Payables 2,000 (liability up).
• Sell goods for 3,000 cash that cost 1,800. Debit Bank 3,000, Credit Sales 3,000; and Debit Cost of Sales 1,800, Credit Inventory 1,800.
• Pay rent of 500. Debit Rent Expense 500 (expense up); Credit Bank 500 (asset down).
• Customer pays an invoice of 1,200. Debit Bank 1,200; Credit Trade Receivables 1,200. Note that no income arises here — the income was recorded when the sale was made.