The accounting equation · Trial Balance

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What it is: A rule that is always true: Assets = Liabilities + Equity.

Why it is true: Everything a business owns was paid for with money from one of two places. The money was either borrowed (a liability) or put in by the owner (equity). So the value of what the business owns always equals the money that paid for it.

What you do: For each transaction, find the two things that change. Check that the equation still balances afterwards.

Important: The business is treated as separate from its owner. The owner’s own house or car is not included.

Example. A business buys a van for £10,000. It pays £2,000 from the owner’s money and borrows £8,000. Assets (van) £10,000 = Liabilities (loan) £8,000 + Equity (owner’s money) £2,000. Both sides are £10,000.

Key words

Asset: Something the business owns or controls that will bring it money or another benefit in future.Example: Cash in the bank, stock to sell, a delivery van, and money customers owe are all assets.
Liability: An amount the business owes to someone else, which it will have to pay in future.Example: A bank loan, an unpaid supplier invoice and tax owed to HMRC are liabilities.
Equity (capital): The owner’s share of the business: the money the owner put in, plus profits kept in the business, minus drawings. It equals assets minus liabilities.Example: Assets £50,000 − liabilities £18,000 = equity £32,000.
Transaction: Any business event involving money, such as a sale, a purchase or a payment. Each transaction is recorded in the accounts.Example: Paying £850 of rent is one transaction.

Learn

Every transaction changes at least two things. After every transaction, this equation is still true:

Assets = Liabilities + Equity

Assets are things the business owns or is owed. Examples: cash, inventory (goods to sell), equipment, money customers owe.
Liabilities are amounts the business owes to other people. Examples: unpaid suppliers, bank loans, tax.
Equity is the owner’s share. It is the money the owner put in, plus profit kept in the business, minus money the owner took out (drawings).

Most transactions follow one of these four patterns:

Pattern	Example	What happens to the equation
An asset goes up, and a liability or equity goes up by the same amount	The owner puts in £5,000 cash	Assets +£5,000. Equity +£5,000.
One asset goes up and another asset goes down	Buy equipment for £2,000 cash	Equipment +£2,000. Cash −£2,000. Totals do not change.
An asset goes down, and a liability or equity goes down by the same amount	Pay a supplier £800	Cash −£800. Liabilities −£800.
Income or an expense	Pay rent of £500	Cash −£500. Equity −£500, because an expense reduces profit.

Why income and expenses change equity. Profit belongs to the owner. Income increases profit, so it increases equity. Expenses reduce profit, so they reduce equity.

Watch it explained

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Videos from YouTube tutors

These videos are made by independent tutors on YouTube, not by Trial Balance. They may use slightly different terms, for example “owner’s equity” instead of “capital”.

Worked example

A new business has four transactions. Track the totals after each one.

Transaction	Assets £	Liabilities £	Equity £
1. Owner invests £10,000 cash	10,000	0	10,000
2. Buys a van for £6,000 cash	10,000	0	10,000
3. Buys inventory for £2,000 on credit	12,000	2,000	10,000
4. Pays rent of £500	11,500	2,000	9,500

After every line, assets equal liabilities plus equity. Transaction 2 changes the mix of assets (£6,000 van, £4,000 cash) but not the total. Transaction 4 reduces equity because rent is an expense.

Practice questions

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