The Accounting Equation

Definition

The accounting equation states that a corporation's economic resources always equal the sum of claims against those resources. Creditors have the first claim (liabilities) and shareholders hold the residual claim (equity). The equation must hold after every transaction, which is why double-entry bookkeeping records two equal and offsetting effects for every event.

Key rules

• Every transaction has at least one debit and one credit of equal total value.
• Total assets on the balance sheet must equal total liabilities plus total equity at every reporting date.
• Equity expands into contributed capital (share capital) and retained earnings. Net income and dividends flow through retained earnings.
• The expanded form used for the full cycle is: Assets = Liabilities + Share Capital + Retained Earnings + Revenue − Expenses − Dividends.
• CRA requires corporations to keep books that permit the determination of taxes payable, which in practice means a double-entry system built on this equation.

Example

A new BC corporation receives $10,000 from its sole shareholder in exchange for common shares, then buys a $2,500 laptop on a company credit card.

Entry 1. Share issuance
Debit:  Cash (Asset)                 $10,000
Credit: Share Capital (Equity)       $10,000

Entry 2. Laptop purchase on credit
Debit:  Computer Equipment (Asset)   $2,500
Credit: Accounts Payable (Liability) $2,500

After both entries: Assets $12,500 = Liabilities $2,500 + Equity $10,000.

Common mistakes

• Treating a shareholder deposit as revenue. A capital contribution increases equity, not income.
• Recording only one side of a transaction, which leaves the trial balance out of agreement.
• Booking dividends as an expense. Dividends reduce retained earnings inside equity and are not deductible for tax.
• Confusing the purchase of a capital asset (asset for asset swap, or asset for liability) with an expense.
• Forgetting that unrealized owner draws from a CCPC typically sit in a shareholder loan (liability or contra-asset), not in equity.

Related concepts

The equation is the foundation for every other topic in this category. Debits and credits are the mechanical language that keeps it in balance, normal balances describe which side increases each account, and journal entries are how each transaction is captured. At the end of the period the equation is proved through the trial balance and presented to users on the balance sheet.