What is the Accounting Equation?

Understanding the accounting equation is a crucial step in managing your business finances effectively. Even if you’re not an accountant, knowing how this equation works can help you keep your books balanced, spot mistakes early, and make better financial decisions.

For small business owners, the accounting equation — Assets = Liabilities + Equity — serves as the foundation for all bookkeeping and financial statements. It explains how your business resources (assets) are funded, whether through debts (liabilities) or the owner’s contributions (equity).

In this guide, we’ll break down the accounting equation in simple terms, explain why it matters, and give easy examples to help you apply it to your own business. Whether you’re just starting out or want to brush up on your bookkeeping knowledge, this post will give you the confidence to understand your numbers better.

The Accounting Equation and the Double Entry Bookkeeping System

The Accounting Equation formula, also known as the balance sheet equation, is a fundamental principle in accounting that must always be balanced. This is due to the system of double-entry accounting, where every financial transaction affects at least two accounts, ensuring that for every debit, there is a matching credit. This ensures that the books are balanced, so that the total value of a company’s assets always equals the sum of its liabilities and equity.

This principle is supported by the Generally Accepted Accounting Principles (GAAP), a set of standard accounting rules and practices used to ensure consistency, accuracy, and fairness in financial reporting. Under GAAP, businesses are required to follow double-entry accounting and maintain balanced financial records, which helps provide a clear and reliable picture of a company’s financial health.

What is the Accounting Equation, and What Does it Mean for a Company’s Financial Health

The Accounting Equation is a key principle in accounting that states a company’s total assets must always equal the sum of its liabilities and equity. This simple formula helps track a business’s financial health and ensures that its resources are properly accounted for, meaning the company isn’t spending more than it has.

In accounting, various financial ratios are also used to measure performance and health. Some of the most common include the debt-to-equity ratio, the current ratio, and the return on equity. These ratios all rely on accurate financial data, which starts with the basic accounting equation.

The basic Accounting Equation formula is written as:

Assets = Liabilities + Equity (Owners or Shareholder funds)

There are three components to the Accounting Equation: assets, liabilities, and shareholder equity

Let’s break it down:

Assets are the tangible and intangible items that a business owns, including computers, equipment, property, goodwill, patents, cash, and accounts receivable.

Liabilities are the amounts that a business owes, including loans, accounts payable, overdrafts, and taxes that are due.

Equity is the value the owners have invested in the business, plus retained earnings from past profits or losses.

Understanding these three components is crucial for maintaining a balanced set of books and making informed financial decisions.

Introduction to the Financial Statements

Financial statements are formal records that show the financial activities and the company’s financial position. They are essential tools for owners, investors, and managers to understand how well the company is performing and where improvements may be needed. The three main financial statements are:

Balance Sheet

The balance sheet provides a snapshot of the company’s assets, liabilities, and equity at a specific point in time. It is directly based on the accounting equation (Assets = Liabilities + Equity) and shows what the business owns and owes.

Profit and Loss

Also called the income statement, the income statement summarises the company’s revenues, expenses, and profits (or losses) over a period. It helps assess how well the business is generating income compared to its costs.

Cash Flow Statement

The cash flow statement tracks the movement of cash in and out of the business. It illustrates how operating, investing, and financing activities affect the company’s cash position, ensuring there is sufficient liquidity to meet its obligations.

Together, these statements provide a comprehensive view of a company’s financial health and are typically prepared in accordance with Generally Accepted Accounting Principles (GAAP) to ensure accuracy and consistency. Understanding these reports helps business owners make informed financial decisions and plan for the future.

Accounting Equation Example

Below is a simple Balance sheet showing Assets, Liabilities and Equity; from this, we can use the accounting equation.

From the simple example above, the accounting equation now looks like this:

Assets 3000 = Liabilities 500 plus Equity 2500

Therefore, both sides equal 3000

The retained earnings are the figures from the profit and loss account.

As with all equations, you can rearrange the accounting equation. Rearranging, it would give the following:

If we go back to our example above, the accounting equation will now look like this:

Equity 2500 = Assets 3000 – Liabilities 500

Therefore, both sides equal 2500

Basic Accounting Equation Explained

The Basic Accounting Equation is a simple equation that states that a business’s assets are equal to its liabilities plus its equity. This equation is important because it helps to understand how a business operates and generates revenue.

We will now look in detail at each section of the accounting equation with a brief description:

Assets

These are items that the company owns and includes the following: 

Fixed Assets

Fixed Assets are long-term assets that a company owns and uses in the production of its goods or services. These assets typically have a lifespan of more than one year and include items such as land, buildings, equipment, and intellectual property, including patents.

Current Assets

Current assets are assets that a company can turn into cash within one year. This includes things such as cash, accounts receivable, and inventory.

Intangible Assets

Intangible assets are items that a business owns that are not physical, including goodwill, trademarks, and patents.

Liabilities

A liability is a financial obligation of a company (money owed). It is recorded on the company’s balance sheet as a debt. Liabilities are divided into two categories: current and long-term.

Current Liabilities

Current liabilities are those that must be paid within one year and include the following:

• Accounts payable – payments owed to suppliers
• Bank loans and overdraft
• Paye and wages owed
• Accruals
• Deferred Revenue

Long-Term Liabilities

A long-term liability is a debt that must be paid back over a period longer than one year. The most common types of long-term liabilities are bonds and mortgages.

Owner’s Equity

Owner’s equity is the portion of a company’s balance sheet that represents the amount of money invested in the company by its owners. It is called owner’s equity because it represents the equity (or ownership) of the company’s owners. It is made up of two components:

• Capital invested – Includes shareholders’ equity
• Retained earnings – Net income from the profit and loss account (Income less expenses)

As shown in the example below, all of the above transactions are recorded on the balance sheet, which is part of the financial statements.

Expanded Accounting Equation

The expanded accounting equation breaks down the equity part of the basic equation to provide more detailed information, especially when examining how profits, investments, and withdrawals affect the business.

Here’s how it looks:

Assets = Liabilities + Owner’s Capital + Revenues – Expenses – Drawings

Or for companies:
Assets = Liabilities + Share Capital + Retained Earnings + Revenues – Expenses – Dividends

Double Entry Accounting System

The double-entry accounting system ensures that the basic accounting equation remains balanced at all times. Every transaction affects at least two accounts, meaning the total value of assets will always equal the sum of liabilities and equity.

For example, when a business purchases a computer for use, both the bank account (an asset) and the computer (also an asset) are affected. The bank balance decreases, while the value of equipment or fixed assets increases by the same amount. Although individual asset accounts change, the total value of assets remains unchanged, maintaining the accounting equation in balance.

A business pays for training. The assets will decrease as money is withdrawn from the bank, and the retained earnings will decrease as training is included as an expense in the profit and loss account.

A cost of sales item is purchased on credit – The accounts payable (liability) will increase, and the retained earnings will reduce.

Further reading is available on the balance sheet and double entry bookkeeping pages.

Accounting Equation and Accounting Software

Using accounting software can greatly simplify managing your business finances by automatically applying the double-entry bookkeeping method. This means every transaction you enter — whether it’s a sale, expense, or payment — is recorded in at least two accounts, following the double-entry system.

Modern software, such as QuickBooks or Xero, handles this behind the scenes, reducing errors and ensuring your accounts stay balanced. With built-in features such as automated reports, bank reconciliations, and financial statement generation, accounting software enables small business owners to maintain accurate records, save time, and stay on top of their financial health without requiring in-depth accounting knowledge.

Conclusion on the Basic Accounting Equation

Understanding the fundamental accounting equation is essential for any small business owner. It forms the foundation of all bookkeeping and financial reporting, ensuring that your assets always equal your liabilities plus owner’s equity.

This balance is maintained through the double-entry accounting system, where every transaction is recorded in at least two accounts — one as a debit and one as a credit. This system ensures the accuracy of your books. It helps prevent errors, ensuring that your financial statements (balance sheet, income statement, and cash flow statement) provide an accurate and fair representation of your business’s financial health.

By mastering these fundamental concepts, you can more effectively track your business’s performance, make informed decisions, and confidently plan for growth.

Return from the free basic accounting equation to the Accounting Basics page.