Basic Accounting Equation

Basic accounting equation assets liabilities and equity

There is a basic accounting equation which relates to the double-entry system. The equation will always balance unless a mistake has been made.

Assets = Liabilities + Equity (Owners or Shareholder funds)

In more detail, an asset is something that you own; this includes computers, equipment, premises, goodwill, patents, money, and accounts receivable.

Liabilities is money that you owe and includes loans, accounts payable, overdrafts and taxes payable.

Equity is the amount that owners have introduced into the business and any profit and loss.

Basic Accounting Equation Example

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

Assets  
Computers 1500
Fixtures and Fittings 750
Accounts Receivable 575
Bank 175
Total Assets 600
Liabilities  
Accounts Payable 425
PAYE 75
Total Liabilities 500
.  
Equity  
Finance Introduced 2000
Retained Earnings 500
Total Equity 2500

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

Assets 3000 = Liabilities 500 plus Equity 2500

Therefore 3000 = 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:

Basic Accounting Equation rearranged

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

Equity 2500 = Assets 3000 – Liabilities 500

Therefore 2500 = 2500

Basic Accounting Equation Explained

We have looked at what the equation is, and now we will look at the detail behind the figures. It is a basic list, but a larger business may have more categories.

Assets

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

  • Fixed Assets – Computers, fixtures and fittings, equipment and land 
  • Current Assets – Bank, stock and accounts receivable
  • Tangible Assets – Goodwill, trademarks and patients

Liabilities

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

Equity

  • Capital invested
  • Retained earnings – Net income from the profit and loss account

Double Entry Accounting

As with all accounting, as it is a double entry, the basic accounting equation will always balance. Below are a few examples of how double entry adjusts the figures in the accounting equation.

A business purchases a computer – As both the bank and computer are both assets, the total figure of assets will not change.

A business pays for training – The assets will reduce as the money is taken from the bank, and the retained earnings will reduce as training is part of 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.

Return from free basic accounting equation to Accounting Basics page.