What Is the Accounting Equation, and How Do You Calculate It? (2024)

What Is the Accounting Equation?

The accounting equation states that a company’s total assets are equal to the sum of its liabilities and its shareholders’ equity.

This straightforward relationship between assets, liabilities, and equity is considered to be the foundation of the double-entry accounting system. The accounting equation ensures that the balance sheet remains balanced. That is, each entry made on the debit side has a corresponding entry (or coverage) on the credit side.

The accounting equation is also called the basic accounting equation or the balance sheet equation.

Key Takeaways

  • The accounting equation is considered to be the foundation of the double-entry accounting system.
  • The accounting equation shows on a company’s balance sheet that a company’s total assets are equal to the sum of the company’s liabilities and shareholders’ equity.
  • Assets represent the valuable resources controlled by a company. The liabilities represent its obligations.
  • Both liabilities and shareholders’ equity represent how the assets of a company are financed.
  • Financing through debt shows as a liability, while financing through issuing equity shares appears in shareholders’ equity.

What Is the Accounting Equation, and How Do You Calculate It? (1)

What Are the Key Components in the Accounting Equation?

The financial position of any business, large or small, is based on two key components of the balance sheet: assets and liabilities. Owners’ equity, or shareholders’ equity, is the third section of the balance sheet.

The accounting equation is a representation of how these three important components are associated with each other.

Assets represent the valuable resources controlled by a company, while liabilities represent its obligations. Both liabilities and shareholders’ equity represent how the assets of a company are financed. If it’s financed through debt, it’ll show as a liability, but if it’s financed through issuing equity shares to investors, it’ll show in shareholders’ equity.

The accounting equation helps to assess whether the business transactions carried out by the company are being accurately reflected in its books and accounts. Below are examples of items listed on the balance sheet.

Assets

Assets include cash and cash equivalentsorliquid assets, which may include Treasury billsandcertificates of deposit (CDs).

Accounts receivablelist the amounts of money owed to the company by its customers for the sale of its products. Inventory is also considered an asset.

The major and often largest value assets of most companies are that company’s machinery, buildings, and property. These are fixed assets that are usually held for many years.

Liabilities

Liabilities are debts that a company owes and costs that it needs to pay in order to keep the company running.

Debt is a liability, whether it is a long-term loan or a bill that is due to be paid.

Costs include rent, taxes, utilities, salaries, wages, and dividendspayable.

Shareholders’ Equity

The shareholders’ equity number is a company’s total assets minus itstotal liabilities.

It can be defined as the total number of dollars that a company would have left if it liquidated all of its assets and paid off all of its liabilities. This would then be distributed to the shareholders.

Retained earningsare part of shareholders’ equity. This number is the sum of total earningsthat were not paid to shareholdersasdividends.

Think of retained earnings as savings, since it represents the total profits that have been saved and put aside (or “retained”) for future use.

Accounting Equation Formula and Calculation

Assets=(Liabilities+Owner’sEquity)\text{Assets}=(\text{Liabilities}+\text{Owner's Equity})Assets=(Liabilities+Owner’sEquity)

The balance sheet holds the elements that contribute to the accounting equation:

  1. Locate the company’s total assets on the balance sheet for the period.
  2. Total all liabilities, which should be a separate listing on the balance sheet.
  3. Locate total shareholders’ equity and add the number to total liabilities.
  4. Total assets will equal the sum of liabilities and total equity.

As an example, say leading retailer XYZ Corp. reported the following on its balance sheet for its latest full fiscal year:

  • Total assets: $170 billion
  • Total liabilities: $120 billion
  • Total shareholders’ equity: $50 billion

If we calculate the right-hand side of the accounting equation (equity + liabilities), we arrive at ($50 billion + $120 billion) = $170 billion, which matches the value of the assets reported by the company.

What Is the Purpose of the Double-Entry System?

The accounting equation is a concise expression of the complex, expanded, and multi-item display of a balance sheet.

Essentially, the representation equates all uses of capital (assets) to all sources of capital, where debt capital leads to liabilities and equity capital leads to shareholders’ equity.

For a company keeping accurate accounts, every business transaction will be represented in at least two of its accounts. For instance, if a business takes a loan from a bank, the borrowed money will be reflected in its balance sheet as both an increase in the company’s assets and an increase in its loan liability.

If a business buys raw materials and pays in cash, it will result in an increase in the company’s inventory (an asset) while reducing cash capital (another asset). Because there are two or more accounts affected by every transaction carried out by a company, the accounting system is referred to as double-entry accounting.

The double-entry practice ensures that the accounting equation always remains balanced, meaning that the left-side value of the equation will always match the right-side value.

In other words, the total amount of all assets will always equal the sum of liabilities and shareholders’ equity.

The global adherence to the double-entry accounting system makes the account-keeping and -tallying processes more standardized and foolproof.

The accounting equation ensures that all entries in the books and records are vetted, and a verifiable relationship exists between each liability (or expense) and its corresponding source; or between each item of income (or asset) and its source.

Limits of the Accounting Equation

Although the balance sheet always balances out, the accounting equation can’t tell investors how well a company is performing. Investors must interpret the numbers and decide for themselves whether the company has too many or too few liabilities, not enough assets, or perhaps too many assets, or whether its financing is sufficient to ensure its long-term growth.

What Is a Real-World Example of the Accounting Equation?

Below is a portion of Exxon Mobil Corp.’s(XOM)balance sheetin millions as of Sept. 30, 2023:

  • Total assets were $372,259
  • Total liabilities were $164,726
  • Total equity was $207,533

The accounting equation is calculated as follows:

$164,726 (total liabilities) + $207,533 (equity) = $372,259 (which equals the total assets for the period)

Why Is the Accounting Equation Important?

The accounting equation captures the relationship between the three components of a balance sheet: assets, liabilities, and equity. All else being equal, a company’s equity will increase when its assets increase, and vice versa. Adding liabilities will decrease equity, while reducing liabilities—such as by paying off debt—will increase equity. These basic concepts are essential to modern accounting methods.

What Are the Three Elements of the Accounting Equation?

The three elements of the accounting equation are assets, liabilities, and shareholders’ equity. The formula is straightforward: A company’s total assets are equal to its liabilities plus its shareholders’ equity. The double-entry bookkeeping system, which has been adopted globally, is designed to accurately reflect a company’s total assets.

What Is an Asset in the Accounting Equation?

An asset is anything with economic value that a company controls that can be used to benefit the business now or in the future. They include fixed assets, such as machinery and buildings. They may include financial assets, such as investments in stocks and bonds. They also may be intangible assets, like patents, trademarks, and goodwill.

What Is a Liability in the Accounting Equation?

A company’s liabilities include every debt it has incurred. These may include loans,accounts payable, mortgages, deferred revenues, bond issues, warranties, and accrued expenses.

What Is Shareholders’ Equity in the Accounting Equation?

Shareholders’ equity is the total value of the company expressed in dollars. Put another way, it is the amount that would remain if the company liquidated all of its assets and paid off all of its debts. The remainder is the shareholders’ equity, which would be returned to them.

The Bottom Line

The accounting equation is based on the premise that the sum of a company’s assets is equal to its total liabilities and shareholders’ equity. As a core concept in modern accounting, this provides the basis for keeping a company’s books balanced across a given accounting cycle.

What Is the Accounting Equation, and How Do You Calculate It? (2024)

FAQs

What Is the Accounting Equation, and How Do You Calculate It? ›

What is the Accounting Equation? The accounting equation is a formula that shows the sum of a company's liabilities and shareholders' equity are equal to its total assets (Assets = Liabilities + Equity).

How do you calculate an accounting equation? ›

The basic accounting equation gives meaning to the balance sheet structure and is the foundation of double-entry accounting. It has the following formula: Assets = Liabilities + Owner's Equity.

What is the accounting equation and explain it? ›

Accounting equation is referred to as the relationship between assets, liabilities and capital of a business. The accounting equation is one of the most important equations in accounting and is used for preparing balance sheet. It can be represented by the following equation: A = C + L.

What are the steps of the accounting equation? ›

Step 1: Locate the company's total assets for the accounting period in question. Step 2: Add up all the liabilities from this same accounting period. Step 3: Locate the shareholder's equity and add this figure to the liabilities. Step 4: Ensure that the total assets equal the sum of total equity and liabilities.

What is the formula for the accounting equation quizlet? ›

For a corporation the equation is Assets = Liabilities + Stockholders' Equity. For a nonprofit organization the accounting equation is Assets = Liabilities + Net Assets. Because of double-entry accounting this equation should be in balance at all times.

What is the accounting equation for dummies? ›

The accounting equation is a formula that shows the sum of a company's liabilities and shareholders' equity are equal to its total assets (Assets = Liabilities + Equity). The clear-cut relationship between a company's liabilities, assets and equity are the backbone to double-entry bookkeeping.

What does the basic accounting equation say? ›

In the basic accounting equation, assets are equal to liabilities plus equity.

How to calculate total assets? ›

Total Assets = Total Liabilities + Total Stockholder's Equity. Total Liabilities are debts that the company owes. The stockholder's equity is shares and stocks owned by the shareholders or owners of the company.

How do you calculate the balance sheet? ›

The balance sheet is based on the fundamental equation: Assets = Liabilities + Equity.

What is the basic accounting equation sheet? ›

Basic Accounting Equation: Assets = Liabilities + Equity

The accounting equation states that a company's assets must be equal to the sum of its liabilities and equity on the balance sheet, at all times.

How to calculate owner's equity? ›

Owner's equity is used to explain the difference between a company's assets and liabilities. The formula for owner's equity is: Owner's Equity = Assets - Liabilities.

What is an example of accounting? ›

Examples of Accounting Transactions

Credit sales and cash from purchases. Receipt of cash from invoices. The purchase of assets. Payments on loans payable to a creditor.

What is the accounting equation defined as *? ›

The accounting equation states that a company's total assets are equal to the sum of its liabilities and its shareholders' equity. This straightforward relationship between assets, liabilities, and equity is considered to be the foundation of the double-entry accounting system.

Which of the following is a accounting equation formula? ›

The correct form of accounting equation is Assets – Liabilities = Equity. It can also be written as Assets = Liabilities + Equity. This equation is also known as the balance sheet equation.

What is the accounting equation stated? ›

The accounting equation can be restated as: Assets - Equity = Liabilities.

What is the accounting equation worksheet? ›

The accounting equation is the basis of double-entry accounting. Used to ensure company assets equal liabilities and equity, the accounting equation helps keep your books balanced. The fundamental accounting equation is the foundation of the double-entry accounting system.

How to calculate profit with assets and liabilities? ›

In fact, it's quite simple! All you need to do is subtract your total liabilities from your total assets. This will give you your net worth or net income.

What is the formula for the financial account? ›

Balance of financial account = Net direct investment + Net portfolio investment + Assets funding + Errors and omissions.

How to calculate owner's equity in accounting? ›

It is calculated by deducting all liabilities from the total value of an asset (Equity = Assets – Liabilities).

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