The Accounting Equation, Explained

The accounting equation is a formula and principle in accounting that says a company’s assets must be equal to its liabilities and equity — otherwise, the company hasn’t recorded its transactions accurately. This equation relies on the double-entry system of accounting, where every transaction results in positive or negative changes to at least two of these accounts: assets, liabilities, or equity.

What Is the Accounting Equation?

The accounting equation shows how a company’s assets, liabilities, and equity are related and how a change in one results in a change to another. In the basic accounting equation, assets are equal to liabilities plus equity. 

You can find a company’s assets, liabilities, and equity on key financial statements, such as balance sheets and income statements (also called profit and loss statements). These financial documents give overviews of the company’s financial position at a given point in time. The accounting equation ensures the balance sheet is balanced, which means the company is recording transactions accurately. 

Who Uses the Accounting Equation?

Accountants and members of a company’s financial team are the primary users of the accounting equation. Understanding how to use the formula is a crucial skill for accountants because it’s a quick way to check the accuracy of transaction records . 

Other professionals who may use the accounting equation include: 

• Business analysts when determining the financial health of a company
• Budget analysts when crafting spending plans for an organization
• Investment bankers when comparing companies in mergers and acquisitions (M&As) 
• Financial analysts when reviewing an organization’s financial records to plan for business or financial decision-making
• Auditors when analyzing the accuracy of a business’s finances and reports

Basic Accounting Equation Formula

The fundamental accounting equation formula is: 

Assets = Liabilities + Equity

You can express this formula in other ways, like “equity = assets – liabilities,” but they all serve the same purpose: ensuring correct and balanced balance sheets and financial records. On the other hand, if assets are not equal to liabilities plus equity (or if it does not balance), it likely means there’s a mistake in financial reporting or data processing.

Components of the Basic Accounting Equation

Assets

An asset is anything a company owns. Assets typically hold positive economic value and can be liquified (turned into cash) in the future. Some assets are less liquid than others, making them harder to convert to cash. For instance, inventory is very liquid — the company can quickly sell it for money. Real estate, though, is less liquid — selling land or buildings for cash is time-consuming and can be difficult, depending on the market. 

Some examples of assets include: 

• Cash
• Prepaid expenses
• Equipment and machinery
• Inventory 
• Buildings or property

Liabilities

Liabilities are the amounts of money the company owes to others. Think of liabilities  as obligations — the company has an obligation to make payments on loans or mortgages or they risk damage to their credit and business. 

Examples of liabilities include: 

• Deferred revenue
• Accounts payable (money owed to lenders or customers)
• Loan payments 
• Mortgages
• Accrued expenses

Equity

There are two ways to look at equity: One is to consider equity as any assets left over after deducting all liabilities. In fact, the equation for determining how much equity a company has involves subtracting the company’s liabilities from its assets. 

However, equity can also be thought of as investments into the company either by founders, owners, public shareholders, or by customers buying products leading to higher revenue. 

Some examples of equity include: 

• Owner contributions
• Net profits
• Investments from shareholders

Expanded Accounting Equation Formula

In the expanded accounting equation, equity is broken down into further components. The formula for the expanded accounting equation is: 

Assets = Liabilities + CC + BRE + R – E – D

In this formula: 

• CC is contributed capital: the money put into the company in exchange for stocks 
• BRE is beginning retained earnings: accumulated income from the previous year or accounting period that was saved and not paid out to shareholders as dividends
• R is revenue: money the company gains from sales and business operations
• E is expenses: money the company spends to run the business (this is subtracted)
• D is dividends: money the company distributes to shareholders (this is subtracted)

With the accounting equation expanded, financial analysts and accountants can better understand how a company structures its equity. Additionally, analysts can see how revenue and expenses change over time, and the effect of those changes on a business’s assets and liabilities.

What Is the Double-Entry Accounting System?

The accounting equation relies on a double-entry accounting system. In this system, every transaction affects at least two accounts. For example, if a company buys a $1,000 piece of equipment on credit, that $1,000 is an increase in liabilities (the company must pay it back) but also an increase in assets. 

These two sides of a transaction are debit (DR) and credit (CR). So, taking out a business loan will increase liabilities (credit) but also increase spending power and assets (debit). Conversely, lowering liabilities, perhaps by paying off a loan or selling a property, will have a positive and negative effect on assets: the lost asset is deducted but the increased spending power is a positive asset change. 

>>MORE: Check out some of the best jobs for accounting majors in 2024.

Accounting Equation in Practice

Using Apple’s 2023 earnings report, we can find all the information we need for the accounting equation. 

For 2023, Apple reported:

• Total assets: $352,583 million
• Total liabilities: $290,437 million
• Total equity: $62,146 million

So, using the accounting equation, we have: 

$352,583m (assets) = $290,437m (liabilities) + $62,146m (equity)

And we find that the numbers balance, meaning Apple accurately reported its  transactions and its double-entry system is working. 

Showing You Understand the Accounting Equation on Resumes

The accounting equation is a foundational hard skill every accountant needs.If you have prior work or internship experience with balancing books or creating and understanding financial statements, employers  will likely expect that you know the accounting equation. 

However, in the description for your accounting work or internship experience, you could say: 

• “I recorded, tracked, and reported Company X’s financial statements, and ensured everything was accurate using the accounting equation.” 

Additionally, you can use your cover letter to detail other experiences you have with the accounting equation. For example, you can talk about a time you balanced the books for a friend or family member’s small business. 

Related Skills for Accountants

Using the accounting equation is vital for a career in accounting, but there are many more skills accountants need to be successful. Some of the most important skills for accountants include: 

• Knowing how to create and read financial statements
• Having the ability to calculate profit margins
• Understanding of accounting-specific formulas, such as the current ratio
• Practical knowledge of the generally accepted accounting principles (GAAP)

Start learning these accounting skills today with Forage’s free accounting job simulations.

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