Accounting Equation


  • What is the Accounting Equation? 
  • What is the Purpose of the Accounting Equation? 
  • Balancing the Accounting Equation 
  • Accounting Equation example
  • The Expanded Accounting Equation 
  • Practical Application of the Accounting Equation 
  • Limitations of the Accounting Equation 

What is the Accounting Equation? 

The accounting equation, also referred to as the balance sheet equation, serves as a cornerstone of accounting. It outlines the relationship among an entity’s assets, liabilities, and owner’s equity at any given moment. 

To compute the accounting equation, the following formula is employed:  

Assets = Liabilities + Owner’s Equity 


  • Assets include the resources possessed by the entity, such as cash, inventory, equipment, and accounts receivable.  
  • Liabilities include the entity’s obligations to external parties, including loans, accounts payable, and taxes.  
  • Equity denotes the owners’ stake or investment in the entity. 

This formula signifies that the total worth of an entity’s assets equals the combined value of its debts and the claims of its owners.  

The equation must always be balanced, meaning that the aggregate value of the entity’s assets must be equivalent to the total of its liabilities plus owner’s equity. This principle adheres to the accounting standard of double-entry bookkeeping. 

The accounting equation forms the basis of financial accounting and facilitates the preparation of the balance sheet, which is one of the primary financial statements offering a snapshot of an entity’s financial status at a specific point in time. 

What is the Purpose of Accounting Equation? 

The accounting equation serves as a fundamental principle in the practise of double-entry accounting, which is the basis for creating balance sheets. These balance sheets showcase an entity’s total assets, liabilities, and shareholder equity. 

Essentially, the accounting equation ensures that an entity’s use of capital (assets) remains in equilibrium with its sources of capital (debt and equity). In double entry accounting, every transaction is recorded in at least two financial accounts.  

For example, when an entity buys raw materials using cash, it records this transaction in both the inventory and cash accounts. This results in an increase in the inventory asset and a decrease in cash capital, in accordance with double entry accounting principles. 

Similarly, when an entity takes out a business loan, the borrowed funds increase assets while simultaneously increasing liabilities in the form of debt. These examples illustrate how double-entry accounting maintains balanced books. 

The accounting equation formalises this balance by stipulating that the total value of assets must always equal the combined value of equity and liabilities. This standardisation facilitates uniform management of accounts for global corporations and ensures balanced transactions at all levels. It establishes a clear relationship between each expense and its financing source, providing verifiable financial records. 

Calculating your fuel tax credit is a straightforward process.

Balancing the Accounting Equation 

To ensure accuracy in financial transactions, accounting teams follow a straightforward process to balance the accounting equation. This involves examining each of the three components: 

Step 1: Identify the total assets of the entity for the relevant accounting period. 

Step 2: Sum up all liabilities recorded during the same accounting period. 

Step 3: Locate the shareholder’s equity and add this amount to the total liabilities. 

Step 4: Verify that the total assets are equal to the combined sum of total equity and liabilities. 

If the equation is not balanced, it indicates the need to carefully review the financial records to identify any inaccuracies or errors in recorded transactions. This meticulous review ensures the reliability and accuracy of the entity’s financial statements. 

Accounting Equation example

XYZ Corporation initiates its operations with certain financial transactions.  

Firstly, the company secures a loan of $40,000 from a bank. This loan is considered a liability as it represents an obligation to repay the borrowed amount in the future. 

Next, let’s examine ABC Corporation’s existing assets and equity. The company possesses $60,000 in cash and $30,000 worth of equipment. These resources constitute the company’s assets, representing the valuable resources it owns. 

In terms of equity, ABC Corporation’s owner has invested $50,000 into the business. This investment represents the owner’s stake or claim on the assets of the company. 

Now, let’s apply the accounting equation: Assets = Liabilities + Equity.  

By plugging in the numbers: 

Assets ($90,000) = Liabilities ($40,000) + Equity ($50,000). 

As we can see, the equation balances: the total value of the company’s assets ($90,000) equals the sum of its liabilities ($40,000) and equity ($50,000). This demonstrates that the company’s financial position is in equilibrium, with its assets financed by a combination of liabilities (the loan) and owner’s equity (the owner’s investment). 

Young Businessman Calculating Tax With Calculator At Desk.

The Expanded Accounting Equation 

Expanding the accounting equation allows for a more detailed representation of an entity’s financial position by incorporating additional categories such as revenues, expenses, gains, losses, dividends, and contributions. 

This expansion results in various formulations of the equation, such as: 

Assets = Liabilities + Contributed capital + Retained earnings 


Assets = Liabilities + Contributed Capital (CC) + Beginning Retained Earnings (BRE) + Revenues + Gains – Expenses – Losses – Dividends 

The expanded accounting equation illustrates how the components of the income statement and the statement of changes in equity impact the balance sheet. It also demonstrates the interconnectedness of an entity’s financial activities, providing insights into how financial transactions affect its overall financial health and position. 

Practical Application of the Accounting Equation 

The accounting equation serves both as a theoretical concept and a practical tool with various applications, including: 

  • Generating the three fundamental financial statements: the balance sheet, income statement, and statement of changes in equity. By adhering to the accounting equation, entities can accurately compile these statements, offering insights into their financial position, performance, and changes in equity over time. 
  • Forming the basis of the double entry bookkeeping system, which is a fundamental accounting method used to record financial transactions. The accounting equation ensures that every transaction recorded in an entity’s books maintains balance, enhancing accuracy and reliability in financial reporting. 
  • Assessing an entity’s book value, which represents its worth based on its financial statements. By utilising the accounting equation, entities can calculate their book value by subtracting liabilities from assets, providing an indication of their net worth as recorded in their financial records. 
  • Calculating income and retained earnings, crucial metrics for evaluating an entity’s profitability and financial stability. The accounting equation facilitates the determination of income by comparing revenues to expenses, while retained earnings represent the portion of net income retained within the entity for future use or distribution to shareholders. 

Thus, the accounting equation serves as a versatile tool for entities in managing their finances, recording transactions accurately, and deriving key financial metrics essential for decision making and performance evaluation. 

Limitations of the Accounting Equation 

While the accounting equation is a useful tool for assessing an entity’s financial position, it has certain limitations that must be acknowledged: 

  • It does not reflect the impact of factors like inflation, impairment, depreciation, and amortisation on the value of assets and liabilities. These factors can affect the true economic value of assets and liabilities over time. 
  • The accounting equation overlooks qualitative aspects of an entity, such as its reputation, brand recognition, and customer loyalty, which can significantly influence its overall value and performance in the market. 
  • It does not account for the risks and uncertainties inherent in business operations, such as market fluctuations, competitive pressures, regulatory changes, and other external factors that may impact an entity’s financial health. 
  • The accounting equation does not consider the time value of money, which refers to the concept that money available today is more valuable than the same amount of money in the future due to its potential earning capacity.  

This omission can affect the accuracy of financial assessments, particularly in evaluating investment decisions and future cash flows. 

This article is general information only and does not provide advice to address your personal circumstances. To make an informed decision you should contact an appropriately qualified professional.