What is the Accounting Equation Formula?

What is the accounting equation?

The accounting formula is one of the most basic financial formulas, but it’s also one of the most important to understand. Here’s how it’s most frequently written: Assets = Liabilities + Owner’s Equity.

Let’s take a closer look at what each of those components means.

Assets

An asset refers to something your business owns with economic value that you can usually express in dollars. Assets generally go on the top half of the balance sheet, where you should split them into current and noncurrent assets based on their liquidity.

Current assets include cash and other assets you expect to convert to cash within the year, such as inventory, accounts receivable, and portions of prepaid expenses. Noncurrent assets are those you don’t expect to become cash in the next year, such as fixed assets like land and machinery or intangible assets like goodwill.

Liabilities

A liability refers to something with economic value that your business owes to another party. Debts are the most common liabilities, such as accounts payable, installment loans, and revolving lines of credit, but they can also include things like unearned revenues.

Liabilities go on the bottom half of the balance sheet with your equity accounts. Once again, you should separate them into current and noncurrent using the same 12-month time horizon used for assets.

Current liabilities are due in the next year, while noncurrent liabilities remain outstanding for longer. When loans have multi-year repayment terms, the portion due in the next 12 months is current while the rest is considered noncurrent.

Equity

A business’ equity represents the value that would be left for the owners if you sold all its assets and paid off its liabilities. As the accounting equation indicates, it equals your assets minus your liabilities.

Equity accounts include any contributions you make to your business, proceeds generated from selling shares to investors, and retained earnings left over from profits generated in previous years.

Generally, the more equity you have, the stronger your business’ financial position. Having greater liabilities than assets increases the risk that you’ll fail to repay your debts, which is a red flag to lenders and investors.

When is the accounting formula used?

The accounting formula is one of the foundations of the double-entry bookkeeping system, which is the method that modern bookkeepers and accountants use to record financial transactions and organize accounting records.

The double-entry accounting system is predicated on the idea that every transaction affects at least two financial accounts. You can use the accounting formula to help figure out which accounts your activities affect and whether to increase or decrease them.

For example, say you have a transaction that increases one of your assets. You know that you must decrease another asset, increase a liability, or increase your equity by the same amount to remain in compliance with the accounting formula.

At a high level, the formula can also help you confirm that your balance sheet is accurate. To do so, double-check that your accounting equation is “balanced,” meaning the two sides are equal to each other. If they’re not, you’ve made a mistake somewhere.

Accounting equation examples.

Let’s go over a few practical examples to give you a better idea of how you might use the accounting equation when doing the books for your business.

First, imagine you’re starting a new landscaping business. You contribute $5,000 of your own money to get the company up and running. You now have $5,000 in assets and increase your equity by $5,000 to rebalance the accounting equation, since you didn’t take on any debt.

Second, you spend $3,000 of your business’ funds on construction equipment for your operation. Cash and equipment are both assets, so you decrease one and increase the other to continue satisfying the formula. 

Next, you take out a $10,000 business loan to generate additional cash. That affects your liabilities and assets, so you increase them both equally to remain in compliance with the equation.

Finally, you double-check that your balance sheet is accurate by recalculating your accounting equation, which states: Assets ($12,000 cash + $3,000 equipment) = Liabilities ($10,000 business loan) + Equity ($5,000 contributions). With both sides in balance, you know your balance sheet is likely correct.