What Is the Accounting Formula?

How to Calculate the Accounting Formula

Accountant calculating the accounting formula
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The accounting formula frames a company's assets in terms of liabilities and shareholder equity. This simple formula serves as the foundation of double-entry bookkeeping, a method of bookkeeping in which there are always two account entries made for a transaction—a debit to one account and credit to another.

Keep reading to understand the accounting formula basics and how it can help you better grasp the contents of a balance sheet.

What Is the Accounting Formula?

This formula represents the relationship between the assets, liabilities, and shareholders' equity of a business. The value of a company's assets should equal the sum of its liabilities and shareholders' equity. The concept this formula reinforces is that every asset acquired by a company was financed either through debt (a liability) or through investment from owners (shareholder equity).

A balance sheet represents a fleshed-out form of the accounting equation with account-level detail.

How Do You Calculate the Accounting Formula?

Calculating the accounting formula is fairly simple and straightforward. Just add together the liabilities and the shareholders' equity. This gives you your total assets.

Accounting formula

How the Accounting Formula Works

The accounting formula essentially shows what the firm owns, or its total assets. These assets have to be purchased somehow, and the accounting formula boils down the sources of financing to two major categories: liabilities and shareholder equity.

This equation must balance because everything the firm owns has to come from one of those two sources.

Assets refer to items like cash, inventory, accounts receivable, buildings, land, or equipment. Buying something with the cash the company has on hand doesn't affect the accounting formula, because it's just converting one type of asset (cash) into another type of asset (inventory, equipment, or whatever else is purchased). The accounting formula doesn't differentiate between types of assets.

Liabilities can include bank loans, credit card accounts, or accounts payable (such as when a supplier offers to extend credit to a business). Shareholders' equity is the total capital the owners have invested in the firm. This equity includes any shares issued by a public company, but it also includes any contributions from the owners who started the business or other early investors.

The accounting formula doesn't differentiate between the types of liabilities or equity, but a company's balance sheet will detail those differences. The balance sheet should detail all the different accounts and types of liabilities or equity, and it'll quantify each of those categories.

Example

Imagine you've created a brand new company. On day one, as the business is hardly more than an idea, your accounting formula would look like the following:

  • Assets = Liabilities + Shareholders' Equity
  • $0 = $0 + $0

This is a very small business, and you—the founder and owner—start it with a deposit of $1,000 into a business checking account. The accounting equation would now look like this:

  • Assets = Liabilities + Shareholders' Equity
  • $1,000 = $0 + $1,000

Now, imagine you've used up your $1,000, but you still need to buy a $500 photocopier for your home office. You use a business credit card to buy the photocopier, and the accounting equation reflects this activity:

  • Assets = Liabilities + Shareholders' Equity
  • $1,500 = $500 + $1,000

As you can see, the accounting formula is all about balance. Any activity on the right side is reflected on the left side.

Limitations of the Accounting Formula

While the accounting formula is a critical component in understanding double-entry bookkeeping, it isn't a great analysis tool in and of itself. This formula doesn't tell you anything about the nature of the liabilities or equity.

Debt, for example, can be a useful instrument for spurring business growth, but it can also be a slippery slope to bankruptcy. The accounting formula alone won't tell you whether a company is effectively using debt or egregiously burning through borrowed cash.

Similarly, the formula doesn't tell you anything about how the company has allocated resources. A company with $1 million in assets could've blown those assets on frivolous spending, or it could've wisely spent on things that will help the business grow and succeed. Differentiating between these scenarios will require a closer look at the balance sheet.

Key Takeaways

  • The accounting formula is a simple equation that poses a company's assets in terms of its liabilities and shareholder equity.
  • The basis of the equation is the concept that every asset the company acquires was either financed through liability (such as credit card debt) or equity (such as issuing public shares).
  • The accounting formula forms the basis of double-entry accounting, which recognizes that every transaction represents a debit to one account and a credit to another.