What Is the Accounting Formula?

The Relationship Between Assets, Liabilities, and Owners' Equity

Debt, deficit on a balance sheet.
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The accounting formula serves as the foundation of double-entry bookkeeping. Double-entry bookkeeping is 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.

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.

Once you understand the accounting formula basics, you'll have a better grasp of the contents of a balance sheet. The accounting formula also helps explain the relationship between a company's financial statements.

The Basic Accounting Formula

The accounting formula essentially shows what the firm owns (its assets.) Assets are purchased with either the money it owes to creditors (its liabilities) or by money its owners invest in the business (its shareholders' equity.) This relationship can be expressed in the form of a simple equation:

Assets = Liabilities + Shareholders' Equity

This equation must balance because everything the firm owns (assets) has been purchased with some form of debt (liability) or shareholders' capital (equity).

Assets refer to items like cash, inventory, accounts receivable, buildings, land or equipment.

Examples of liabilities include bank loans, credit accounts or accounts payable. Accounts payable are the accounts that a business owes money to, such as suppliers.

Shareholders' equity is the capital the owners have invested in the firm. Business profits retained from prior periods also qualify as capital or equity (retained earnings).

If a firm has $20,000 in liabilities, $50,000 in assets and $30,000 in shareholders' equity the accounting formula would read:

Liabilities ($20,000) = Assets ($50,000) - Shareholders' Equity ($30,000)
Shareholders' Equity ($30,000) = Assets ($50,000) - Liabilities ($20,000)

If you know any two of the three components of the accounting equation, you can calculate the third component.

If you look at a balance sheet, you can also see that a balance sheet represents a fleshed-out form of the accounting equation with account-level detail.

Transaction Illustration

When you start up a new company, your accounting formula would look like the following:

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

This start-up is a very small business, and the owner deposits $1,000 in the business' checking account. Assuming the business uses double-entry bookkeeping the accounting equation would now look like this:

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

Next, this small business purchases a $500 photocopier on its credit account. The accounting equation reflects this activity as follows:

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

An asset or liability account is created for each type of asset. Thus, the asset account (and total assets) for Office Equipment was increased by $500 and the liability account for the company's credit card was increased by $500.

Regardless of the type of transaction, when it's recorded properly, the accounting equation stays in balance.

The accounting equation contains several components in each section, reflecting the detail on a company's balance sheet. It acts as a checks and balances system to make sure that all relevant accounts have received entries, and each transaction has been recorded properly.

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