What Is the Accounting Equation?
The formula behind every transaction, with a worked example you can follow step by step.
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| Also called | Balance sheet equation, basic accounting equation |
|---|---|
| Rearranged | Equity = Assets − Liabilities |
| Related to | Debit · Credit |
| Level | Beginner |
| Topic | Financial accounting · Foundations |
The accounting equation in plain English
Everything a business owns (assets) was paid for by someone. Either it was borrowed from outsiders (liabilities) or it was put in by the owners or earned and kept (equity). So the two sides must always be equal. Think of a house: if it is worth 300,000 and you owe the bank 200,000, your share (equity) is 100,000.
The three parts
- Assets: what the business owns, such as cash, inventory, equipment and money owed by customers.
- Liabilities: what the business owes, such as loans and amounts owed to suppliers.
- Equity: the owner’s claim on the business, made up of capital put in plus profits kept, minus drawings.
The expanded equation
This version shows how profit changes equity: revenue increases it, expenses and owner drawings reduce it.
Worked example: the equation stays balanced
| Transaction | Assets | = | Liabilities | + | Equity |
|---|---|---|---|---|---|
| 1. Owner invests 10,000 cash | 10,000 | = | 0 | + | 10,000 |
| 2. Buys equipment for 4,000 on credit | 14,000 | = | 4,000 | + | 10,000 |
| 3. Earns 3,000 cash from services | 17,000 | = | 4,000 | + | 13,000 |
| 4. Pays 1,000 rent in cash | 16,000 | = | 4,000 | + | 12,000 |
After every transaction, the left side equals the right side. Step 2 raised assets and liabilities together. Step 3 raised assets and equity (through revenue). Step 4 lowered assets and equity (through an expense).
- Forgetting that profit is part of equity. Revenue and expenses change equity, not liabilities.
- Treating borrowed money as equity. A loan is a liability even though it increases cash.
- Thinking the equation can be unbalanced mid-way. Each transaction changes both sides equally, so it always balances.
If a question gives you two of the three figures, rearrange: Equity = Assets − Liabilities, or Liabilities = Assets − Equity. Check that your answer makes the equation balance.
Quick check
1. A business has assets of 50,000 and liabilities of 20,000. What is its equity?
30,000 (Equity = Assets − Liabilities = 50,000 − 20,000).
2. A business buys inventory for 2,000 on credit. What happens to the equation?
Assets rise by 2,000 (inventory) and liabilities rise by 2,000 (payable). Both sides increase equally.
3. Which part of the equation does the owner’s investment increase?
Equity (and assets, because cash goes up).
Frequently asked questions
Why must the accounting equation always balance?
Because every transaction is recorded with equal debits and credits, so each one changes both sides of the equation by the same amount.
Can equity be negative?
Yes. If liabilities are greater than assets, equity is negative, which shows the business owes more than it owns.
What is the accounting equation used for?
It underpins double-entry bookkeeping and the balance sheet, and it helps you check that transactions have been recorded correctly.
What is the difference between the basic and expanded equation?
The basic equation is Assets = Liabilities + Equity. The expanded version splits equity into capital, revenue, expenses and drawings to show how profit builds up.
Keep learning
This page is for general learning. Accounting rules vary by country and standard.