Zelalem: What Is The Accounting Equation?

Zelalem
By JASON FERNANDO
Reviewed By AMY DRURY
Updated Jan 24, 2021
What Is the Accounting Equation?
The accounting equation is considered to be the foundation of the double-entry accounting
system. On a company's balance sheet, it shows that a company's total assets are equal to the
sum of the company's liabilities and shareholders' equity.
Based on this double-entry system, the accounting equation ensures that the balance sheet
remains “balanced,” and each entry made on the debit side should have a corresponding entry
(or coverage) on the credit side.
KEY TAKEAWAYS

T he accounting equation is considered to be the foundation of the double-entry
accounting system.
The accounting equation shows on a company's balance that a company's total assets are
equal to the sum of the company's liabilities and shareholders' equity.
n nx n ( n−1 ) x 2
 ∞( 1+ x ) =1+ + +…their obligations.
1! 2!
 Both liabilities and shareholders' equity represent how the assets of a company are financed.
 Financing through debt shows as a liability, while financing through issuing equity shares
appears in shareholders' equity.
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Accounting Equation
Understanding the Accounting Equation

The financial position of any business, large or small, is assessed based on two key
components of the balance sheet: assets and liabilities. Owners’ equity, or shareholders'
equity, is the third section of the balance sheet. The accounting equation is a representation of
how these three important components are associated with each other. The accounting
equation is also called the basic accounting equation or the balance sheet equation.
While assets represent the valuable resources controlled by the company, the liabilities
represent its obligations. Both liabilities and shareholders' equity represent how the assets of
a company are financed. If it's financed through debt, it'll show as a liability, and if it's
financed through issuing equity shares to investors, it'll show in shareholders' equity.
The accounting equation helps to assess whether the business transactions carried out by the
company are being accurately reflected in its books and accounts. Below are examples of
items listed on the balance sheet:
Assets
Assets include cash and cash equivalents or liquid assets, which may include Treasury
bills and certificates of deposit. Accounts receivables are the amount of money owed to the
company by its customers for the sale of its product and service. Inventory is also considered
an asset.
Liabilities
Liabilities are what a company typically owes or needs to pay to keep the company running.
Debt, including long-term debt, is a liability, as are rent, taxes, utilities, salaries, wages,
and dividends payable.
Shareholders' Equity
Shareholders' equity is a company's total assets minus its total liabilities. Shareholders' equity
represents the amount of money that would be returned to shareholders if all of the assets
were liquidated and all of the company's debt was paid off.
Retained earnings are part of shareholders' equity and are equal to the sum of total
earnings that were not paid to shareholders as dividends. Think of retained earnings as
savings since it represents a cumulative total of profits that have been saved and put aside or
retained for future use.
Accounting Equation Formula and Calculation

\text{Assets}=(\text{Liabilities}+\text{Owner's
Equity})Assets=(Liabilities+Owner’s Equity)
The balance sheet holds the basis of the accounting equation:
1. Locate the company's total assets on the balance sheet for the period.
2. Total all liabilities, which should be a separate listing on the balance sheet.
3. Locate total shareholder's equity and add the number to total liabilities.
4. Total assets will equal the sum of liabilities and total equity.
As an example, let's say for the fiscal year, leading retailer XYZ Corporation reported the
following on its balance sheet:
 Total assets: $170 billion

 Total liabilities: $120 billion
 Total shareholders' equity: $50 billion
If we calculate the right-hand side of the accounting equation (equity + liabilities), we arrive
at ($50 billion + $120 billion) = $170 billion, which matches the value of the assets reported
by the company.
The Double-Entry System

The accounting equation forms the foundation of double-entry accounting and is a concise
representation of a concept that expands into the complex, expanded, and multi-item display
of a balance sheet. The balance sheet is based on the double-entry accounting system where
the total assets of a company are equal to the total liabilities and shareholder equity.
Essentially, the representation equates all uses of capital (assets) to all sources of capital,
where debt capital leads to liabilities and equity capital leads to shareholders' equity.
For a company keeping accurate accounts, every single business transaction will be
represented in at least two of its accounts. For instance, if a business takes a loan from a
financial entity like a bank, the borrowed money will raise the company's assets and the loan
liability will also rise by an equivalent amount.
If a business buys raw material by paying cash, it will lead to an increase in

the inventory (asset) while reducing cash capital (another asset). Because there are two or
more accounts affected by every transaction carried out by a company, the accounting system
is referred to as double-entry accounting.
The double-entry practice ensures that the accounting equation always remains balanced,
meaning that the left side value of the equation will always match with the right side value. In
other words, the total amount of all assets will always equal the sum of liabilities and
shareholders' equity.
The global adherence to the double-entry accounting system makes the account keeping and
tallying processes much easier, standardized, and fool-proof to a good extent. The accounting
equation ensures that all entries in the books and records are vetted, and a verifiable
relationship exists between each liability (or expense) and its corresponding source; or
between each item of income (or asset) and its source.
Limits of the Accounting Equation

Although the balance sheet always balances out, the accounting equation doesn't provide
investors information as to how well a company is performing. Instead, investors must
interpret the numbers and decide for themselves whether the company has too many or too
few liabilities, not enough assets, or perhaps too many assets, or is financing the company
properly to ensure long term growth.
Real World Example

Below is a portion of Exxon Mobil Corporation's (XOM) balance sheet in millions as of Dec.
31, 2019:
 Total assets were $362,597

 Total liabilities were $163,659
 Total equity was $198,938
The accounting equation whereby assets = liabilities + shareholders' equity is calculated as

follows:
 Accounting equation = $163,659 (total liabilities) + $198,938 (equity) equals

$362,597, (which equals the total assets for the period)
Image by Sabrina Jiang © Investopedia 2020

Frequently Asked Questions
What is the accounting equation?
The accounting equation is the proposition that a company’s assets must be equal to the sum
of its liabilities and equity. Phrased differently, it means that the equity of a company is equal
to its assets minus its liabilities. This concept is part of the theoretical foundation behind
double-entry bookkeeping, and forms the basis for how investors and accountants interpret
and analyze financial statements.
Why is the accounting equation important?

The accounting equation is important because it captures the relationship between the three
components of a balance sheet: assets, liabilities, and equity. All else being equal, a
company’s equity will increase when its assets increase, and vice-versa. Likewise, adding
liabilities will decrease equity, whereas reducing liabilities—such as by paying off debt—will
increase equity. These basic concepts are captured by the accounting equation and are
essential to modern accounting methods.
What is an example of the accounting equation?

To illustrate, suppose we have a company with $1 million in assets and $500,000 in
liabilities. According to the accounting equation, Assets = Liabilities + Equity. By plugging
in these figures, we can quickly discern that the company’s Equity would be $500,000. These
values would appear on the company’s balance sheet, and could be used by investors,
analysts, or company managers to assess the quality of the business and forecast its future
prospects.
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Related Terms
How General Ledgers Work

A general ledger represents the record-keeping system for a company's financial data with
debit and credit account records validated by a trial balance.
more
Equity
Equity typically refers to shareholders' equity, which represents the residual value to
shareholders after debts and liabilities have been settled.
more
How the Expanded Accounting Equation Works
The expanded accounting equation is derived from the accounting equation and illustrates the
different components of stockholder equity in a company.
more
Balance Sheet
A balance sheet is a financial statement that reports a company's assets, liabilities and
shareholders' equity at a specific point in time.
more
Understanding the Shareholder Equity Ratio
The shareholder equity ratio is used to get a sense of the level of debt that a public company
has taken on.
more
How Double Entry Works
Double entry is an accounting term stating that every financial transaction has equal and
opposite effects in at least two different accounts.
more
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Zelalem

Understanding the Accounting Equation

Accounting Equation Formula and Calculation

 Total assets: $170 billion

The Double-Entry System

If a business buys raw material by paying cash, it will lead to an increase in

Limits of the Accounting Equation

Real World Example

 Total assets were $362,597

The accounting equation whereby assets = liabilities + shareholders' equity is calculated as

 Accounting equation = $163,659 (total liabilities) + $198,938 (equity) equals

Image by Sabrina Jiang © Investopedia 2020

Why is the accounting equation important?

What is an example of the accounting equation?

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How General Ledgers Work

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