Accounting Equation

In one sentence: The accounting equation says everything a business owns equals what it owes to others plus what belongs to its owners.

$\text{Assets} = \text{Liabilities} + \text{Equity}$

Read it out loud: “Assets equals liabilities plus equity. Assets are everything the business owns that has value. Liabilities are what it owes to other people. Equity is the owners' share, what is left over after the debts are paid. The two sides of the equation always match.”

Before you start

The ideas and signs this page uses, explained from zero. For powers of ten, Greek letters and other notation in general, see Math basics.

Balance sheet: A balance sheet is a list of what a business owns and what it owes on one specific day, such as the last day of the month or the year. It is one of the main financial statements. Its two halves always show the same total, which is why it is called a balance sheet. Here owns means money and things of value that the business controls, and owes means money or goods it must pay back to someone else.
Assets: Assets are things a business owns that have value and can be used to earn money or turned into cash. Examples are cash in the bank, tools, a delivery van and the stock of parts on the shelves. Assets are recorded as an amount of dollars at the date of the balance sheet, usually at the price the business paid for them.
Liabilities: Liabilities are debts and other obligations the business must settle later. Examples are a bank loan, a bill from a supplier that has not yet been paid, and wages owed to staff. Each one is a claim by another person on the business’s assets, which is why liabilities reduce what is left over for the owners.
Equity: Equity, also called owners’ equity, is the owners’ share of the business. It is the value that would be left for the owners if the business sold all its assets at their recorded values and paid all its liabilities. It rises when the owners put in money or the business keeps its profits, and it falls when money is taken out.
Double-entry bookkeeping: Double-entry bookkeeping is the rule that every transaction affects at least two accounts, so the equation stays in balance. Buying a tool with cash makes one asset go down and another go up by the same amount. Buying it on credit makes an asset rise and a liability rise by the same amount. The two sides of the equation always move together, which is how the books are checked.

What each symbol means

Symbol	Meaning
$\text{Assets}$	Everything the business owns that has value, measured in dollars at one date. In the example a bike repair shop has 8000 dollars of assets, made up of cash, tools and spare parts. Tools are recorded at what the shop paid for them, not at what a buyer might offer today.
$\text{Liabilities}$	Everything the business owes to other people, measured in dollars at the same date. In the example the shop owes a bank loan of 3000 dollars and an unpaid parts bill of 500 dollars, which makes 3500 dollars in total.
$\text{Equity}$	The owners’ share, measured in dollars: the assets left over after the liabilities are subtracted. In the example the owner’s equity is 4500 dollars. Equity can even be negative, which happens when a business owes more than all its assets are worth.

The formula piece by piece

$\text{Assets}$: Start with what the business owns. Assets are the total value, in dollars, of cash, equipment, stock and anything else that has value to the business.
$\text{Liabilities}$: Next, what the business owes to others, such as loans, unpaid bills and wages. These are claims that other people have on the business, and they come before the owners.
$\text{Equity}$: The owners’ share, the part of the assets that is left after the debts are paid. It is the owners’ claim on the business.
$\text{Liabilities} + \text{Equity}$: Add the two claims. Liabilities are the lenders’ share and equity is the owners’ share, and together they make the total claim on the assets.
$\text{Assets} = \text{Liabilities} + \text{Equity}$: The whole formula in one sentence: the things a business owns equal what it owes to others plus what belongs to its owners.
$\text{Equity} = \text{Assets} - \text{Liabilities}$: The same equation rearranged to put equity on its own, which is how the owners’ share is worked out from the balance sheet.

What the formula is doing, and why

The accounting equation is the basic rule of bookkeeping. It says that a business’s assets always equal its liabilities plus its equity. Every asset has to be paid for by someone. Either a lender or a supplier provided it on credit, which is a liability, or the owners provided it, which is equity. Those are the only two possibilities, so the two sides must balance.

Why add on the right? Liabilities and equity are two different claims on the same pool of assets. The lenders have a claim for the amount they are owed, and the owners have a claim for whatever is left. Adding the two claims gives the total claim on the assets, and that total must equal the assets themselves.

Why rearrange? Subtracting liabilities from both sides gives $\text{Equity} = \text{Assets} - \text{Liabilities}$ . This is the version to use when you want the owners’ share. A house gives a familiar picture of it: the house’s value minus the mortgage is the owner’s equity in the house. A house worth 300000 dollars with a 200000 dollar mortgage gives 100000 dollars of equity.

Why every entry keeps it balanced. When a business buys a tool for cash, one asset falls by the price and another asset rises by the same amount, so the total of assets stays the same. When it borrows money, cash rises and a liability rises by the same amount. A correctly recorded transaction never breaks the equation, which is why the equation works as a check on the bookkeeping.

What the equation does not show. The balance sheet is a snapshot of one date. It does not show how much the business earned during the year, which is the job of the income statement. But the equation must balance on the date that the balance sheet describes.

An everyday picture

Think of buying a house with a mortgage. The house is the asset, the bank’s share of its value is the liability, and what the owner keeps is the equity. If the house is worth 300000 dollars and the mortgage is 200000 dollars, the owner’s equity is 100000 dollars. If the house gains value, the equity grows even though the mortgage has not changed. The same rule describes a bike shop: its tools and cash are the house, its loans are the mortgage, and the owner’s share is what is left over.

Worked example: Balancing a bike repair shop’s books

A bike repair shop shows the following on its balance sheet at the end of June. Assets: cash of 2000 dollars, repair tools worth 5000 dollars and spare parts worth 1000 dollars. Liabilities: a bank loan of 3000 dollars and an unpaid bill to a parts supplier of 500 dollars. All figures are made up for illustration. We want the owner’s equity. Then we check what happens when the shop buys a new 1000 dollar tool on credit.

Add up the assets. Assets are everything the shop owns, so we add the cash, the tools and the spare parts: $2000 + 5000 + 1000 = 8000$ dollars. Adding is right here because each item is a separate piece of what the shop owns, and together the pieces make the total.
Add up the liabilities. Liabilities are everything the shop owes to other people, so we add the bank loan and the supplier bill: $3000 + 500 = 3500$ dollars. The supplier bill counts even though it is small, because the shop has to pay it, which makes it a claim on the shop’s assets, the same as the loan.
Rearrange the equation to find equity. We start from assets equal liabilities plus equity, and subtract liabilities from both sides. That gives equity equal to assets minus liabilities: $\text{Equity} = 8000 - 3500$ . Subtracting the debts is what leaves the owner’s share.
Calculate the owner’s equity. $8000 - 3500 = 4500$ , so the owner’s equity is 4500 dollars. This is the part of the shop that would belong to the owner if every asset were sold at its recorded value and every debt were paid.
Check that the two sides balance. Liabilities plus equity should equal assets, so we add $3500 + 4500 = 8000$ . That matches the 8000 dollars of assets. If the two sides did not match, there would be a mistake somewhere in the books.
Buy a tool on credit. The shop buys a new 1000 dollar tool and does not pay for it yet, so the supplier lends the money through an unpaid bill. The tools rise to $5000 + 1000 = 6000$ dollars, so the assets rise to $8000 + 1000 = 9000$ dollars. The supplier is owed 1000 dollars more, so the liabilities rise to $3500 + 1000 = 4500$ dollars.
Check the balance again. The owner put nothing in and took nothing out, so equity stays at 4500 dollars. Liabilities plus equity is $4500 + 4500 = 9000$ , which equals the new assets of 9000 dollars, so the equation still holds after the purchase.

Answer: The owner’s equity is 4500 dollars. After the credit purchase the shop has 9000 dollars of assets, 4500 dollars of liabilities and still 4500 dollars of equity. Because $9000 = 4500 + 4500$ , the books balance.

The numbers in this example are recomputed by script every time the site is built.

Common mistakes

Treating equity as something the business owns. Equity is not an asset. It is the owners’ claim on the assets, so it sits on the same side of the equation as liabilities.
Forgetting an unpaid bill. A bill that has not yet been paid is still a liability, even though no money has left the bank yet.
Working out equity the wrong way round, as assets plus liabilities. Equity is what is left after the liabilities are subtracted from the assets.
Believing that a profitable year makes the balance sheet balance by itself. Profit increases equity, but the assets or liabilities must move by the same amount, so the books still balance on every date.

Where you will meet it

Bookkeeping software, which checks every entry so that assets always equal liabilities plus equity.
Balance sheets in the annual reports of companies, which show these three totals at a set date.
Loan applications, where a bank checks how much of a business’s assets are paid for by the owners rather than borrowed.
Personal net worth calculations, where your assets minus your debts gives the same kind of owner’s share.

Questions people ask

Why is it called the accounting equation?

It is the basic rule behind double-entry bookkeeping, the system in which every transaction is recorded in at least two places. The equation is the check that the books still balance after each entry, so the name is the rule written as an equals sign.

Can equity be negative?

Yes. If a business owes more than all its assets are worth, equity is negative, and the owners have a deficit rather than a share. Using the formula, equity equals assets minus liabilities, so a negative answer means the debts are bigger than the assets.

Does the equation tell me whether a business is profitable?

Not directly. It is a snapshot of one date. Profit is reported in the income statement over a period, and retained profit then adds to equity over time. The equation shows where a business stands on one day, not how well it did during the year.

Return on Equity (ROE): Return on equity tells you how many cents of yearly profit a business earns for each dollar its owners have in it.
Debt-to-Equity Ratio: The debt-to-equity ratio shows how much a business is funded by borrowing compared with money from its owners: a higher number means more debt.
Current Ratio: The current ratio tells you whether a business has enough short-term assets to cover its short-term debts, by dividing one total by the other.