Accounting equation
The accounting equation, assets = liabilities + equity, explained with a simple formula and worked example.
Published Friday 24 July 2026
Table of contents
Key takeaways
- The accounting equation is assets = liabilities + equity, and it always stays in balance.
- It shows how much of your business you own once you account for what you owe.
- Every transaction affects at least 2 parts of the equation, which is the basis of double-entry accounting.
- The equation confirms your books balance, but it doesn’t measure profit or the market value of what you own.
What is the accounting equation?
The accounting equation states that a business’s assets equal its liabilities plus its equity. It’s the foundation of double-entry accounting and shows how much of your business you actually own after settling what you owe.
Put simply, everything your business owns is funded either by money it owes to others or by money the owners have put in and kept in the business.
The accounting equation formula
The formula is assets = liabilities + equity. Here’s what each part of the equation means for your business.
- Assets are things the business owns, such as buildings, vehicles, work tools, office equipment, inventory, cash in the bank, and money owed by customers. They can also include intangible assets like licences, copyrights, trademarks, and other intellectual property.
- Liabilities are amounts the business owes, including unpaid bills, overdrafts, credit cards, and long-term loans. They also cover things like holiday pay owed to workers and tax that hasn’t yet been paid.
An intuitive version of the accounting formula
You can rearrange the formula to make the relationship easier to picture. Written as assets – liabilities = equity, it shows how the book value of your business comes from known figures.
In this form, you start with the value of what you own, subtract what you owe, and the amount left over is your equity. It’s a quick way to see the health of your business at a glance.
The expanded accounting equation
The expanded accounting equation breaks equity into the parts that change it over time. It helps you see why your equity grows or shrinks from one period to the next.
Revenue increases equity because it adds value the owners keep. Expenses reduce equity because they use up value, and owner drawings or dividends reduce it too, since that money leaves the business. So equity rises with profits and falls when costs or withdrawals outpace what you earn.
Double-entry accounting and the accounting equation
Double-entry accountingrecords every transaction in at least 2 places. This is what keeps the accounting equation in balance.
When one side of the equation changes, another entry offsets it. If you buy a $2,000 laptop with cash, one asset goes up and another goes down, so total assets stay the same. If you buy it on credit, your assets rise by $2,000 and your liabilities rise by the same amount. Either way, both sides still match.
Accounting equation example
A worked example makes the equation easier to follow. Here’s how it looks for a small business adding up what it owns and what it owes.
The business has $15,000 worth of equipment, $16,000 worth of inventory, $20,000 of cash in the bank, and it’s owed $24,000 by customers. Added together, that’s $75,000 worth of assets.
It owes $37,000 in loans, $7,000 in taxes, and $6,000 in bills, for total liabilities of $50,000.
Using assets minus liabilities equals equity, that’s $75,000 minus $50,000, which leaves $25,000. So the owner’s equity, or net worth, of the business is $25,000.
Limitations of the accounting equation
The accounting equation is useful, but it only tells you so much. It confirms your books balance without showing how well the business is performing.
It won’t reveal whether you’re profitable, since it doesn’t track revenue against costs on its own. It also records assets at their book value, which can differ from what they’d actually fetch on the open market. For those insights, you’ll need reports like the profit and loss statement alongside it.
Solvency and the accounting equation
The equation can also flag a warning sign about your finances. When it produces a negative result, the business owes more than it owns.
At that point the business is said to be insolvent, which means it couldn’t pay its debts even if it sold, or liquidated, everything it owned. Keeping an eye on this helps you act early if equity starts to slip.
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FAQs on the accounting equation
Here are answers to some frequently asked questions about the accounting equation.
What happens if the accounting equation doesn’t balance?
If the 2 sides don’t match, it usually points to a bookkeeping error, such as a missing entry or a figure recorded on the wrong side. You’ll need to trace the transactions to find and fix the mistake before your reports can be trusted.
Is the accounting equation the same as a balance sheet?
They’re closely linked but not the same, as the balance sheet is the report that presents the equation for a point in time. It lists your assets on one side and your liabilities and equity on the other.
Does the accounting equation apply to sole traders and small companies?
Yes, it applies to every business that keeps double-entry records, whatever its size or structure. The equity portion is simply labelled differently, such as owner’s capital for a sole trader or shareholders’ equity for a company.
What’s the difference between the basic and expanded accounting equation?
The basic equation shows equity as a single figure, while the expanded version splits it into revenue, expenses, and owner drawings or dividends. The expanded form helps you see what’s driving changes in your equity.
Related terms
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Disclaimer
This glossary is for small business owners. The definitions are written with their requirements in mind. More detailed definitions can be found in accounting textbooks or from an accounting professional. Xero does not provide accounting, tax, business or legal advice.