Accounting equation
Learn the accounting equation, how it works, and what it shows about your business's net worth and solvency.
Published Friday 24 July 2026
Table of contents
Key takeaways
- The accounting equation states that assets equal liabilities plus equity, and it's the foundation of double-entry bookkeeping.
- Rearranged as assets minus liabilities equals equity, it shows the net worth of your business at a glance.
- The equation must always balance; if it doesn't, there's likely an error in your records.
- A negative result means you owe more than you own, which points to a solvency problem worth acting on quickly.
What is the accounting equation?
The accounting equation shows that what your business owns is funded either by money it owes or by money the owner has put in. It sets out the net worth and solvency of a business in a single line.
Put simply, the equation shows how the net worth (equity) of a business is determined by the things it owns (assets) on one side, and the debts it owes (liabilities) on the other.
The accounting equation formula
The accounting equation is written in one standard form, with a rearranged version that many owners find more intuitive. Both say the same thing, so use whichever is clearer for the question you're answering.
The standard form is:
Assets = Liabilities + Equity
Rearranged to focus on net worth, it becomes:
Assets − Liabilities = Equity
In this second form it's easier to see how assets and liabilities interact. The book value (equity) of your business comes from 2 known quantities: the value of what you own and the size of your debts.
Assets, liabilities and equity explained
The equation has 3 components, and each one answers a different question about your finances. Here's what each term covers.
Assets
Assets are the things your business owns, such as buildings, vehicles, work tools, office equipment, inventory, cash in the bank and even money owed to you by customers. They can also include intangible assets like licences, copyrights, trademarks and other forms of intellectual property.
Liabilities
Liabilities are the amounts your business owes. These include debts like unpaid bills, overdrafts, credit cards and long-term loans, plus holiday pay owing to workers and tax that hasn't been paid yet.
Equity
Equity is the net worth of the business, or what you'd be left with if you sold every asset and used the money to clear all debts. In Ireland and the UK, equity is often called capital, so you'll see both terms used to mean the same thing.
How the accounting equation works with double-entry bookkeeping
The accounting equation is the reason double-entry bookkeeping works the way it does. Every transaction affects at least 2 accounts, so the 2 sides of the equation always stay equal.
Say you buy €2,000 of equipment with cash. Your equipment (an asset) goes up by €2,000 and your cash (another asset) goes down by €2,000, so total assets are unchanged and the equation still balances.
If you instead bought that equipment on credit, your assets would rise by €2,000 and your liabilities would rise by €2,000, keeping both sides equal. You can read more in our guide to double-entry bookkeeping.
Accounting equation example
A worked example shows how the numbers come together in practice. Here's how the equation looks for a small business.
A 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.
Meanwhile it owes €37,000 in loans, €7,000 in taxes and €6,000 in bills, for total liabilities of €50,000. Applying the rearranged formula:
Assets − Liabilities = Equity
€75,000 − €50,000 = €25,000
So the owner's equity, or net worth, of the business is €25,000.
The expanded accounting equation
The expanded accounting equation breaks equity down into the parts that change it over time. It's useful when you want to see how trading and owner activity affect net worth.
One common form is: Assets = Liabilities + Capital + Revenue − Expenses − Drawings. Revenue and owner investment increase equity, while expenses and drawings (money the owner takes out) reduce it.
The expanded version doesn't change the basic relationship; it just gives you more detail on why equity has moved between one period and the next.
The accounting equation and your balance sheet
Your balance sheet is the accounting equation set out as a financial statement. It lists your assets on one side and your liabilities and equity on the other, and the two must match.
Because the equation always balances, the totals on a correctly prepared balance sheet will always be equal. That's why the balance sheet gives you a reliable snapshot of what your business is worth on a given date. See our guide to the financial statement for more on how it fits together.
Solvency and what the accounting equation shows
The accounting equation is a quick way to gauge whether your business owns more than it owes. It's a useful signal of solvency, though it has limits.
When the equation gives a negative result, the business owes more than it owns and is said to be insolvent. That means it couldn't pay its debts even if it sold, or liquidated, everything it owned.
The equation values assets at their book value, which may differ from what they'd sell for today, so it's a starting point rather than a full health check. Pair it with your cash flow and profit figures for a complete picture.
Simplify your accounts with Xero
Keeping the accounting equation in balance is far easier when your records update themselves. Xero handles the double-entry behind the scenes, so your assets, liabilities and equity stay accurate as you work.
You get a real-time view of your balance sheet and net worth, with less manual admin and fewer errors to chase. Start today and get one month free.
FAQs on the accounting equation
Here are answers to some frequently asked questions about the accounting equation.
Why must the accounting equation always balance?
Every transaction has 2 equal and opposite effects, so both sides move together. If the two sides don't match, something has been recorded incorrectly.
What are the three components of the accounting equation?
The 3 components are assets, liabilities and equity. Assets are what you own, liabilities are what you owe, and equity is the difference between them.
What's the difference between the basic and expanded accounting equation?
The basic equation shows assets equal liabilities plus equity, while the expanded version splits equity into capital, revenue, expenses and drawings. The expanded form gives more detail on why equity changes over a period.
Is equity the same as capital?
In Ireland and the UK, equity and capital are often used to mean the same thing: the owner's stake in the business. Both describe what would be left after all debts are paid.
What happens if the accounting equation doesn't balance?
A mismatch signals an error, such as a missing entry or a figure posted to the wrong account. You'll need to review your records to find and correct it before your accounts can be trusted.
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.