Accounting equation
Learn how the accounting equation, assets equals liabilities plus equity, shows your business's net worth.
Published Thursday 23 July 2026
Table of contents
Key takeaways
- The accounting equation states that assets equal liabilities plus equity, and it always stays in balance.
- You can rearrange it to find your equity: subtract what you owe from what you own.
- Every transaction touches at least two accounts, which is why double-entry bookkeeping keeps the equation balanced.
- The equation is the foundation of your balance sheet, so it gives you a quick read on your financial position.
What is the accounting equation?
The accounting equation is a simple rule that shows a business's net worth equals what it owns minus what it owes. In other words, your equity is the value left over once you account for your assets and liabilities.
It's the starting point for how businesses record and report their finances, and it holds true no matter how big or small the business is.
The accounting equation formula
The accounting equation is usually written as: Assets = Liabilities + Equity. Each part represents a different piece of your financial picture, and together they always balance.
- Assets: what your business owns, such as buildings, vehicles, inventory, cash, money owed to you by customers, and intangibles like licences and trademarks
- Liabilities: what your business owes, such as unpaid bills, overdrafts, loans, holiday pay, and unpaid tax
- Equity: what the owner keeps after selling the assets and paying off the debts
Equity = assets minus liabilities
To calculate the equity in a business, you subtract your total liabilities from your total assets. This rearranged form, Equity = Assets − Liabilities, is often the most intuitive way to think about the equation.
It answers a practical question every owner cares about: if you sold everything and settled every debt, how much would be left for you? That leftover value is your equity.
How the accounting equation works with double-entry bookkeeping
The equation stays balanced because of double-entry bookkeeping. Every transaction you record affects at least two accounts, so both sides of the equation move together.
For example, if you buy a $2,000 laptop with cash, one asset (equipment) goes up and another asset (cash) goes down by the same amount. If you buy it on credit, your assets rise and your liabilities rise to match. Either way, the equation still balances.
The accounting equation and the balance sheet
The accounting equation is the logic behind your balance sheet, also known as the statement of financial position. The balance sheet lists your assets on one side and your liabilities and equity on the other.
Because the equation always holds, those two sides must match. If your balance sheet doesn't balance, it's a sign that something has been recorded incorrectly.
The expanded accounting equation
Equity isn't fixed; it changes as your business trades and as money moves in and out. The expanded accounting equation breaks equity down into the things that grow or shrink it over time.
- Income increases equity as you earn revenue from sales
- Expenses reduce equity as you pay the costs of running the business
- Owner contributions increase equity when you put your own money in
- Drawings reduce equity when you take money out for personal use
Any profit you keep in the business rather than take out becomes retained earnings, which build up your equity over time.
Accounting equation example
Here's how the accounting equation works with real numbers. Imagine a business adding up everything it owns and everything it owes.
Its assets come to $75,000: $15,000 in equipment, $16,000 in inventory, $20,000 in cash, and $24,000 owed by customers.
Its liabilities come to $50,000: $37,000 in loans, $7,000 in taxes, and $6,000 in bills.
Subtract the liabilities from the assets and you get the equity: $75,000 − $50,000 = $25,000. So the owner's stake in the business is $25,000.
Solvency and the accounting equation
The accounting equation also tells you whether a business is solvent. When the calculation gives a positive result, the business owns more than it owes.
When it gives a negative result, the business owes more than it owns and is insolvent. That's a clear signal to review your finances and get advice early.
Simplify your small business accounting with Xero
Keeping the accounting equation balanced gets far easier when your numbers update themselves. Xero handles the double-entry bookkeeping in the background and keeps your balance sheet current, so you can see your true financial position at any time.
Spend less time on manual admin and more time running your business, and you can get one month free when you start.
FAQs on the accounting equation
Here are answers to some frequently asked questions about the accounting equation.
What is the basic accounting equation?
It's Assets = Liabilities + Equity, the rule that every business's resources are funded either by debt or by the owner's stake.
Why must the accounting equation always balance?
Every transaction is recorded in two places, so a change on one side is always matched by an equal change elsewhere. If it doesn't balance, there's a recording error to find.
What are retained earnings in the accounting equation?
They're the profits you reinvest in the business instead of taking out as drawings or dividends. They sit within equity and grow it year on year.
What is the difference between the accounting equation and the balance sheet?
The equation is the underlying rule, while the balance sheet is the report that presents it. The balance sheet lays out the actual figures for your assets, liabilities, and equity on a set date.
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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.