Accounting equation
Assets = liabilities + equity, explained with examples of how the accounting equation keeps your books balanced.
Published Friday 24 July 2026
Table of contents
Key takeaways
- The accounting equation states that assets = liabilities + equity, and it must always balance.
- You can rearrange it as assets − liabilities = equity to see what your business is really worth once debts are settled.
- The expanded accounting equation breaks equity into its parts, so you can see how capital, profits and drawings shape your business.
- Because the equation always balances, it underpins double-entry bookkeeping and shapes your balance sheet.
What is the accounting equation?
The accounting equation is the rule that keeps your books in balance. It states that assets = liabilities + equity, which means everything your business owns is funded either by what it owes or by what the owners have put in.
This simple relationship sits at the heart of every set of accounts. When you record a transaction correctly, both sides of the equation stay equal, and your financial records stay accurate.
The accounting formula
The accounting formula has three parts, and each one tells you something different about your business. Here's what assets = liabilities + equity actually covers.
- Assets: everything your business owns that has value, such as cash, stock, equipment and money owed to you by customers
- Liabilities: everything your business owes to others, such as loans, unpaid supplier bills and tax owed
- Equity: the owner's stake in the business, or what's left over once you subtract liabilities from assets
Because assets are always funded by a mix of liabilities and equity, the two sides of the formula stay equal. If they don't match, there's an error somewhere in your records.
An intuitive version of the accounting formula
You can rearrange the formula to make it easier to picture. Written as assets − liabilities = equity, it shows what your business would be worth if you settled every debt today.
Read this way, equity is simply what's left for the owners once liabilities are taken out of assets. It's a quick way to gauge the real value tied up in your business at any point in time.
The expanded accounting equation
The expanded accounting equation takes the same idea further by breaking equity into its parts. This gives you a clearer view of what's driving changes in the owner's stake over time.
- Contributed capital: money the owners have invested in the business
- Retained earnings: profits from earlier periods that have been kept in the business
- Revenue: income earned from selling goods or services
- Expenses: the costs of running the business, which reduce equity
- Drawings or dividends: money taken out by the owners, which also reduces equity
Put together, the expanded version reads as assets = liabilities + contributed capital + retained earnings + revenue − expenses − drawings. It helps you see how trading and owner decisions each move the numbers.
Accounting equation example
A quick example shows how the equation holds together. Imagine your business has $75,000 in assets and $50,000 in liabilities.
To find equity, you subtract liabilities from assets: $75,000 − $50,000 = $25,000. So your equity is $25,000, and the equation balances because $75,000 = $50,000 + $25,000.
How the accounting equation powers double-entry bookkeeping
The accounting equation is the reason double-entry bookkeeping works. Every transaction affects at least two accounts, so the two sides of the equation always stay equal.
Say you buy a $2,000 laptop with cash. One asset (equipment) goes up by $2,000 while another asset (cash) goes down by $2,000, so the equation still balances. This built-in check helps you catch mistakes early and trust your numbers.
The accounting equation and the balance sheet
The balance sheet is where the accounting equation shows up in practice. It's a financial statement that lists your assets on one side and your liabilities and equity on the other.
A balance sheet only balances when assets equal liabilities plus equity, which is the accounting equation in action. If the two sides don't agree, it's a signal to review your records for errors.
Solvency and the accounting equation
The equation also gives you a fast read on solvency, which is your ability to cover what you owe. Rearranged as assets − liabilities = equity, a positive result means your assets outweigh your debts.
A negative result means liabilities are greater than assets, which points to insolvency. Watching this figure helps you spot trouble early and take action before it grows.
Keep your books balanced with Xero
When your bookkeeping follows the accounting equation, your accounts stay accurate and your balance sheet always adds up. Xero handles the double-entry behind the scenes, so both sides stay equal while you focus on running your business.
You can try it and get one month free to see how much time you save on day-to-day money work.
FAQs on the accounting equation
Here are answers to some frequently asked questions about the accounting equation.
Why is the accounting equation important?
It keeps your financial records accurate by making sure what your business owns always matches how it's funded. When the equation balances, you can trust that your books are complete and error-free.
What is the expanded accounting equation?
It splits equity into contributed capital, retained earnings, revenue, expenses and drawings. This shows you exactly what's causing the owner's stake to rise or fall.
How does the accounting equation relate to the balance sheet?
The balance sheet is a snapshot of the accounting equation on a given date. Its two sides only agree when assets equal liabilities plus equity.
What does it mean if the accounting equation doesn't balance?
An out-of-balance equation usually means a transaction was recorded incorrectly or left out. It's a prompt to check your entries and fix the gap.
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.