What is the accounting equation?

Accounting equation (formula)

Assets equals liabilities plus equity is the foundational formula in accounting. It helps establish the net worth (and solvency) of a business.

The accounting equation succinctly shows how the net worth (equity) of a business is determined by the things it owns (assets) on the one hand, and by the debts it owes (liabilities) on the other.

The accounting formula

Assets = Liabilities + Equity

Where:

  • Assets are things the business owns and includes the likes of buildings, vehicles, work tools, office equipment, inventory, cash in the bank and even money owed by customers. It can also include “intangible assets” like licenses, copyrights, trademarks and other forms of intellectual property.
  • Liabilities are amounts the business owes. These include debts like unpaid bills, overdrafts, credit cards, and long-term loans, plus things like holiday pay owing to workers and tax liabilities that haven’t yet been paid.
  • Equity is the net worth of the business. It’s what the owner would be left with if they sold their business assets and used that money to pay down all business debts.

An intuitive version of the accounting formula

Assets – Liabilities = Equity

In this form, it’s a little easier to see how assets and liabilities interact. You can see how the book value (equity) of their business is based on known quantities like the value of assets and the size of debts.

Accounting equation example

A business has R15,000 worth of equipment, R16,000 worth of inventory, R20,000 of cash in the bank, and it’s owed R24,000 by customers. Added together, that is R75,000 worth of assets. Meanwhile it owes R37,000 in loans, R7000 in taxes, and R6000 in bills for total liabilities of R50,000.

Assets – Liabilities = Equity

R75,000 – R50,000 = R25,000

The owner’s equity (or net worth) of the business is R25,000.

Solvency and the accounting equation

When the accounting equation gives a negative result, the business owes more than it owns and it’s said to be insolvent. This means it couldn’t pay its debts even if it sold (or liquidated) everything it owned.

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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.