Accounting Equation
The fundamental balance-sheet identity.
Formula
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Example
Always balances
How it works
The accounting equation shows how a business is financed: everything the business owns (assets) must be funded either by money it owes to outsiders (liabilities) or by the owner’s own stake in the business (equity). It works because every transaction affects both sides of the balance sheet in a way that preserves this total, so the books stay in balance if recorded correctly. This is the core check that links the balance sheet together.
When to use it
Use this when preparing or checking a balance sheet, or when analyzing how a company has financed its resources. It is also useful for spotting bookkeeping errors because the equation should always remain balanced.
Worked example, step by step
A small business has cash, equipment, and inventory worth a total of $85,000. It also has a bank loan of $32,000. Using the accounting equation: Assets = Liabilities + Equity $85,000 = $32,000 + Equity Equity = $85,000 - $32,000 Equity = $53,000 Final answer: the owner’s equity is $53,000.
Common mistakes to avoid
- Treating equity as the same thing as cash in the business
- Forgetting that liabilities are subtracted from assets only when solving for equity
- Using income or profit directly instead of the balance-sheet value of equity
Did You Know?
The accounting equation, assets equal liabilities plus equity, has anchored bookkeeping since 1494.
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View allAccounting Equation
BasicThe foundation of double-entry bookkeeping: everything a business owns is financed either by debt or by owners’ capital.
Cost of Goods Sold
BasicThe direct cost of the inventory actually sold during a period.
Gross Profit
BasicWhat remains from sales after subtracting the direct cost of the goods sold, before operating expenses.
Net Income
BasicThe “bottom line” — total earnings after all expenses, interest and taxes are deducted from revenue.
Retained Earnings
BasicCumulative profit kept in the business rather than paid out to shareholders.
Current Ratio
IntermediateA liquidity measure of whether a firm can cover its short-term obligations with short-term assets.