What Is The Accounting Equation And Why Does It Work?

This post focuses on answering a popular question – What is the accounting equation? We’ll start off with the equation itself and then dive in to the details of each variable.

In its simplest form, the Accounting Equation is…

Assets – Liabilities = Equity

This basic accounting equation is akin to / identical to the Balance Sheet (aka Statement of Financial Position).

More on that later on. For now, let’s think about what each of these 3 items actually means.

Components of the Accounting Equation

Like we showed above, the accounting equation (in its broadest form) is made up of:

• Assets,
• Liabilities, and
• Equity

What are Assets?

Assets are things that we own, and expect to make money from.

A building that you own is an asset because you’ll earn money from it, either by renting it out, or using it to deliver services or manufacture products.

More formally, an asset is something that you…

• Own and control as a result of a past transaction,
• From which you expect to earn “future economic benefits”.

“Future economic benefits” is just a very fancy way of saying you expect to make money.

What are Liabilities?

Liabilities on the other hand, are things that we owe, and expect to pay money for.

A loan from a bank is a liability because you’ll eventually have to repay it.

More formally, a liability is something that you…

• Owe as a result of a past transaction,
• From which you expect “future economic outflows”.

Where “future economic outflows” is a sophisticated way of saying you expect to pay money.

What is Equity?

Perhaps the most important part of a “Balance Sheet” (one of five financial statements), ‘Equity’ reflects a firm’s “net worth”, i.e. how much the firm is worth.

Crucially, it does not reflect the market value of the firm.

Net worth in this context refers exclusively to the “book value”, i.e. how much it’s worth in accounting terms, not economic terms.

And because Accountants love jargon, there are a host of other terms for Equity including:

• Owner’s Equity
• Owner’s Interest
• Ownership Interest
• Net Assets
• Net Asset value
• Shareholder’s Equity

Interpreting the Accounting Equation

The accounting equation is a better representation of the dreaded “double entry bookkeeping system”.

In reality, it is nothing but the double-entry accounting system. The only real difference is that it’s arguably easier to read!

In its simplest form, the accounting equation shows us how much a firm owns (Total Assets), owes (Total Liabilities), and hence, how much it’s worth (Equity).

In another way, it shows us a firm’s resources and its sources of finance.

Because while the accounting equation in its simplest form is written like…

Assets – Liabilities = Equity

We can rearrange it by adding ‘Liabilities’ to both sides of the equations.

It then looks like this…

Assets = Liabilities + Equity

In this form of the accounting equation, the left hand side (Assets) represents a company’s “resources”. The right hand side of the equation (Liabilities + Equity) shows that company’s “sources of finance”.

As a side note, this latter interpretation of the accounting equation is used more so in Finance vis-a-vis the former interpretation.

RELATED: Difference Between Finance and Accounting

In other words, the Accounting equation can be interpreted either as…

Everything We Own – Everything We Owe = The Amount We’re Worth

OR…

Everything We Own = The Money We Raised by Borrowing plus Issuing Shares.

Expanding Assets Within the Accounting Equation

We choose to further sub-categorise “everything we own”.

Assets are sub-categorised into:

• those we expect to use for the long term, and
• those we expect to use within the next twelve months.

Assets held for the long term are called “Non-current assets”. That’s because they’re assets that will be used in not just the current period (hence “non-current”).

Previously, a non current asset used to be called a fixed asset. Largely because those assets tend to be “fixed” (e.g., buildings).

Today, we tend to distinguish more between “tangible” and “intangible” vis-a-vis “fixed” vs “moveable” assets. More on that in a bit.

A “Current Asset” on the other hand, is an asset that we expect to hold for twelve months or lesser. In other words, we expect to use these assets in the current period.

Examples of Current Assets include (but aren’t limited to):

• Inventory (aka “Stock”)
• Accounts Receivable (aka Debtors, Trade Receivables)
• Cash and cash equivalents

Now, what is the accounting equation with the assets sub-categorised?

Here’s what it looks like…

(Non-current Assets + Current Assets) – Liabilities = Equity

Now, note that this isn’t the only way in which we could sub-categorise Total Assets.

For instance, we might further split non-current assets into:

• Tangible Assets, and
• Intangible Assets

Tangible assets are those assets you can touch. Buildings, vehicles, computers, for instance, are all examples of tangible assets.

Intangible assets on the other hand are those assets that you cannot touch. For instance, software, trademarks, patents, etc.

We’ll save tangible vs intangible assets for another post. For now, let’s just keep things simple and think about how we can expand to basic accounting equation into an expanded accounting equation.

Expanding Liabilities Within the Accounting Equation

Chances are you’re thinking “if assets are sub-categorised, then surely liabilities should be too.”

And you’re right! Here’s what it looks like…

(Non-current Assets + Current Assets) – (Current Liabilities + Non-current Liabilities) = Equity

Examples of Non-current liabilities typically include long-term loans, bonds issued, and debentures.

Typical examples of Current Liabilities include Accounts Payable (aka Trade Payables, Creditors) and bank overdrafts.

Now while we’re at expanding Assets and Liabilities, we may as well expand Equity too.

Expanding Equity Within the Accounting Equation

Unlike Assets and Liabilities though, Equity does not split into “Current” and “Non-current”.

This is because Equity is the only part of the “Balance Sheet” that can last forever – at least in theory.

You may well have already heard that “companies can exist forever”.

Equity can be thought of as the reason they can exist forever.

Equity comprises of two parts:

1. The amount invested into the company by investors (we call this “Share Capital” or “Common Stock“).
2. The amount of net income that is reinvested into the business by the company (we call this “Retained Earnings”).

Some firms can have other things in Equity too, including Share Premium, Reserves, etc. This will vary from one firm to another, but every single firm will have Share Capital and Retained Earnings in their Equity section.

Incidentally, it is the Retained Earnings section of the Balance Sheet that connects it with the Income Statement.

What is The Accounting Equation in its Expanded Form?

If we combine all of the points above, we have the expanded accounting equation:

(Non-current assets + Current assets) – (Current Liabilities + Non-current Liabilities) = Share Capital + Retained Earnings

There are so many things to list, it just doesn’t fit in one line. And maybe that’s why we come up with annotations to make our life easier!

Non-current assets are often written as “NCA”; current assets as “CA”; current liabilities as “CL… you get the idea.

So here’s what it looks like (in one line this time)…

(NCA + CA) – (CL + NCL) = SC + RE

Doesn’t that look so much neater? Here’s the equation again, this time with annotations included!

How Does the Accounting Equation Work?

Every single transaction always has two sides to it.

Traditionally, this fact is represented in the “double entry bookkeeping” system starting with journal entries.

In more recent years, this is being taught by the accounting equation to make students’ lives easier.

The best way to understand this is by an example.

Accounting Equation Example

Let’s walk through Joe’s new business.

Joe sets up a company (Joe Ltd) and invests £1,000 into the business.

Here’s Joe Ltd’s fundamental Accounting Equation before he set it up:

Assets – Liabilities = Equity

0 – 0 = 0

As soon as Joe invests the money into the business, the Accounting Equation would become…

£1,000 – 0 = £1,000

That’s because Joe would put in £1,000 as cash (a Current Asset), in exchange for £1,000 worth of Share Capital (in the Equity section).

If Joe Ltd bought an iPad for £400 and intended to use it exclusively for work purposes (and expect to earn money in future), then the equation would look like this…

£1,000 – 0 = £1,000

Wondering why nothing changed? It’s because in the most recent transaction, both sides related to “Assets”.

Joe Ltd buys an iPad (asset), paying for it by cash (asset). The asset of cash decreases by £400 but a new asset (the iPad) enters the equation at a £400 valuation. The net effect is a 0 change.

£1,000 (initial cash) – £400 (payment for iPad) + £400 (iPad purchase) – £0 (liabilities) = £1,000 (Equity)

Let’s say Joe Ltd borrows £5,000 from a bank. The fundamental accounting equation would now be…

£6,000 – £5,000 = £1,000

Borrowing from the bank increased Joe Ltd’s cash balance by £5,000 to £5,600 (do you know how we got this?) and Total Assets to £6,000, simultaneously increasing the company’s liabilities by £5,000.

The bottom line is no matter what transaction you look at, the fundamental accounting equation will always remain “balanced”. And this is why the Balance Sheet / aka Statement of Financial Position always remains balanced, too!