Understanding the Accounting Equation: Assets = Liabilities + Equity

Meaning of Accounting Equation 

The accounting equation is a principle in accounting that says that a company’s assets must be equal to its liabilities and equity. Where did this equation come from in 1494 an Italian mathematician Luca Pacioli formulated this accounting equation based on mathematic equation LHS (left hand side) = RHS (right hand side). 

Represents the relationship between the assets are a company’s resources; liabilities are a company’s obligations and capital of a business owner’s equity or stockholders’ equity.

Financial accounting is built on one fundamental principle called the Accounting Equation. Whenever a business starts or carries out transactions, this equation must always remain true. Accounting equation is a mathematical expression which shows that the assets and liabilities of a firm are equal.

Assets = Liabilities + Capital (Equity)

This means:

• Assets are the resources owned by the business
• These resources are financed either by:
• the owner (Capital), or
• outsiders such as banks or suppliers (Liabilities)

So, we can also say: Resources in the business = Owner’s contribution + Outsiders’ contribution

Based on double entry bookkeeping principle where every transaction has a dual effect on the financial statements. States that a company’s total assets are equal to the sum of liabilities and its shareholders equity.

Accounting equation is also known as basic accounting equation or balance sheet equation.

Accounting equation is the foundation of double entry accounting system; every transaction has two effects Debit = Credit so it ensures that balance sheet remains balanced.  No matter what happens in a business this accounting equation will always hold its place.

Meaning of the Terms

1. Assets - Assets are all the resources owned by a business that have economic value and help in earning income.  Resources owned by the business that provide future economic benefits. Examples: Cash, machinery, furniture, inventory, accounts receivable.
2. Capital (Owner’s Equity) -  Capital is the amount invested by the owner in the business. It represents the owner’s claim on the assets of the business. Owner’s claim on business assets.
• Sole proprietorship → Owner’s Equity
• Company → Shareholders’ Equity
3. Liabilities - Liabilities are amounts owed by the business to outsiders for the use of their resources. Obligations or claims of creditors arising from past transactions. Examples: Bank loan, creditors, accounts payable.

Accounting Equation Formula 

1. Asset – Capital – Liabilities = 0 (also known as basic or fundamental accounting equation, balance sheet equation)
2. Asset = Capital + Liabilities (This balance sheet equation tells you that all the assets owned by the business are either sponsored using the owner’s equity or the amount which company should owe other like suppliers (creditors) or loans
3. Capital = Assets – Liabilities (This equation reveals the value of assets owned purely by owner equity. While trying to do this correlation, we can note that incomes or gains will increase owner’s equity and expenses, or losses will reduce it.
4. Liabilities = Assets – Capital (the difference of assets and owner’s investment into business is your liabilities which you owe others in the form of payables to suppliers, banks etc.

Why the Accounting Equation Always Balances

1. The total value of assets will always equal the total of capital plus liabilities
2. Individual items may change due to transactions, but the equality never breaks
3. This is why the accounting equation is also called the Balance Sheet Equation: Assets = Owner’s Capital + Outside Liabilities

Normal Balance of Accounts

Type of Account	Increase with	Decrease with	Normal Balance
Asset	Debit	Credit	Debit
Liability	Credit	Debit	Credit
Equity	Credit	Debit	Credit
Income	Credit	Debit	Credit
Expense	Debit	Credit	Debit

Accounting Equation Approach

It is also called Modern Approach or American Approach,  This approach records all transactions based on the dual aspect concept, which states that:

Every transaction has two effects.

Debit and Credit Rules (Modern Approach)

1. Assets → Normally have Debit (Dr.) balance
2. Capital & Liabilities → Normally have Credit (Cr.) balance

Rules of Accounting Equation 

1. Every transaction has two aspects.
2. Increase or decrease in asset will be adjusted from asset
3. Every expense will be deducted from capital and every income will be added to capital 

This fundamental equation is the foundation of double entry bookkeeping

1. Assets are what a company owns
2. Liabilities are what it owes
3. Owner’s equity is the owner’s investment in the business.

1. Assets: All property owned by the company. These are the assets to the business - cash, stock, furniture, debtors, shares, prepaid expenses, accrued income, building, machinery, computer, investment etc if assets added to the business must be debited and if assets reducing from the business must credited in books.
• Cash: The most liquid account. This includes all cash and cash equivalents. 
• Accounts Receivable: The balance of revenue still on credit, net of any allowances for doubtful accounts. In other words, this is what customers owe the company.
• Inventory: This account includes raw materials, work-in-progress (WIP) and finished goods. When a sale is reported, the cost of the sale pulls from this account and is reported under cost of goods sold on the income statement. 
• PP&E: Tangible fixed assets listed net of accumulated depreciation e.g., land, buildings, equipment. 
• Intangible Assets: Examples of identifiable intangible assets include patents and licenses. Examples of unidentifiable intangible assets include goodwill and the company’s brand. 
2. Liabilities: All debts the company currently has outstanding. Creditors, outstanding expenses, bank loan, unearned income (advance income) etc. if liabilities increase in the business its debited and if liabilities decrease from the business must be debited in the books. 
• Accounts Payable: Sums the company owes its vendors and suppliers for items and / or services purchased on credit. 
• Notes Payable: The equivalent of debt. You can have both short- and long-term notes payable (short-term debt is due within one year’s time). 
• Debt: A loan from a bank, for example. 
3. Stockholders’ Equity: Ownership interest in the company after all debts or liabilities have been repaid. it is the residual interest in the total assets of the entity after deducting all its liabilities. It is the claim of owners in the total assets.
• Contributed Capital: Value of the capital that shareholders have contributed (invested) in the company. 
• Retained Earnings: The amount of net income that is retained by the business. 

Examples of Common Accounts

Assets	Liabilities	Capital	Revenue	Expenses	Withdrawals
Cash	Accounts Payable	Investments made by Owner	Rent Revenue	Wage Expense	Drawings by Owner
Accounts Receivable	Notes Payable	Cash	Commission Revenue	Salaries Expense	Personal Withdrawals
Supplies	Wages Payable	Land	Service Revenue	Rent Expense
Equipment	Interest Payable	Vehicle	Fees Earned	Telephone Expense
Furniture	Unearned Revenue	Building	Interest Earned	Internet Expense
Land		Equipment	Service Fees	Interest Expense
Building		Computer	Sales	Hydro Expense
Prepaid Insurance		Furniture
Prepaid Rent		Office Equipment

Process of Accounting Equation 

1. Step 1 – Analyse the transaction to ascertain to which variable of accounting equation it affects by using CLEAR.
2. Sept 2 – Decide the effect of transaction on components of accounting equation i.e., whether they will increase if decrease assets, liability and capital.
3. Step 3 – Finally, record the effect on accounting equation in monetary terms 

Note 

1. C – Capital (Capital + Revenue – Expense)
2. L – Liability
3. E – Expenses & Losses
4. A – Assets 
5. R – Revenue or Income or Profit

Format of accounting equation

Accounting Equation 

Serial No.	Transaction	Assets                                                   =   Liabilities + Capital

Accounting Equation examples 

Transaction	Assets	=	Liabilities + Capital
	Cash + Stock	=	Creditors + Capital
Started business with cash Rs. 1,00,000	1,00,000 + 0	=	0 + 1,00,000
Purchased goods for cash 30,000	-30,000 + 30,000	=	0 + 0
New Equation	70,000 + 30,000	=	0 + 1,00,000
Purchased goods on credit 40,000	0 + 40,000	=	40,000 + 0
Paid Salaries 20,000	-20,000 + 0	=	0 + (-20,000)
New Equation	50,000 + 70,000	=	40,000 + 80,000
Received interest	10,000 + 0	=	0 + 10,000
New Equation	60,000 + 70,000	=	40,000 + 90,000

Balance Sheet

A balance sheet is statement prepared with a view to measure the exact financial position of a business on certain fixed date.

Balance sheet as at 31st March, ….

LIABILITIES	AMOUNT	ASSETS	AMOUNTS

Effect of Transactions on the Accounting Equation

Transaction	Effect on Assets	Effect on Liabilities / Equity
Buy fixed assets on credit	Fixed assets increase	Accounts payable increase
Buy inventory on credit	Inventory increases	Accounts payable increase
Pay supplier invoices	Cash decreases	Accounts payable decreases
Pay rent	Cash decreases	Equity decreases
Pay dividends	Cash decreases	Retained earnings decrease
Sell goods on credit  (Inventory effect)	Inventory decreases	—
Sell goods on credit  (Income effect)	Accounts receivable increase	Equity (income) increases
Sell services on credit	Accounts receivable increase	Equity (income) increases
Issue shares	Cash increases	Equity increases

Conclusion

If correct accounting procedures are followed:

1. The accounting equation remains balanced before and after every transaction
2. This equation forms the foundation of:
• Double entry bookkeeping
• Ledger accounts
• Balance Sheet preparation

Practical Insight: When recording any transaction, think “does this change what I own or what I owe (or both)?” — if you keep this balance in mind, your balance sheet will always stay correct.

FAQs 

1. What is the accounting equation?

The accounting equation is a fundamental accounting principle explaining: Assets = Liabilities + Equity This means what a business owns (assets) is always funded by what it owes to others (liabilities) plus what the owners invested or retained (equity).

2. What are assets?

Assets are resources owned by the business with future economic value like cash, inventory, buildings, equipment, and receivables.

3. What are liabilities?

Liabilities are obligations the company must pay  such as loans, accounts payable, salaries owed, taxes due, etc.

4. What is equity?

Equity is the owner’s claim on the business after all liabilities are subtracted from assets. It includes: 

•  Owner’s capital or contributions 
• Retained earnings (profits kept in business)

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Sandeep Ghatuary

Finance & Accounting blogger simplifying complex topics.

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