Accounting Foundation

What is the Accounting Equation?

The Accounting Equation is a fundamental principle that states assets must equal the sum of liabilities and shareholders equity at all times.

On the balance sheet, the assets side represents a company’s resources with positive economic utility, while the liabilities and shareholders equity side reflects the funding sources.

Basic Accounting Equation: Assets = Liabilities + Equity

The accounting equation states that a company’s assets must be equal to the sum of its liabilities and equity on the balance sheet, at all times.

The accounting equation is a core principle in the double-entry bookkeeping system, wherein each transaction must affect at a bare minimum two of the three accounts, i.e. a debit and credit entry.

There are three components to the accounting equation, otherwise referred to as the “balance sheet equation”:

1. Assets → An asset is a resource owned by a company with positive economic value, which either possesses monetary value (i.e. can be sold for a net gain) or is expected to produce future benefits, such as PP&E. Assets can either be tangible, like fixed assets (e.g. equipment and machinery) or intangible (e.g. patents, trademarks, intellectual property and copyrights).
2. Liabilities → A liability represents a company’s obligations that represent future outflows of cash, i.e. unmet payments. For instance, common liabilities include debt securities such as loans, accounts payable (A/P), accrued expenses and deferred revenue.
3. Equity → The equity section of the balance sheet, often called “Shareholders’ Equity”, is the net assets of a company (i.e. the remaining value of a company’s assets after subtracting liabilities). The equity component is composed of items such as paid-in capital, retained earnings and treasury stock (or share repurchases).