What is an Accounting Equation?

The accounting equation is the fundamental formula that keeps the company’s books in balance.

In simple terms, every asset that a company possesses (the assets of the business) can be financed through what it owes to other companies (liabilities), or what the investors in the company have put into the company (equity). Since every business transaction impacts at least two accounts, both sides of the equation will always balance.

Here is a Quick Example for Accounting Equation Calculation

Assume an enterprise having the below figures:

• Current Assets: $60,000 (includes cash, inventories, and accounts receivable)
• Fixed Assets: $140,000 (includes property, equipment, and vehicles)
• Current Liabilities: $40,000 (includes accounts payable and short-term borrowing)
• Long-term Liabilities: $90,000 (includes business loans and mortgages)
• Owner’s Equity: $70,000 (includes owner’s contribution and retained earnings)

First, find out the Total Assets by summing up the current assets and fixed assets:

Total Assets = Current Assets + Fixed Assets

Total Assets = $60,000 + $140,000

Total Assets = $200,000

Next, find out the Total Liabilities by summing up the current liabilities and long-term liabilities:

Total Liabilities = Current Liabilities + Long-term Liabilities

Total Liabilities = $40,000 + $90,000

Total Liabilities = $130,000

Lastly, apply the accounting equation to verify whether the enterprise’s accounting system is balanced or not:

Assets = Liabilities + Equity

$200,000 = $130,000 + $70,000

$200,000 = $200,000

The equation is in balance, meaning that the company’s assets are entirely accounted for by its liabilities and owner’s equity. 

Why is the Accounting Equation Important? 

Understanding the accounting equation is crucial for businesses for several reasons. 

• It provides the basis for effective bookkeeping. It should be kept in mind that any journal entry will ensure that the accounting equation remains intact and therefore will serve as an error detection mechanism in case the accounts do not balance.
• It exposes the actual financial position. It allows the investors and stakeholders to see whether the company is funded by debt or equity and what ownership interest the proprietors have in the company.
• It promotes better decision-making. This financial ratio serves as a basis for assessing solvency and creditworthiness and making financing decisions.
• It forms the core of the balance sheet. Any balance sheet will be just the presentation of this equation, which means that the knowledge of this equation will make it easier to analyze other financial statements.
• It ensures compliance. It promotes consistency in transaction recognition and therefore makes companies audit-ready.

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