The Accounting Equation
Assets = Liabilities + Equity — the fundamental balance
* Why This Matters
Everything you'll ever do in accounting flows from one simple equation. It's not just a rule—it's the foundation that keeps every financial record balanced and honest.
If you understand the accounting equation, you'll understand why debits and credits work the way they do, how financial statements connect, and why accountants obsess over balance sheets. Get this wrong, and every decision built on top collapses. Get it right, and the whole system makes sense.
The Accounting Equation Explained
Assets = Liabilities + Equity
This is the heartbeat of accounting.
What Each Part Means
AAssets
Everything the company owns or controls that has value
- Cash in the bank
- Equipment and buildings
- Inventory (products for sale)
- Accounts receivable
Anything that puts money in your pocket
LLiabilities
Everything the company owes to others
- Loans from banks
- Credit card debt
- Accounts payable
- Salaries owed to employees
Anything that takes money out of your pocket
EEquity
What's left for the owners after subtracting debts
- Owner's initial investment
- Profits kept (retained earnings)
- Stock issued to shareholders
"If we sold everything and paid all debts, what's left?"
The Balance Sheet Concept
Think of the accounting equation as a balance scale. The left side (what you own) must always equal the right side (what you owe + what owners invested).
The Balance Scale
Perfectly balanced - as it should be
Assets
$100,000
Liab + Equity
$100,000
This isn't optional. It's not a guideline. It's the law of accounting. If it doesn't balance, something's wrong—and you have to find and fix it.
Real Example: Starting a Business
Let's say you're launching a marketing consultancy. Watch how the accounting equation stays balanced through each transaction.
You Invest Your Own Money
You put $50,000 of your own cash into the business.
Assets
Liabilities + Equity
The Logic Behind the Equation
Here's why this equation must always balance:
Every transaction affects at least two accounts.
Because every transaction affects both sides of the equation, it always stays balanced. This is called double-entry accounting, and it's the reason balance sheets work.
Why This Matters for You
1. Catches Errors
If your balance sheet doesn't balance, you know something's wrong. You can find and fix mistakes before they compound.
2. Tells the Story
High assets + low liabilities = healthy company. High liabilities + low equity = risky. Growing equity = profitable.
3. Explains Every Decision
Buying equipment? Paying off a loan? Earning profit? Every decision connects to the equation.
How a Transaction Flows Through the Equation
TRANSACTION: You sell a product for $1,000 cash
Debit (+)
Cash (Asset)
+$1,000
Credit (+)
Sales (Equity)
+$1,000
Assets = Liabilities + Equity
$101,000 = $0 + $101,000
The Expanded Accounting Equation
As you go deeper into accounting, you'll see this expanded version:
Assets = Liabilities + Beginning Equity + Revenues - Expenses - Dividends
This is the same equation, just broken down further:
- +Revenues increase equity (you earn money)
- -Expenses decrease equity (you spend money)
- -Dividends decrease equity (you pay owners)
But the core concept stays the same: everything balances.
Key Takeaway
The accounting equation isn't just a formula—it's the law of accounting. Every transaction maintains this balance, and the moment it doesn't balance, you know something's wrong.
Master this equation, and you'll understand how debits and credits work, how financial statements connect, and why accountants obsess over balance sheets.
Test Your Understanding
Can you apply the accounting equation? Try these practice questions.
Question 1: A company has $80,000 in assets and $30,000 in liabilities. How much is the owner's equity?
Question 2: A company receives a $10,000 loan from a bank. What happens to the accounting equation?
Question 3: A company earns $5,000 in revenue. Which accounts change?
Question 4: A company's balance sheet shows: Assets: $100,000, Liabilities: $60,000, Equity: $30,000. Is this balanced?
Question 5: True or False: The accounting equation only applies to large companies, not small businesses.
Ready to See It in Action?
You now understand the theory behind the accounting equation. The Practice Lab is where you'll apply it. Enter transactions, watch the balance sheet update, and see how every move maintains the equation.
Try the Practice LabWhat's Next?
Now that you understand the fundamental balance, let's learn debits and credits—the mechanism that makes the equation work.