This type of accounting equation reflects the relationship between the balance sheet and income statement. The income statement shows the company’s net profit, which is the difference between revenues and expenses for a specified reporting period. The accounting equation asserts that the value of all assets in a business is always equal to the sum of its liabilities and the owner’s equity. For example, if the total liabilities of a business are $50K and the owner’s equity is $30K, then the total assets must equal $80K ($50K + $30K).

A portion of this profit may go towards the company’s development, other needs, or be used as reserves. The working capital formula is Current Assets – Current Liabilities. Metro Corporation earned a total of $10,000 the accounting equation can be expressed as in service revenue from clients who will pay in 30 days. With Deskera you can automate other parts of the accounting cycle as well, such as managing inventory, sending invoices, handling payroll, and so much more.

The major and often largest value assets of most companies are that company’s machinery, buildings, and property. Over 1.8 million professionals use CFI to learn accounting, financial analysis, modeling and more. Start with a free account to explore 20+ always-free courses and hundreds of finance templates and cheat sheets. Shareholder Equity represents the net or book value of a business.

  1. So, it appears that the accounting equation is necessary for any business owner who wants an in-depth analysis of the current state of their business.
  2. By paying attention to cost indicators, the company can also develop new marketing strategies, pricing models or other ways of improving the profitability of the enterprise.
  3. The owner(s) of the enterprise may be an individual or a group of people.
  4. As our example, we compute the accounting equation from the company’s balance sheet as of December 31, 2021.

If an accounting equation does not balance, it means that the accounting transactions are not properly recorded. In this example, we will see how this accounting equation will transform once we consider the effects of transactions from the first month of Laura’s business. The accounting equation shows the amount of resources available to a business on the left side (Assets) and those who have a claim on those resources on the right side (Liabilities + Equity). The assets of the business will increase by $12,000 as a result of acquiring the van (asset) but will also decrease by an equal amount due to the payment of cash (asset).

Assets, Liabilities, And Equity

Taking time to learn the accounting equation and to recognise the dual aspect of every transaction will help you to understand the fundamentals of accounting. Whatever happens, the transaction will always result in the accounting equation balancing. An error in transaction analysis could result in incorrect financial statements. Now, these changes in the accounting equation get recorded into the business’ financial books through double-entry bookkeeping.

Like any brand new business, it has no assets, liabilities, or equity at the start, which means that its accounting equation will have zero on both sides. Capital essentially represents how much the owners have invested into the business along with any accumulated retained profits or losses. The capital would ultimately belong to you as the business owner. As we’ve learned previously, the accounting equation is a mathematical expression that shows the relationship among the different elements of accounting, i.e. assets, liabilities, and capital (or “equity”). To prepare the balance sheet and other financial statements, you have to first choose an accounting system. The three main systems used in business are manual, cloud-based accounting software, and ERP software.

Income and expenses relate to the entity’s financial performance. Individual transactions which result in income and expenses being recorded will ultimately result in a profit or loss for the period. The term capital includes the capital introduced by the business owner plus or minus any profits or losses made by the business. Profits retained in the business will increase capital and losses will decrease capital. The accounting equation will always balance because the dual aspect of accounting for income and expenses will result in equal increases or decreases to assets or liabilities.


The fundamental components of the accounting equation include the calculation of both company holdings and company debts; thus, it allows owners to gauge the total value of a firm’s assets. The accounting equation states that a company’s total assets are equal to the sum of its liabilities and its shareholders’ equity. In this form, it is easier to highlight the relationship between shareholder’s equity and debt (liabilities). As you can see, shareholder’s equity is the remainder after liabilities have been subtracted from assets.

What Are the Three Elements in the Accounting Equation Formula?

It’s essentially the same equation because net worth and owner’s equity are synonymous with each other. Other names for owner’s equity you may face are also net assets, or stockholder’s equity (for public corporations). Essentially, the representation equates all uses of capital (assets) to all sources of capital, where debt capital leads to liabilities and equity capital leads to shareholders’ equity. This transaction affects only the assets of the equation; therefore there is no corresponding effect in liabilities or shareholder’s equity on the right side of the equation. For example, if a company becomes bankrupt, its assets are sold and these funds are used to settle its debts first.

Another way to look at the equation it is:

(Note that, as above, the adjustment to the inventory and cost of sales figures may be made at the year-end through an adjustment to the closing stock but has been illustrated below for completeness). Although the balance sheet always balances out, the accounting equation can’t tell investors how well a company is performing. What is the practical use of the accounting equation, and why is it so important? It provides the basis for calculating various financial ratios (liquidity, return on investment, profitability, etc.).

Accounting Equation Definition

In other words, this equation allows businesses to determine revenue as well as prepare a statement of retained earnings. This then allows them to predict future profit trends and adjust business practices accordingly. Thus, the accounting equation is an essential step in determining company profitability.

⮚ Liabilities everything the company owes to others and has an obligation to return within a specified period. So, let’s take a look at every element of  the accounting equation. As the fintech industry continues to expand, memorizing accounting equations will become obsolete. The bread and butter lies in freeing up your human labor to work on value-based tasks, while automating manual processes. Understanding how the accounting equation works is one of the most important accounting skills for beginners because everything we do in accounting is somehow connected to it.

Accordingly, the number of obligations is the real state of the company’s liabilities in the current time. Using this as an indicator works very well because it shows the existing liabilities of the company, which must be taken into account when calculating the total net income. The balance of the total assets after considering all of the above transactions amounts to $36,450. It is equal to the combined balance of total liabilities of $20,600 and capital of $15,850 (a total of $36,450). It’s telling us that creditors have priority over owners, in terms of satisfying their demands.