The accounting equation is a principle in accounting that says that a company’s assets must be equal to its liabilities and equity. This equation relies on the double-entry system of accounting, where every transaction results in positive or negative changes to at least two of these accounts: assets, liabilities, or equity.
In this guide, we’ll cover:
- What Is the Accounting Equation?
- Accounting Equation Formula
- What Is the Double-Entry Accounting System?
- Accounting Equation in Practice
- Showing You Understand the Accounting Equation on Resumes
- Related Skills for Accountants
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What Is the Accounting Equation?
The accounting equation shows how a company’s assets, liabilities, and equity are related and how a change in one typically results in a change to another. In the accounting equation, assets are equal to liabilities plus equity.
You can find a company’s assets, liabilities, and equity on a few key financial statements, including the balance sheet and the income statement. These financial statements give a quick overview of the company’s financial position. The accounting equation makes sure the balance sheet is balanced, showing that transactions are recorded accurately.
Who Uses the Accounting Equation?
Accountants and members of a company’s financial team are the primary users of the accounting equation. Understanding how to use the formula is a crucial skill for accountants because it is a quick way to check that transactions are recorded correctly.
>>MORE: Find the right accounting career path for you.
Accounting Equation Formula
The basic accounting equation formula is:
Assets = Liabilities + Equity
There are different ways to express this concept, like “equity = assets – liabilities,” but they all serve the same purpose: ensuring correctly reported transactions and balanced balance sheets. On the other hand, if assets are not equal to liabilities plus equity (or if it does not balance), it likely means there was a mistake in financial reporting or data processing.
Components of the Accounting Equation
An asset is anything a company owns. Assets typically hold positive economic value and can be liquified (turned into cash) in the future. However, some assets are less liquid than others, making them harder to convert to cash. For example, inventory is very liquid — the company can quickly sell it for money. Real estate, though, is less liquid — selling for cash is time-consuming and sometimes difficult, depending on the market.
Some examples of assets include:
- Prepaid expenses
- Equipment and machinery
- Buildings or property
Liabilities are amounts of money that the company owes to others. Sometimes, liabilities are called obligations — the company has an obligation to make payments on loans or mortgages, or they risk damage to their credit and business.
Some examples of liabilities include:
- Deferred revenue
- Accounts payable (money owed to lenders or customers)
- Loan payments
- Accrued expenses
There are two ways to look at equity. One is to consider equity as any assets left over after deducting all liabilities. In fact, the equation for determining how much equity a company has is subtracting the company’s liabilities from its assets.
However, equity can also be thought of as investments into the company either by founders, owners, public shareholders, or by customers buying products leading to higher revenue.
Some examples of equity include:
- Owner contributions
- Net profits
- Investments from shareholders
>>MORE: Learn the accounting skills you need to succeed with the Chartered Accountants ANZ Accounting and Business Performance Virtual Experience Program.
What Is the Double-Entry Accounting System?
The accounting equation relies on a double-entry accounting system. In a double-entry accounting system, every transaction affects at least two accounts. For example, if a company buys a $1,000 piece of equipment on credit, that $1,000 is an increase in liabilities (the company must pay it back) but also an increase in assets.
These two sides of a transaction are debit (DR) and credit (CR). So, taking out a business loan will increase liabilities (credit) but also increase spending power and assets (debit). Conversely, lowering liabilities, perhaps by paying off a loan or selling a property, will have a positive and negative effect on assets: the lost asset is deducted, but the increased spending power is a positive asset change.
Accounting Equation in Practice
Using Apple’s 2022 earnings report, we can find all the information we need to fill in the accounting equation.
For 2022, Apple reported:
- Total assets: $352,755 million
- Total liabilities: $302,083 million
- Total equity: $50,672 million
So, using the accounting equation, we have:
$352,755m (assets) = $302,083m (liabilities) + $50,672m (equity)
And we find that the numbers do balance, meaning Apple has been reporting transactions accurately, and its double-entry system is working.
Showing You Understand the Accounting Equation on Resumes
The accounting equation is a foundational hard skill every accountant needs. So, if you have prior work or internship experience with balancing books or creating and understanding financial statements, it will be understood that you know the accounting equation. In the description for your accounting work or internship experience, you could say something like:
- “I recorded, tracked, and reported Company X’s financial statements, and ensured everything was accurate using the accounting equation.”
Additionally, you can use your cover letter to detail other experiences you have using the equation. For example, you can talk about how you checked that the books were balanced for a friend or family member’s small business.
Related Skills for Accountants
While using the accounting equation is vital, there are many more skills accountants need to succeed. Some of the most important skills for accountants include:
- Knowing how to create and read financial statements
- Having the ability to calculate profit margins
- Understanding of accounting-specific formulas, such as the current ratio
- Practical knowledge of the generally accepted accounting principles (GAAP)
You can start learning these accounting skills today with Forage’s accounting virtual experience programs.
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