Basic accounting formula

3 key takeaways

• The basic accounting formula is: Assets = Liabilities + Equity.
• It ensures that a company’s balance sheet remains balanced, reflecting accurate financial health.
• This formula is fundamental to double-entry bookkeeping, where each transaction affects at least two accounts.

What is the basic accounting formula?

The basic accounting formula, also known as the accounting equation, is the cornerstone of accounting and financial reporting. It states that a company’s total assets are always equal to the sum of its total liabilities and equity. This equation forms the basis of the balance sheet, one of the main financial statements, and ensures that the company’s financial position is accurately represented.

The formula is expressed as:

Assets = Liabilities + Equity

Components of the basic accounting formula

1. Assets: Resources owned by a company that have economic value and can provide future benefits. Examples include cash, inventory, accounts receivable, property, equipment, and investments.
2. Liabilities: Obligations or debts that a company owes to external parties, which must be settled in the future. Examples include loans, accounts payable, mortgages, and other forms of debt.
3. Equity: The residual interest in the assets of a company after deducting liabilities. It represents the owners’ claim on the company’s assets. Examples include common stock, retained earnings, and additional paid-in capital.

How does the basic accounting formula work?

1. Recording transactions: In double-entry bookkeeping, every financial transaction affects at least two accounts, keeping the accounting equation in balance. For example, purchasing equipment with cash decreases cash (asset) and increases equipment (asset), with no net change in total assets.
2. Maintaining balance: The formula ensures that the balance sheet remains balanced, meaning the total value of assets always equals the combined value of liabilities and equity. This balance reflects the company’s financial health and stability.
3. Financial analysis: By analyzing the components of the accounting equation, stakeholders can assess the company’s financial position, including its liquidity, solvency, and overall financial health.

Examples of the basic accounting formula in action

1. Purchasing equipment with cash

• Transaction: A company buys equipment worth $10,000 and pays in cash.
• Impact on accounts:
• Decrease in cash (asset): -$10,000
• Increase in equipment (asset): +$10,000
• Accounting equation: The total assets remain unchanged, and the equation stays balanced.

2. Taking a loan

• Transaction: A company takes out a loan of $50,000.
• Impact on accounts:
• Increase in cash (asset): +$50,000
• Increase in loans payable (liability): +$50,000
• Accounting equation: The increase in assets is matched by the increase in liabilities, keeping the equation balanced.

3. Issuing stock

• Transaction: A company issues $20,000 worth of common stock.
• Impact on accounts:
• Increase in cash (asset): +$20,000
• Increase in equity (common stock): +$20,000
• Accounting equation: The increase in assets is matched by the increase in equity, maintaining balance.

Importance of the basic accounting formula

• Financial accuracy: Ensures the accuracy of financial statements, reflecting a true and fair view of the company’s financial position.
• Double-entry bookkeeping: Fundamental to the double-entry bookkeeping system, where every transaction affects at least two accounts.
• Decision-making: Provides valuable insights for stakeholders, including investors, creditors, and management, to make informed decisions.

Real-world application

Example: A company starts the year with $100,000 in assets, $40,000 in liabilities, and $60,000 in equity. During the year, it earns $30,000 in revenue (increasing assets) and incurs $20,000 in expenses (decreasing assets). Additionally, it pays off $10,000 of its liabilities.

Starting equation:

• Assets = Liabilities + Equity
• $100,000 = $40,000 + $60,000

Changes during the year:

• Increase in assets (revenue): +$30,000
• Decrease in assets (expenses): -$20,000
• Decrease in liabilities (loan repayment): -$10,000

Ending equation:

• Assets = Liabilities + Equity
• $110,000 = $30,000 + $80,000

The accounting equation remains balanced, accurately reflecting the company’s financial position.