Basic accounting formula

The basic accounting formula forms the logical basis for double entry accounting. The formula is:

Assets = Liabilities + Shareholders' Equity

The three components of the basic accounting formula are:

  • Assets. These are the tangible and intangible assets of a business, such as cash, accounts receivable, inventory, and fixed assets.
  • Liabilities. These are the obligations of a business to pay its creditors, such as for accounts payable, accrued wages, and loans.
  • Shareholders' equity. This is funds obtained from investors, as well as accumulated profits that have not been distributed to investors.

In essence, a business uses liabilities and shareholders' equity to obtain sufficient funding for the assets its needs to operate.

The basic accounting formula must balance at all times. If not, a journal entry was entered incorrectly, and must be fixed before financial statements can be issued. This balancing requirement is most easily seen in the balance sheet (also known as the statement of financial position), where the total of all assets must equal the combination of all liabilities and all shareholders' equity.

The basic accounting formula is one of the fundamental underpinnings of accounting, since it forms the basis for the recordation of all accounting transactions. In essence, if both sides of the basic accounting formula do not match at all times, there is an error in the accounting system that must be corrected.

The following table shows how a number of typical accounting transactions are recorded within the framework of the accounting equation:

Transaction Type Assets Liabilities + Equity
Buy fixed assets on credit Fixed assets increase Accounts payable (liability) increases
Buy inventory on credit Inventory increases Accounts payable (liability) increases
Pay dividends Cash decreases Retained earnings (equity) decreases
Pay rent Cash decreases Income (equity) decreases
Pay supplier invoices Cash decreases Accounts payable (liability) decreases
Sell goods on credit (part 1) Inventory decreases Income (equity) decreases
Sell goods on credit (part 2) Accounts receivable increases Income (equity) increases
Sell services on credit Accounts receivable increases Income (equity) increases
Sell stock Cash increases Equity increases

The basic accounting formula only relates to the double entry bookkeeping system, where all entries made are intended to balance using this formula. If you are using a single entry system, the formula does not apply.