Basic accounting formula definition
/What is the Basic Accounting Formula?
The basic accounting formula forms the logical basis for double entry accounting. It states that the assets listed on an organization’s balance sheet must equal its liabilities and shareholders’ equity. 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. The calculation of the basic accounting formula is as follows:
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.
The totals for each of the preceding components of the basic accounting formula are highlighted in the following balance sheet example.
In essence, a business uses liabilities and shareholders' equity to obtain sufficient funding for the assets its needs to operate.
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.
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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 a business is using a single entry system, the formula does not apply.
Example of the Accounting Formula
As an example of the basic accounting formula, let’s look at a simplified version of Apple's balance sheet numbers. Suppose Apple Inc. has the following at the end of its fiscal year:
Assets:
Cash and Cash Equivalents: $50 billion
Inventory: $5 billion
Property, Plant, and Equipment: $45 billion
Total Assets = $50B + $5B + $45B = $100 billion
Liabilities:
Accounts Payable (to suppliers): $10 billion
Long-Term Debt: $30 billion
Total Liabilities = $10B + $30B = $40 billion
Now, we can find Apple's Shareholders’ Equity using the accounting equation:
$100 billion assets = $40 billion liabilities + $60 billion shareholders’ equity
In short, Apple Inc. owns $100 billion in total assets, which represents what the company controls or owns (cash, inventory, equipment, etc.). It also owes creditors a total of $40 billion (liabilities). The difference, $60 billion, represents the equity or ownership interest shareholders have in the company.
This simple illustration demonstrates how the accounting equation works in practice and highlights its importance for accurate, balanced financial reporting.