Definition: Accounting Equation

Definition of Accounting Equation

What is the Accounting Equation?

The Accounting Equation summarizes the relationship of property and ownership, such that the total amount of property in a business equals the total amount of ownership of the property. A simple form of the Accounting Equation is Property = Ownership. Since property can be owned by owners and lenders, the Accounting Equation can be written as Property = Third-Party Ownership + Owner Ownership. The following figure summarizes the Accounting Equation:

Relationship of Property and Ownership

Here is an example of using the Accounting Equation. Let's say a business has $10,000 of cash property, where $4,000 of the cash was obtained from a loan and $6,000 is owned by the owners of the business. The Accounting Equation would calculate this as:

Accounting Equation
Property = Third-Party + Owner
$10,000 = $4,000 + $6,000
$10,000 = $10,000 (balanced)

In formal accounting terms, the Accounting Equation uses Assets as property, Liabilities as third-party ownership, and Equity as owner ownership. This gives us the formal version of the Accounting Equation:

Same Relationship using Accounting Terms

If we use the same example of the Accounting Equation above, we get:

Accounting Equation
Assets = Liabilities + Equity
$10,000 = $4,000 + $6,000
$10,000 = $10,000 (balanced)​

The Accounting Equation & The Balance Sheet

The Accounting Equation is used to create a business's Balance Sheet statement. The Balance Sheet statement summarizes a business's assets, liabilities, and owner equity just like we did in the previous examples. It is called a Balance Sheet statement because it uses the Accounting Equation to calculate the equality between property and ownership. These values must balance or a mistake would have been made. In the Accounting Equation, every cent of property and ownership must be accounted for.

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