Loading the player...

What is the 'Accounting Equation'

The equation that is the foundation of double entry accounting. The accounting equation displays that all assets are either financed by borrowing money or paying with the money of the company's shareholders. Thus, the accounting equation is: Assets = Liabilities + Shareholder Equity. The balance sheet is a complex display of this equation, showing that the total assets of a company are equal to the total of liabilities and shareholder equity.

BREAKING DOWN 'Accounting Equation'

Any purchase or sale by an accounting equity has an equal effect on both sides of the equation, or offsetting effects on the same side of the equation. The accounting equation could also be written as Liabilities = Assets – Shareholder Equity and Shareholder Equity = Assets – Liabilities.

The basic equation shows that a company can fund the purchase of an asset with assets (a $50 purchase of equipment using $50 of cash) or fund it with liabilities or shareholder equity (a $50 purchase of equipment by borrowing $50 or using $50 of retained earnings). In the same vein, liabilities can be paid down with assets, like cash, or by taking on more liabilities, like debt.

Total Liabilities

The total liabilities indicate the amount of money a company owes to its short-term and long-term creditors. The total liabilities are divided into short-term liabilities, also known as current liabilities, and long-term liabilities. Short-term liabilities are expected to be paid off within one year, while long-term liabilities include debts that are expected to be paid off over one year from the balance sheet recording date. For example, assume a hypothetical company has total current liabilities of $5 million and total long-term liabilities of $20 million. Therefore, the company has total liabilities of $25 million, or $5 million + $20 million.

Shareholders' Equity

The shareholders' equity portion of the accounting equation could be calculated by summing the amount of share capital and retained earnings and subtracting the amount in treasury shares from the sum. The equation could be written as: Share Capital + Retained Earnings - Amount in Treasury Shares. For example, assume hypothetical company Rocket has share capital of $10 million, retained earnings of $25 million and treasury shares worth $5 million. Therefore, Rocket has total shareholders' equity of $30 million, or $10 million + $25 million - $5 million.

Real World Example

For example, Apple Inc. reported its annual balance sheet in September 2015. Apple had total current liabilities of $80.61 billion and total long-term liabilities of $90.51 billion. Therefore, it had total liabilities of $171.12 billion, or $80.61 billion + $90.51 billion. Apple had total common stock worth $27.42 billion, retained earnings of $92.28 billion and other stock holder equity of -$345 million. Therefore, it had total shareholders' equity of $119.36 billion, or $27.42 billion + $92.28 billion - $345 million. Consequently, it had total assets of $290.48 billion, or $171.12 billion + $119.36 billion.

RELATED TERMS
  1. Balance Sheet

    A balance sheet reports a company's assets, liabilities and shareholders' ...
  2. Liability

    Liabilities are defined as a company's legal debts or obligations ...
  3. Total Liabilities

    The aggregate of all debts an individual or company is liable ...
  4. Other Long-Term Liabilities

    Other long-term liabilities are a balance sheet item that lumps ...
  5. Current Liabilities

    A company's debts or obligations that are due within one year. ...
  6. Other Current Liabilities

    Other current liabilities are obligations coming due in the next ...
Related Articles
  1. Personal Finance

    How To Improve Net Worth By Decreasing Liabilities

    Here's an analysis of how to adjust liabilities and assets to improve net worth.
  2. Investing

    Reading the Balance Sheet

    Learn about the components of the statement of financial position and how they relate to each other.
  3. Investing

    How to Analyze a Company's Financial Position

    Find out how to calculate important ratios and compare them to market value.
  4. Investing

    Examples Of Asset/Liability Management

    In its simplest form, asset/liability management entails managing assets and cash inflows to satisfy various obligations; however, it's rarely that simple.
  5. Investing

    Understanding Coca-Cola's Capital Structure (KO)

    Since the crisis of 2008 and the implementation of an accommodative monetary policy by the Fed, Coca-Cola's capital structure has significantly shifted.
  6. Investing

    What Does Negative Shareholder Equity On A Balance Sheet Mean?

    Negative shareholder equity on a company’s balance sheet is a red flag that should prompt potential investors to take a closer look before committing their money.
  7. Personal Finance

    Common Liabilities That Hurt Your Net Worth

    Every penny that you keep out of the liability side of the net worth equation essentially ends up on the asset side.
  8. Investing

    Understanding Amazon's Capital Structure (AMZN)

    Following the 2008 financial crisis, many companies, including Amazon, have been increasing their leverage, causing significant changes to capital structure.
RELATED FAQS
  1. On which financial statements does a company report its long-term debt?

    Discover which financial statements are used to report a company’s long-term debt, as well as how a company uses debt to ... Read Answer >>
  2. How are accounts payable listed on a company's balance sheet?

    Find out how accounts payable is listed on a company's balance sheet, why it is considered a current liability, and how it ... Read Answer >>
  3. How do I calculate current liabilities in Excel?

    Learn what current liabilities are and examples of a company's current liabilities, and find out how to calculate total current ... Read Answer >>
  4. How do you calculate net debt using Excel?

    Learn about the net debt formula and how to calculate this financial metric using Microsoft Excel, including a brief explanation ... Read Answer >>
  5. What does negative shareholder equity on a balance sheet mean?

    Negative shareholder equity could show up on a company's balance sheet for a number of reasons, all of which should serve ... Read Answer >>
  6. Can working capital be negative?

    Negative working capital can arise under certain circumstances. Working capital can be negative if a company's current assets ... Read Answer >>
Hot Definitions
  1. Price-Earnings Ratio - P/E Ratio

    The Price-to-Earnings Ratio or P/E ratio is a ratio for valuing a company that measures its current share price relative ...
  2. Internal Rate of Return - IRR

    Internal Rate of Return (IRR) is a metric used in capital budgeting to estimate the profitability of potential investments.
  3. Limit Order

    An order placed with a brokerage to buy or sell a set number of shares at a specified price or better.
  4. Current Ratio

    The current ratio is a liquidity ratio that measures a company's ability to pay short-term and long-term obligations.
  5. Return on Investment (ROI)

    Return on Investment (ROI) is a performance measure used to evaluate the efficiency of an investment or compare the efficiency ...
  6. Interest Coverage Ratio

    The interest coverage ratio is a debt ratio and profitability ratio used to determine how easily a company can pay interest ...
Trading Center