Finance and Accounting: Learn It 2

The Accounting Equation

the accounting equation

Assets = Liabilities + Owner’s Equity

 

  • Assets: Things of value owned by the organization
  • Liabilities: The organization’s debts
  • Owner’s equity: The total amount of investment in the organization minus the liabilities

The accounting equation represents the relationship between assets, liabilities, and the owner’s equity of a business. It can be calculated at any point in time using information from the balance sheet, which we will discuss later. It’s the foundation for the double-entry accounting system, accepted to be the most reliable and accurate method of recording the financial transactions of a business.

  • Assets may be anything tangible or intangible that can be owned or controlled to produce value. Tangible assets are things like cash, equipment, and buildings. Intangible assets are things like patents and trademarks.
  • Liabilities are debts, or what the organization owes to its creditors. Liabilities include things like loans and monies owed to suppliers.
  • Owner’s equity is the difference between the value of the assets and the amount of the liabilities. It is also sometimes called net worth. When the owners are shareholders, the interest can be called shareholders’ equity; the accounting remains the same, and it is ownership equity spread out among shareholders.

Double-entry Bookkeeping

The accounting equation must always be in balance (that is, the total of the elements on one side of the equals sign must equal the total on the other side). Suppose you start a coffee shop and put [latex]$10,000[/latex] in cash into the business. At that point, the business has assets of [latex]$10,000[/latex] and no liabilities. This would be the accounting equation:

Assets=Liabilities+Owners’ equity$10,000=$0+$10,000

The liabilities are zero and owners’ equity (the amount of your investment in the business) is [latex]$10,000[/latex]. The equation balances.

To keep the accounting equation in balance, every transaction must be recorded as two entries. As each transaction is recorded, there is an equal and opposite event so that two accounts or records are changed. This method is called double-entry bookkeeping.

Suppose that after starting your business with [latex]$10,000[/latex] cash, you borrow another [latex]$10,000[/latex] from the bank. The accounting equation will change as follows:

Assets=Liabilities+Owners’ equity$10,000=$0+$10,000Initial equation$10,000=$10,000+$0Borrowing transaction$20,000=$10,000+$10,000Equation after borrowing
 

Now you have [latex]$20,000[/latex] in assets—your [latex]$10,000[/latex] in cash and the [latex]$10,000[/latex] loan proceeds from the bank. The bank loan is also recorded as a liability of [latex]$10,000[/latex] because it’s a debt you must repay. Making two entries keeps the equation in balance.