What is the Accounting Equation?

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Definition:

The accounting equation — assets equal liabilities plus shareholder equity — is fundamental to the double-entry system that records a firm's financial transactions on balance sheets, income statements, and cash flow statements.

🤔 Understanding the accounting equation

The accounting equation is the logic behind the double-entry accounting system used on balance sheets, income statements, and cash flow statements. It states that all assets must equal all liabilities plus shareholder equity. What a firm owns and what a firm owes must always balance. A business owns assets and owes liabilities to others and equity to its owners. Every financial transaction recorded reflects movement of economic value from a source to a destination within a closed system. Credits represent the destination on the right side, debits on the left. Everything must be accounted for, and the two sides must be equal. Investors can get a picture of a company's financial position by examining how the accounting equation relates a business's assets, liabilities, and shareholder equity on its financial statements.

Example

The accounting equation acts differently than your bank account statement. In a bank account, money just comes and goes. The accounting equation demands that where it goes equals where it came from, and both places must be named. A firm can't just withdraw money and do whatever it wants with it. In financial accounting, businesses operate in a closed system. Value never leaves — It just moves somewhere else. The value of what is owed must always equal the value of what is owned.

Takeaway

The accounting equation is like yin and yang…

Each entry is reflected in at least two places, like two sides of the same coin. They tell a different story about what happened to the same value. One cannot change without affecting the other, and neither can be stronger or weaker — just different. They must always balance each other — like yin and yang.

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What is the Accounting Equation?

The accounting equation (also called the basic accounting equation, or the balance sheet equation) represents the relationship between assets, liabilities, and owners’ (or shareholders’) equity. It describes what a company owns (assets) and what a company owes (liabilities and equity).

  • Assets: Stuff that has future economic benefits
  • Liabilities: Stuff that represents a financial obligation to someone else
  • Equity: Stuff that represents a financial obligation to the owner of the business (and its shareholders)

The critical thing to remember is that the stuff the business owns (assets) must be equal to the stuff the company owes (liabilities and equity). The accounting equation must balance — always.

Assets = Liabilities + Equity.

Here is a simple example.

Say you don't have any debt, and you've saved up $500K. What does that look like in an accounting equation?

But you’ve decided to buy a house selling for $2M. You need a loan from the bank for $1.5M. Once you get the loan, this is how your accounting equation changes.

Woah! You have $2M bucks. Does this mean you’re a millionaire now? Nope. You are still only worth $500K. (Equity = Assets – Liabilities)

How does the accounting equation work?

In the accounting equation, assets must always balance with liabilities and equity. Every transaction that increases or decreases value on one side of the equation must be matched on the other side of the equation. This is why the accounting system used with the accounting equation is called a double-entry system.

The accounting equation is continually updated on a balance sheet. A balance sheet is like a snapshot of assets, liabilities, and equity in a single slice of time.

Let's look at a simple example of this.

Say, you start a neighborhood doughnut business. First, you need to fund it. So you loan the business $20 to buy doughnuts. Here is the first entry in your balance sheet. The business has $20 cash, but it owes $20 as well.

You go to the doughnut shop and buy doughnuts. Now the business doesn’t have cash anymore. But it has inventory, so you have to reflect that in your balance sheet.

Suppose you decide that if you offered coffee as well, you’d probably get more doughnut sales. But you don’t have any more money to buy coffee. So you borrow $50 from your cousin. The loan from your cousin is a liability because the business is obligated to pay it back. But now you have $50 in cash account.

You buy coffee for $20 and a coffee pot for $25. The coffee pot is considered equipment. It’s tallied as an asset because an asset is anything the business owns that can help it generate income. The $20 worth of coffee has increased our inventory, and we have $5 in cash left over. Even though we have multiple entries with varying amounts, our accounting equation still balances.

So now you're ready to sell. You set up a stand on the corner of your neighborhood, and you sell all the doughnuts and coffee and walk away with $120. Nice job! But how do we reflect this in the balance sheet?

Your $40 in inventory is gone, but you made $120. You add the $120 to your cash account. Your profit is $80 because the doughnuts and coffee cost $40, and you made $120 in sales. $120 – $40 = $80. Notice that both sides still balance $150 = $150.

What is the double-entry system?

The double-entry system is the accounting system used to record the transactions of a business. It's the vehicle used by the accounting equation: Assets = Liabilities + Equity.

In double-entry accounting, everything on the left side under "assets" and everything on the right side under "liabilities and equity" in the accounting equation must balance. If something decreases on the left side, it must decrease on the right side. If something goes up on the left side, it must go up on the right side. The left-hand side is called the "debit" side. The right-hand side is called the "credit side."

Let's look at a simple instance of this. Jim wants to start a horseback-riding business. He funds the venture with $10,000 of his own money and takes out a small business loan for $30,000.

$10,000 is debited to cash, and $10,000 is credited to equity because it's owed to Jim. $30,000 is also debited to cash, and $30,000 is credited to liabilities because it's owed to the bank.

Then Jim buys some horses.

$30,000 is credited to cash, and $30,000 is debited to inventory.

Notice the assets are debited when entered and the liabilities are credited? Don't let this confuse you. In the double-entry system of the accounting equation, debits and credits have nothing to do with subtraction and addition, negative and positive, or good and bad.

In 1494, the father of accounting, Luca Pacioli, published, Summa de Arithmetica Geometria Proportioni et Propertionalita. It was published in Latin and introduced the double-entry system to the world. The original term credito meant "owed to X by the firm." And debito meant "owed or belonging to the firm." These terms were more conceptual than mathematical. In a business, assets don’t just appear, they come from a source. That source is given credits, and the assets are given debits. Another way to look at it is: Credit is the source of the value, and debit is the use or destination of the value.

What's the difference between a balance sheet and a cash flow statement?

While a company's balance sheet records cash entries, it can't track cash flow. The income statement and balance sheet typically use the accrual method of accounting, which means transactions are made, but money may not be collected or paid out yet.

Cash flow describes how cash and cash equivalents (CCE) flow in and out of businesses over time. CCEs are assets that can be converted into cash quickly, such as short term debt securities, like 90-day bonds or money market holdings. The cash flow statement is generated in bookkeeping from information on the balance sheet. It gives a more detailed account of how a firm manages its cash and CCE's through its operating, financing, and investing activities.

How does the accounting equation assess assets, liabilities, and equity?

Assets

Assets are resources that are expected to provide economic benefit. They have to be measurable and obtained in a transaction or exchange. Assets rise with a debit and decrease with a credit. Some assets you may see on a balance sheet are:

  • Cash
  • Accounts receivable: Money owed to a firm by credit customers.
  • Inventory: Products intended to be sold at a higher price.
  • PPE: Plant, property, and equipment used for business operations
  • Land and Buildings
  • Investments

Liabilities

Liabilities are financial obligations a company has to pay. Liabilities increase with a credit and decrease with a debit. Common liabilities are:

  • Accounts payable: Goods or services received by a firm on credit.
  • Taxes
  • Wages payable
  • Loans

Equity

Owners’ and shareholders’ equity are claims on assets minus liabilities. Equity increases with a credit and decreases with a debit. Common forms of equity in the accounting equation are:

  • Common stock: Outstanding shares
  • Treasury stock: Shares repurchased by the company
  • Additional Paid-In Capital (APIC): Most stocks have a par value below which a firm agrees not to sell. When stocks are sold, any amount over that par value is additional paid-in capital (APIC).
  • Dividends: Distribution of retained earnings to stockholders
  • Retained earnings: Money not paid out as dividends. Profit for future use.

What are the limits of the accounting equation?

The accounting equation can't see ongoing political and economic events, the rise and fall of industries, corrupt or weak corporate governance, and any other real-life things that have a bearing on the financial health of a firm. It only measures things with money. But money fluctuates. It can't account for inflation or depression, nor the change in the value of assets.

Humans are behind all accounting entries and have different points of view, intent, and accounting procedures. Depreciation of an asset can be allocated variably, depending on the point of view of the person assessing the asset. Balance sheets can be "window dressed" by burying losses or pumping profits to present a better financial position. Funds can be straight-up embezzled. When this happens, it's called "cooking the books."

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