Introduction to the accounting equation
The accounting equation is the foundation of accounting – it guides accountants on how to record transactions and how to report a summary of those transactions in the financial statements. It shows what the organisation owns and the sources of (or claims against) those resources.
The accounting equation can be thought of from a “sources and claims” perspective; that is, the assets (items owned by the business) were obtained by incurring liabilities or were provided by owners. Stated differently, everything a company owns must equal everything the company owes to creditors (lenders) and owners (individuals for sole proprietors or shareholders for companies or corporations).
Components of the accounting equation
An asset is a resource that the entity owns or controls that provides it with current or future economic benefit. That economic benefit might be from selling that asset – such as goods held as inventory in a retail business; or from using the asset – such as using a computer and software to create social media marketing images for a client.
A liability is an obligation or debt that the entity holds that must be repaid in the future. The entity will need to use some of its assets to repay the obligation.
Owners’ equity (or Equity)
The owners equity represents the net value of the business – that is, the value of assets once all liabilities are settled. An entity that has more liabilities than assets it owns is not in a great financial position – this is called negative equity! This happens quite often when there is a significant change in the business environment such as a sharp decline in customers or increase in debt. Once a business has negative equity, it may not be long until they are insolvent and no longer a going concern (and under Australian laws, are not permitted to continue in business). If you’re interested in reading more – check out this piece in the Small Business Chronicle.
Rearranging the accounting equation
You may recall from mathematics courses that an equation must always be in balance. Therefore, we must ensure that the two sides of the accounting equation are always equal. We explore the components of the accounting equation in more detail shortly.
The accounting equation can therefore be re-arranged using simple algebra.
Assets = Liabilities + Owner’s Equity
Assets – Liabilities = Owner’s Equity
Liabilities = Assets – Owner’s Equity
Practical example of the accounting equation
Felix’s Fresh Flowers (FFF) has assets of $250,000. These assets include equipment, cash and inventory used to make floral arrangements. FFF also owes the bank a loan of $50,000.
What is the Owner’s Equity for FFF?
Assets = Liabilities + Owner’s Equity
$250,000 = $50,000 + Owner’s Equity
Owner’s Equity = $250,000 – $50,000
Owner’s Equity = $200,000
Accounting is based on what we call a double-entry accounting system, which requires the following:
- Each time we record a transaction, we must record a change in at least two different accounts. Having two or more accounts change will allow us to keep the accounting equation in balance.
- Thus assets, liabilities and/or equity will increase or decrease with every accounting transaction
- The increases and decreases must be equal to each other
In real life, accountants record transactions in journal entries to various accounts using a recording system that involves Debits and Credits. The transactions in the accounts are then summarised to create summary values for each account. This data will then be used to construct the financial statements.
In Accounting, Business and Society – we will delve into using Debits and Credits to record these transactions as accountants would. However, this introductory textbook focuses on developing a general understanding of accounting. We will discuss changes in our assets, liabilities and owner’s equity as increases or decreases to those accounts.
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