The Accounting Equation
As an entrepreneur, who are thinking of going into business, or who is already conducting business, you have to start learning about the basic concepts of Accounting because they are the concepts that are used in reporting your business activities to the government come tax time. It is time you must know about one of the most fundamental concepts in accounting.
Accountants process data into documents called financial statements. It is the accounting equation that is the basis for the entire accounting system.
So what is this magical equation?
The Accounting Equation is:
ASSETS = LIABILITIES + OWNERS’ EQUITY.
In crude definition,
ASSETS are economic resources of the business that are expected to bring benefits for the business in the future.
LIABILITIES are economic resources borrowed by the business from another person or an organization.
OWNERS’ EQUITY is the economic resources that was contributed by the owners of the business to the business.
One way of thinking of this equation is that the left side is what the business has including its money, equipment, building, land, furniture, etc… The right side indicates where these assets had come from. Were they borrowed from parties outside the business, or were they contributed by the people who own the business.
The other version of this equation, that you might bump into is the:
ASSETS – LIABILITIES = OWNERS’ EQUITY.
In other words, if the business’s assets pay off all its liabilities, you are left with a figure that indicates the economic resources that belongs to the business’s owner.
It is pretty much the same thing, a concept of transposition in algebra.
If you take a look at a business’s BALANCE SHEET – or what is now modernly called as A STATEMENT OF FINANCIAL POSITION – you’ll notice that all the items in there are arranged following this accounting equation in either one of its versions.
Of course in a BALANCE SHEET, it is written vertically, instead of horizontally as it is in the equation.
You’ll see the items arranged somewhat as:
ASSETS XXX LIABILITIES YYY OWNERS EQUITY ZZZ
Where, XXX = YYY + ZZZ.
So, next time you see a balance sheet aka statement of financial position, take the time to recognize this logic.
This article was written for OrangesAndLime.com, to help creative individuals — artists, musicians, designers, illustrators and entertainers — build their own freelance businesses. Please note that this article serves as a guideline only. You should still seek professional advice regarding the matter because laws and practices change over time and they differ from country to country.