Although accounting is described as the “language of business” at its core accounting is based upon a single equation referred to as the Accounting Equation.
Though the expanded definition of the accounting equation tends to vary amongst accounting authors the basic equation is always the same.
The Accounting Equation
You can use basic mathematics to manipulate the equation into different formats:
Assets – Liabilities = Equity
Assets = Liabilities + Equity
The final version of the equation may also be referred to as the Balance Sheet equation as it represents the information presented on that financial statement.
To understand this equation we need to understand the parts that make up the equation.
An asset is any item that can be used by a business to generate future economic benefit through use within the business or sale in the business’s operations. Examples of assets include: Cash, Inventory, Accounts Receivable and Capital Equipment.
Assets are further categorized as Current and Non-Current. Current assets are expected to be liquidated within a year. Cash is recorded as a current asset as are Accounts Receivable (few businesses extend credit terms beyond 30 days). Non-current assets are expected to bring economic benefit over a period longer than twelve months. Property Plant and Equipment are examples of non current assets.
Liabilities can be considered the opposite of assets. It is an obligation a business faces in the future due to past transactions. They are settled over time through the transfer of economic benefit in the form of goods, money or services.
Liability accounts include: Accounts Payable, Loans, mortgages, deferred revenues and accrued expenses. Like assets Liabilities are categorized as current or non-current depending on when they are due.
The label attached to the equity section of a Balance Sheet will be described differently depending on the type of entity being reported.
A business established as a sole proprietor will label equity as Owners Equity whereas a public company is more likely to refer to this part of the accounting equation as Shareholders Equity. The terminology used in this section of the Balance Sheet is different depending on the type of entity doing the reporting but the concepts are the same.
Equity records the value attributed to the owners of the business . As a business makes a profit the equity value increases. If a business sustains a loss, likewise equity goes down. This profit line item is referred to as Retained Earnings. This item has a special relationship with the Profit and Loss Statement and will be discussed further later.
Another way of reducing equity is to disburse profits to the owners of a business. A sole proprietor does this by making drawings on the business and a public company does the same when it issues dividends to its shareholders.
The Balance Sheet
The Balance Sheet is also referred to as a Statement of Financial Position. It is one of three major financial reports generated as part of the accounting function. It puts the accounting equation discussed above into a report format.
A Balance Sheet reports at a point in time a business’s financial position. The Balance Sheet presents the wealth of the business at the date specified on the header of the report.
Example 1: A Personal Balance Sheet
Perhaps the easiest way to understand a balance Sheet is to put together one in terms that most of us can understand. We’ve discussed the major classes of accounts reported on a Balance Sheet above: Assets, Liabilities and Owners Equity.
From the accounting equation we know that the balance sheet balances. That is, Assets = Liabilities +Owners Equity.
Anyone who has ever filled in a loan application has put together a modified version of a personal balance sheet. The lending institution will want to know your Asset and Liabilities. Once they have these details, Equity, or what you are worth is a plug figure.
So let’s look at Mary’s personal Balance Sheet. Mary has been saving to buy her first home. She has a deposit saved, has done her best to keep her credit card balances low, pay down her student loans and found the property she wants to buy. The Bank, before approving her home loan wants to know some information.
What are Mary’s assets and liabilities?
Mary gathers the current balances of her savings accounts and credit cards. She estimates the value of her late model car and uses the market value of her stocks to come up with the following information for the bank.
Taxable Investments $10,000
Retirement Accounts $15,000
Total Assets: $57,000
Credit Card $3,000
Student Loans: $20,000
Total Liabilities: $23,000
From the accounting Equation we can calculate Mary’s wealth – or Equity.
Assets-Liabilities = Equity
$57,000 - $23,000 = $34,000
Presented as a Balance Sheet, Mary’s statement of financial position may look like this:
Exercise 1: Complete YOUR Personal Balance Sheet
You understand your personal finances better than any one else’s. For this exercise you should do exactly what Mary has done. Find the balances of your cash accounts, checking accounts, credit cards, investments and loans and prepare your personal Balance Sheet.
Depending on where you are in life, your personal Balance Sheet may be simpler than Mary’s or more complex. If you are early in your adult life with student loans you may also find that your Equity value is negative. That simply means that you have accumulated more debt than you have assets. Student loans that common for young people nowadays.