3 ways to understand the Accounting Equation

Anyone who has ever done an accounting course has been forced to MEMORIZE the accounting equation. After all, the accounting equation is the basis of accounting and everyone needs to know it. I memorized too when I first started studying accounting. Did I understand it? No!! But, over the years, I began to understand it and my understanding of it influenced my entire understanding of accounting. Here's what I've learnt.

1. The accounting equation is: ASSETS = LIABILITIES + EQUITY

The problem is that many people don't know what these words mean so let's start by defining them:

• Assets: these are things that a company has - bank accounts, investments, land, buildings, inventory, vehicles etc.
• Liabilities: these are things that a company owes, obligations and commitments of the company to pay money or deliver services at a future date
• Equity: This is the owners' share, the portion of assets funded by the shareholders and is comprised of the portion the owners actually invest in the business as well as profits earned by the business.

Let's make it even simpler:

Assets - This is WHAT s business HAS

Liabilities and Equity - This represents WHERE the business got the funds to have what it is has.

So, a second way to look at the accounting equation is:

2. WHAT = WHERE

What we have will always equal WHERE we got the funds to have what we have. Assets are not acquired from thin air. The funds to acquire assets either come from lenders or shareholders.

There is a third way to understand the accounting equation. Let's give each one of the financial terms a simple, layman's term:

Assets - Things we OWN

Liabilities - Things we OWE

Equity - The OWNERS' SHARE

We now have a third way to display the accounting equation:

3. OWN = OWE + OWNERS' SHARE

What we own must at any point in time equal what we owe PLUS our owners' share. If it doesn't, we've left something out!!

Now, what does the accounting equation form?

It forms the balance sheet or statement of financial position.

If you're a visual person, like me, you'll appreciate this visual depiction of the accounting equation and how it forms the balance sheet.

Keep learning and growing.

If you think accounting is hard, you were taught badly ;)

Have a great weekend.

Mark

www.accountingmadeeasy.co

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