The Accounting Equation

Hi there,

There is a fun fact about accounting. That is the accounting equation is the most popular and famous feature of the accounting area. Every single person has been studying accounting. They would recall and describe the accounting equation first if they were questioned about how accounting works.

So without further ado,

We’ll find out what is the Accounting Equation:

In a nutshell, the accounting equation is Assets?= Liabilities?+?Owner’s Equity. It means Everything a business owns must be equal to everything a business owes.

Or you can break it down in the theoretical style that is:

The accounting equation hands over the underlying framework for recording and summarizing economic events of the business regardless of the size, form, and nature of the business.

Next, I would like to refer to an example:

The IHA company totally owns 100$ in assets, while, the company owes 40$ in debts and 60$ in owners’ investment.

So now, I want you guys to apply the accounting equation to this example.

Firstly, on the left side of this equation, we got 100$ in the company's assets following our example, right? Secondly, on the right side of this equation, we got the company's debts, as well as the company's liabilities, equal 40$. Moreover, the owner invested 60$ for the IHA company that indicted us the owner's equity equal 60$. So to sum it up. we got 100$ assets = 40$ liabilities + 60$ owner's equity. It is naturally balanced. Right?

Okay, so, next we'll discover more about Assets in the Accounting Equation:

In a nutshell, Assets are everything a company owns that could carry out future services or benefits.

For instance,

If you are an owner of a pizza restaurant, your restaurant will own the delivery motorbikes for delivering pizzas to customers, tables, and chairs to serve people who want to eat at your restaurant, cash for trading, an oven for roasting pizzas, etc. So mostly all of those assets will carry out future services or benefits for your restaurant.

Next, the Liabilities of the Accounting Equation:

The liabilities have a claim against assets which are debts and obligations of a company that the company must be liable to pay back.?

However, people are going to ask:

What do you mean the liabilities have a claim against assets?

So I will answer this query by referring to the example.

IHA restaurant owes 1000$ from the ABC bank, 100$ on credit from suppliers for buying materials, and 5000$ in playable wages for employees. So basically, the IHA restaurant had been owed 6100$ in the liabilities category which is based on the concept above. If the owner of the IHA restaurant wants to stop doing business, the restaurant has to pay off the liabilities before the owner will collect the rest. So this is the explanation for the sentence "the liabilities have a claim against on assets".

Next, that is the Owner's Equity.

The owner's equity is the ownership that is claimed on the entire company’s assets after paying off liabilities. Moreover, it is often pointed out as the residual equity.

Owner’s Equity (residual equity)?=?Assets -?Liabilities

which means the assets of a business are claimed by either creditors or owners. So to find out what belongs to the owners, we subtract the liabilities from the assets. The remainder is the owner’s equity. Since the claims of creditors must be paid before ownership claims, the owner’s equity is often referred to as residual equity.

I am going to crack it up a notch by introducing to you guys the 4 basic subcategories of the Owner's Equity.

Those are the owner's capital, the owner's drawings, revenues, and expenses.

First, we are going to jump into the Owner's Capital category or we can call it under a friendly name which is the Owner's Investment.

So the owner’s Capital category stores the money that the company's owners have been investing in the business. Therefore, the owner’s capital tends to increase the owner’s equity.

For example:

The total owner’s equity of the IHA company reached 1000$ in 2019. Afterward, the IHA company received an investment is 100$ from an owner. Therefore, the IHA company’s owner’s equity was built up to 1100$.

Secondly, the Owner's Drawings.

The owner’s drawings category stores the money (cash) that is withdrawn by the owner of a company for personal uses. Therefore, the owner’s drawings tend to decrease the owner’s equity.

For example:

In 2020, the IHA company had a total owner’s equity of 1100$. Afterward, The owner withdrew 1000$. Then, the IHA company's owner's equity just remained 100$.

Third is the Revenues category.

Well, I think the word "revenues" is already defined for itself, Of course, the revenues category records the money generated from the sale of goods or the performance of services in normal business operations. Therefore, revenues tend to increase the owner’s equity.

For example,

January 2020, IHA company’s owner’s equity was 1000$. Afterward, the next quarter the company’s revenues were 1000$. Then, the IHA company’s owner’s equity developed to 2000$.

The final is the Expenses category.

The expenses category stores the money spent or costs incurred in the process of generating income for the company.

For instance,

The IHA restaurant's quarterly revenues are 1000$, however, during the time was doing business, the restaurant had been paying 100$ for local advertisement. So all in all the IHA restaurant's owner's equity or you can call it under the name residual equity is 900$ why? Because 1000-100 = 900. Therefore, Expenses tend to decrease the owner’s equity.

Finally,

I'm going to wrap up everything that we have been learning so far. First, the accounting equation: Assets = Liabilities + Owner’s Equity. It means everything the company owns equals everything the company owes. The definition of Assets, Liabilities, Owner’s Equity, and most importantly are 4 subcategories of Owner's Equity. There are Owner’s Capital, Owner’s Drawings, Revenues, and Expenses.

THE END!

For further information, you can what my YouTube video "Accounting for Beginners 3: The accounting equation | assets, liabilities, owner's Equity."

Bye! Oh almost forget, like, and share this article if you think it is useful.