The Accounting Equation

Assets = Liabilities + Owner’s Equity*
*Sometimes called Shareholder’s Equity, or Capital – but nonetheless the same concept
Those 3 pieces are what accounting is all about. Simply put Assets are things you have. For example cash, trucks, inventory, and even non-physical things, like copyrights, trademarks and this mysterious thing called Goodwill (which deserves its own article so I won’t get into it here) are all different kinds of assets. Liabilities are things you owe. For example, your monthly bills (in business we call these Accounts Payable), Car note, personal loans from the bank, and even mortgages, these are all liabilities. Lastly, Owner’s Equity there are probably a few ways to define this, but the most basic way is to say that it consists of what you own of your assets, rather than the part you owe to others. For simplicity, when I use the term Equity I’m referring to Owner’s Equity. Equity also consists of other things are can’t be described as assets or liabilities, I know all this sounds kind of abstract, but let’s work through a couple of examples, I’m not going to get into the actual accounts used, or double-entry bookkeeping, those I’ll save for future lessons.

Remember from high school algebra, equations always have to be balanced. In other words the left side of the equal sign has to be the same as the right side of the equal sign. I’m not a math wizard, so they may be better ways to explain this but just to illustrate this. 2 = 2. 4 = 2 + 2. In both instances the left and right sides of the equation are equal. Just to illustrate what’s wrong. 5 = 2 + 1. This equation is not in balance because 2 + 1 = 3 not 5. Ok, that’s enough math, and I won’t get any deeper with it I promise, just remember the sides have to be balance.

So let’s get back to accounting, I’m going to provide a few examples and we will look at the effect on the accounting equation.
1. Jim buys a car for $10,000 and its 100% financed
        Assets = Liabilities + Owner’s Equity
     $10,000 = $10,000 + 0
Jim now has a car (An Asset) and he owe’s the bank $10,000 for it (A Liability) since the car was 100% financed Jim doesn’t own any of it, that’s why there is 0 equity. Notice how the equation is in balance.\

2. Silda gets paid her monthly paycheck of $5,000.
      Assets = Liabilities + Owner’s Equity
     $5,000 = 0 + $5,000
In this transaction Silda had received cash of $5,000 (an asset). There is no other claim to her paycheck so there is $0 Liability, and since she owns all of her paycheck we have $5,000 equity.

3. With me so far, here’s a tricky one, Rick and Mary have bought a house for $100,000. They put $20,000 down and have a mortgage for the rest ($80,000). Let’s see what this looks like**
        Assets = Liabilities + Owner’s Equity
   $100,000 = $80,000 + $20,000
Yes, it’s in balance. Rick and Mary have a house worth $100,000 (an Asset) they have a mortgage of $80,000 (a liability) however, they own $20,000 of the house they purchased because of the down payment so they have Equity of $20,000.

I’ve introduced you to the basics of the accounting equation. I hope you found this insightful and if you have any questions please comment!

**Ok, so this is a bit more complex then I eluded to, because it assumes that they already had $20,000 in cash and also equity. The end result would still be the same as above but it requires some extra steps to get there. Of course these steps are what accounting is all about, the flows of money and its end state. So I will repeat the example with steps for the cash flows.
   Assets = Liabilities + Owner’s Equity
$20,000 = 0 + $20,000
This is their initial state before they buy the house they have $20,000 in cash and no claim against it, so $20,000 in equity also. For the next few steps I’ll put the signs of movement in ().
         Assets = Liabilities + Owner’s Equity
      $20,000 = 0 + $20,000 Initial State
  (-)$20,000 Paying of $20,000 as a down payment, they are giving up Cash (an Asset)
(+)$100,000 = (+)$80,000 +0 Buying the house they are getting the asset (the house) and a liability  (the        mortgage)
    $100,000 = $80,000 + $20,000 Ending state.
It’s a bit more complex because of the intra-asset transaction with the $20,000 down payment. It might seem that taking away the $20,000 cash unbalances the transaction, but remember these events are happening simultaneously with the purchase of the house.