This page describes the fundamental accounting equation.
Businesses usually own assets. Assets are things that can be used to generate revenue through the sale of goods and services. Assets include cash, inventory, furniture and equipment, and accounts receivable. A business may also own intangible assets such as patents, trademarks and goodwill.
Generally Accepted Accounting Principles (GAAP) assumes that all assets of a business are either owned outright by the business owners or are subject to the claims of creditors. Creditors include anyone who has loaned money or extended credit to the business. Loans and other forms of extended credit are called liabilities. The portion of assets not subject to claims by creditors is called equity.
In the GAAP framework there must be a continuous equilibrium between assets on the one side and the total of liabilities and equity on the other side. This is represented by the fundamental equation of accounting:
This equation is also the basis for the most basic of accounting reports, the aptly named Balance Sheet. A balance sheet reports what a business owns (assets), what it owes (liabilities) and what remains for the owners (equity) as of a certain date. This equation must always be in balance. Always keep in mind the teeter totter illustration shown above.
Example. If a business has $1,000 of assets at a particular time those assets must be matched by the total of the claims of creditors and owners. Here is one example of an infinite number of acceptable balance sheets:
Equity is simply the difference between assets and liabilities. The owner has positive equity only to the extent that assets exceed liabilities. If a business has $1,000 of assets and $600 of liabilities the $600 of liabilities are, in effect, a claim on the assets. Equity is the difference between the assets and liabilities, or $400.
Equity is simply the difference between assets and liabilities. The owner has positive equity only to the extent that assets exceed liabilities. If a business has $1,000 of assets and $500 of liabilities the $500 of liabilities are, in effect, a claim on the assets. Equity is the difference between the assets and liabilities, or $500.
If a business ceases operations remaining assets first go to outside creditors. The claims of owners can be realized only after outside creditors’ claims are satisfied. So equity represents the owners’ residual claim on business assets.
Accounting measurements reflect the changes in the composition of a firm’s assets, liabilities and equity, subject to the conservation rule reflected in the fundamental equation. The conservation rule is simply that any net change up or down in a firm’s assets must be offset by an equal change to the combination of liabilities and equity. If there is an increase in assets, there must be an increase in the total of liabilities and equity. If there is a decrease in assets, there must be a decrease in the total of liabilities and equity. The teeter totter must always be balanced.
For a description of typical balance sheet accounts click here.
For a description of how the accounting equation is related to the debit/credit measurement system click here.
For an interesting discussion on the history of accounting click here.