Why You Should Know the Accounting Equation

By Amanda Karen | CrunchSum

accounting equation

“I own and run my own company. I don’t want or need to know about accounting – that’s what my bookkeeper and CPA are for. It was that subject that I hated taking in school.

These are some of the most common opinions of accounting. No matter your opinion, as the owner of your company, a basic understanding of fundamental principles will significantly benefit you and your business!

The most basic principle is the accounting equation, and knowing this can help you analyze the financial condition of your company at a given point in time.

The Accounting Equation

Assets = Liabilities + Owner’s Equity

    The accounting equation will always remain in balance because every business transaction effects at least two accounts. This is called double entry accounting and will be discussed in more detail in future posts.

    Accounting Equation Terms

    are the economic resources of a company – these are the things your company owns. Examples include cash, land, buildings, equipment, and inventory.
    are the economic obligations of a company – this is the money your company owes. Examples include, accounts payable, notes payable, mortgage payable and salaries payable.
    Owner’s Equity
    is best described as capital. It represents the amount of funds that remain when all liabilities have been deducted from assets. An example is capital stock.

    *The term “owner’s equity” is used for sole proprietors and the term “shareholder’s equity” or “stockholder’s equity” is used for corporations. We are using “owner’s equity” for this explanation.

    What the Equation Tells You

    The accounting equation describes the relationship between what the company owns (assets) and what the company owes to its creditors (liabilities) and investors (owner’s equity).

    Simple Examples

    Jack owns a boat manufacturing company. Jack purchases equipment (asset) to produce boat parts by taking out a loan (liability) for $2,000. The accounting equation looks like this:

    $2,000(A) = $2,000(L) + $0(O/E)

      The equation remains equal because Jack’s assets increase with the equipment purchase, and his liabilities increase by taking out the loan.

      Jill invests $6,000 cash to start a coffee shop. The accounting equation looks like this:

      $6,000(A) = $0(L) + $6,000(O/E)

      The equation remains equal because the company’s cash flow (asset) increases, and at the same time, so does the amount in owner’s equity.

      Why Is This Important?

      Balance Sheet

      All of your asset, liability, and owner’s equity accounts are reported on your balance sheet. The balance sheet is used to assess your company’s ability to pay your debts.

      Understanding the accounting equation will help you read and analyze your balance sheet. Whether or not you do your own bookkeeping, this will be valuable knowledge to have.

      Now you understand the accounting equation. Not too complicated right? Go and analyze your balance sheet with this new knowledge!

      What is your opinion of accounting? How has understanding the accounting equation helped you? What questions do you have? I’d be interested to hear your thoughts in the comments below or send me an email at info@crunchsum.com.

      CrunchSum provides web-based bookkeeping and QuickBooks support services to web and technology companies.

      Is this your first time visting the CrunchSum blog? Subscribe to future posts for more accounting tips and follow @CrunchSum on Twitter.

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