The Accounting Equation
If you’re going to do either bookkeeping or accounting, you need to understand the accounting equation. It’s the basis for everything we do in financial management. The equation works the same for every business no matter how large or small. It applies to the mom and pop shop on the corner and to General Motors. Ready? Here we go.
Assets = Liabilities + Equity
Assets are things that you own that will provide future benefit. Some assets have a short life such as cash, inventory and accounts receivable. Other assets last longer such as furniture, equipment, and buildings. Assets with a life longer than one year are depreciated. This is a process where you gradually convert the asset into an expense.
Liabilities occur when you take on a financial obligation to another business entity. An example would be accounts payable. Accounts payable is the account you use to track your purchases from vendors with whom you deal regularly. They have checked your credit rating and have decided to let you buy goods and services on account. You’ll be billed each month and you’ll have thirty days to pay on your account. Other liabilities include mortgages on business property and loans for business equipment and vehicles.
Equity is your net worth. It’s what you own free and clear. Take all of your assets and use them to pay off all of your liabilities. What’s left over is your equity. Equity is increased when owners invest in the business. It’s also increase by profits. Equity is decreased when owners take out assets for personal use or when dividends are paid to stockholders. It is also increased when there is a net loss.
Together, assets, liabilities, and equity comprise the balance sheet accounts. Your balance sheet is a financial statement that tells you the financial condition of the business on one day in time. It’s usually prepared as of the last day of the month. Analysts use the figures on the balance sheet to determine, among other things, the business’s ability to meet short-term and long-term obligations. They can also determine if your inventory is turning over as often as it should. Much more information can be gleaned from the financial statements once you learn to appreciate what the numbers can tell you.
Categories: For Bookkeepers