accounting-equation

Accounting Equation And Why It Matters In Business

The accounting equation is the fundamental equation that keeps together a balance sheet. Indeed, it states that assets always equal liability plus equity. The foundation of accounting is the double-entry system which assumes that a company balance sheet can be broken down in assets, and how they get sources (either though equity/capital or liability/debt).

Case study: Imagine you are starting a company, which manufactures biscuits. Beside the cost to run the operations, you need the machine to produce them.

In total, for the machine you need $100,000.

The purchase is financed: 80% through equity and 20% through debt.

Even though this transaction is one step in the real world, it becomes three steps in the accounting world:

Step 1: Initially your balance sheet will show $80K under cash and equity, since remember that you will contribute 80% of $100K to buy the machine. The transaction will look like the following:

Step 2: Next, you will borrow $20K from the Bank as long-term loan, since 20% will be financed with debt. It means, you will show $100K under cash now ($80K + $20K). On the other side, you will show $80K under equity and $20K under liability. The transaction will look like the following: 

Step 3: With the resources acquired you will buy the machine that will cost you $100K. The machine will show as a long-term asset on the balance sheet. This asset, financed with $20K as a long-term liability and $80K as Equity. See below:

Core principles of the accounting equation and double-entry system

First, Assets always equals Liabilities + Equity.

Second, what is a one step transaction in the real world becomes a three steps transaction in the accounting world. I am sure at this point you are thinking of accounting as of “the art of making easy things hard”.

Although, I can assure you that once you internalize the two principles above you will see the light. To develop an accountant mindset you must always ask yourself “What is behind this transaction?”

Indeed, in today’s world accounting software do not allow you to understand what is going on behind the scenes. Thereby, once you keep in mind the two principles above, transactions that before you did not understand will suddenly reveal to your eyes.

At that point you will understand what I mean when I say that accounting is simple. Once you reach that enlightenment level the whole financial world will unravel to your eyes.

Suddenly, this deeper level of understanding will make you love the subject. You will no longer be like a car designer who does not know how the engine works. Therefore, each time the designer has to add a feature to the car skeleton he has to stop and wait for the engineer approval.

Key takeaway

In conclusion, the balance sheet is divided in two main parts. The first part is the one dedicated to Assets. Within it you will find two sub-sections: 

  • Current Assets.
  • Long-Term Assets. 

On the other hand, the second part is dedicated to liabilities and equity (sources of finance). Within that you will find two sub-sections:

  • Liabilities: Current and Non-Current or Long Term Liabilities.
  • Equity.

Keep in mind the balance sheet is a picture of the business in that moment. Where, the P&L is like a collage of pictures taken in the whole year. 

Connected Business Concepts

Double-Entry

double-entry-accounting
Double-entry accounting is the foundation of modern financial accounting. It’s based on the accounting equation, where assets equal liabilities plus equity. That is the fundamental unit to build financial statements (balance sheet, income statement, and cash flow statement). The basic concept of double-entry is that a single transaction, to be recorded, will hit two accounts.

Balance Sheet

balance-sheet
The purpose of the balance sheet is to report how the resources to run the operations of the business were acquired. The Balance Sheet helps to assess the financial risk of a business and the simplest way to describe it is given by the accounting equation (assets = liability + equity).

Income Statement

income-statement
The income statement, together with the balance sheet and the cash flow statement is among the key financial statements to understand how companies perform at fundamental level. The income statement shows the revenues and costs for a period and whether the company runs at profit or loss (also called P&L statement).

Cash Flow Statement

cash-flow-statement
The cash flow statement is the third main financial statement, together with income statement and the balance sheet. It helps to assess the liquidity of an organization by showing the cash balances coming from operations, investing and financing. The cash flow statement can be prepared with two separate methods: direct or indirect.

Capital Structure

capital-structure
The capital structure shows how an organization financed its operations. Following the balance sheet structure, usually, assets of an organization can be built either by using equity or liability. Equity usually comprises endowment from shareholders and profit reserves. Where instead, liabilities can comprise either current (short-term debt) or non-current (long-term obligations).

Capital Expenditure

capital-expenditure
Capital expenditure or capital expense represents the money spent toward things that can be classified as fixed asset, with a longer term value. As such they will be recorded under non-current assets, on the balance sheet, and they will be amortized over the years. The reduced value on the balance sheet is expensed through the profit and loss.

Financial Statements

financial-statements
Financial statements help companies assess several aspects of the business, from profitability (income statement) to how assets are sourced (balance sheet), and cash inflows and outflows (cash flow statement). Financial statements are also mandatory to companies for tax purposes. They are also used by managers to assess the performance of the business.

Read next:

How To Read A Balance Sheet Like An Expert

Other business resources:

Published by

Gennaro Cuofano

Gennaro is the creator of FourWeekMBA which reached over a million business students, executives, and aspiring entrepreneurs in 2020 alone | He is also Head of Business Development for a high-tech startup, which he helped grow at double-digit rate | Gennaro earned an International MBA with emphasis on Corporate Finance and Business Strategy | Visit The FourWeekMBA BizSchool | Or Get The FourWeekMBA Flagship Book "100+ Business Models"