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 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.
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.
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.
Connected Business Concepts
Other business resources:
- Financial Ratio Guide
- Financial Options Guide
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- Business Strategy Examples
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