Introduction to Accounting and the Accounting Equation

In Accounting there are plenty of formulas, theories, and equations, but by far the most important is the following:

Assets = Liabilities + Equity

First, I will describe in layman’s terms the three variables within the equation above. An asset is a resource that will be used to operate a business (e.g. inventory, plant, machinery). A liability is a creditors right to the resources within the business (e.g. loan, accounts payable). Equity is the owner’s interest in the business (e.g. stock, retained earnings).

Home ownership is an easy way to understand the relationship between the three variables. The house itself is an asset because it can be used to generate revenue from rent or a business can be ran within the home (e.g. daycare, tax preparation). The mortgage on the home is a liability because a mortgage is a loan from a bank. The home is collateral for the loan, so if the owner cannot pay back the loan the bank will be able to take ownership of the asset. The difference between the value of the home and the amount of the loan is called home equity. For example, if the home is worth \$100,000 and the bank mortgage was for \$80,000 then the owner has \$20,000 of equity.

Next, I will describe three business transactions involving the Accounting Equation.

1) Issuing stock for a business

In order to finance business operations, a business will issue stock. In this example, ABC Co. issues \$100,000 worth of stock in exchange for \$100,000 cash. Cash is an asset because it is a resource that will be used to operate the business. Stock is a type of equity.

Assets = Liabilities + Equity
\$100,000 = \$0 + \$100,000

2) Borrowing money from a bank

Another way to finance business operations, a business will borrow money from a creditor. In this example ABC Co. borrows \$50,000 cash from XYZ bank. The loan is a liability because XYZ Bank will have a right to ABC Co.’s resources if the loan is not paid back.

Assets = Liabilities + Equity
\$50,000 = \$50,000 + \$0

After receiving the cash to finance the business, ABC Co. will buy a new machine in order to start production. The machine cost \$120,000 and ABC Co. pays all cash for the machine.

Assets = Liabilities + Equity
-\$120,000 +\$120,000 = \$0 + \$0

You should notice that this transaction only effects one side of the Accounting Equation. ABC Co. paid out \$120,000 cash (-\$120,000 to assets), but also received a machine in return (+\$120,000). The net effect of the transaction is zero dollars on both sides of the Accounting Equation.

Now let’s examine all three transactions together.

Assets = Liabilities + Equity
1) Issuing stock             \$100,000 = \$0 + \$100,000
2) Borrowing loan          \$50,000 = \$50,000 + \$0
3) Purchase machine      -\$120,000 + \$120,000 = \$0 + \$0
Total                             \$150,000 = \$50,000 + \$100,000

\$54p/h

Andika P.

Accounting, Finance, and Statistics Tutor

300+ hours