Accounting Equation

The Accounting Equation states that at all times, and without exceptions, the following will be true:

Assets = Liabilities + Owners’ Equity

Before you can create financial statements, you must first understand this single most fundamental concept of accounting – The Accounting Equation. Definitions of the equation as followed:

Assets: All of the property owned by the company.

Liabilities: All of the debts that the company currently has outstanding to lenders.

Owners’ Equity or Shareholders’ Equity: The company’s ownership interest in its assets, after all debts have been repaid.

For exampe:

Mary owns a $300,000 home. To pay for the home, she took out mortgage on which she still require to pay $230,000. Lisa would be said to have $70,000 “equity in the hom.” Applying the Accounting Equation to Mary’s scenario would be this:

Assets = Liabilities + Owners’ Equity

$300,000 = $230,000 + $70,000

In other words, the owners’ equity is just a plug figure. It’s simply the leftover amount after paying off the liabilities or debts. So while the Accounting Equation is conventionally written as:

Assets = Liabilities + Owners’ Equity => might be easier to think as : Assets – Liabilities = Owners’ Equity

If one year later, Mary had paid off $15,000 of her mortgage, her accounting equation would now appear as:

Assets = Liabilities + Owners’ Equity

$300,000 = $215,000 + $85,000

Because her liabilities have gone down by $15,000 and her assets have not changed, her owner’s equity has by default, increased by $15,000.

A liability for one person is an asset for somebody else. For example, if you take out a loan with your bank, the loan is clearly a liability for you. From the perspective of your bank, however, the loan is an asset. Similarly, the balance in your savings or checking account is an asset to you. For the bank, however, the balance is a liability. It’s money that they owe you, as you are allowed to demand full or partial payment of it at any time.

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