The Accounting Equation

As mentioned in the previous article, assets are the resources owned by a company. These resources, however, do not come from nowhere. In fact, they come from two sources: the owners who invested into the business or lenders who lent to the company. In other words, the value of a company’s asset (resources owned) depends on how much owners and lenders have put into the business.

The terms which denote owners’ investment and borrowings from lenders are Shareholders’ Equity and Liabilities respectively.

Accounting Equation

The meaning behind the accounting equation

This brings us to the infamous accounting equation:

Assets = Shareholders’ Equity + Liabilities

Intuitively, this means the more shareholders invest into and/or the more lenders lend to the company, higher the value of the company assets.

Alternatively, the accounting equation can be rearranged as follows:

Shareholders’ Equity = AssetsLiabilities

When a company closes down, the resources it owned (assets) will be used to repay lenders (the liabilities) first. The shareholders get what is left. Shareholders’ equity is also known as “residual interest” as owners are always the last ones to get their money back in case the business ceases.

Examples on how the Accounting Equation Works

(1) You invest a $10,000 car into your new business

The business now owns a car worth $10,000. As the motor vehicle is an asset, the business has a $10,000 in assets. And where did that asset come from? You as the owner. So the business’s equity (i.e. owners’ investments) increased by $10,000 as well.

Transaction

Assets

=

Shareholders’ Equity

+

Liabilities

(1)

+10,000 (Motor Vehicle)

+10,000 (Paid-in Capital)

 

(2) Your business borrowed $3,000 from the bank

After this transaction, the business has $3,000 extra cash. Cash is an asset as well. Hence, the business has an extra $3,000 worth of assets. Where did the asset come from this time? The business borrowed that from a lender. The liability of the business increases by $3,000.

Transaction Assets = Shareholders’ Equity + Liabilities
(1) +10,000 (Motor Vehicle) +10,000 (Paid-in Capital)
(2) +3,000 (Cash) +3,000 (Bank Loan)

 

(3) Your business earns $100 in revenue. The revenue came in form of cash.

The business has another $100 cash. The revenue increases the business’s earnings, and the earnings belong to the equity investors. So the amount of shareholders’ equity increases by $100 correspondingly.

Transaction Assets = Shareholders’ Equity + Liabilities
(1) +10,000 (Motor Vehicle) +10,000 (Paid-in Capital)
(2) +3,000 (Cash) +3,000 (Bank Loan)
(3) +100 (Cash) +100 (Retained Earnings)

 

(4) Your business buys a machine for $300.

The business gave up $300 cash, which is an asset. It in return gains a machine, which is also an asset. So the business’s asset decreases by $300 and then increases by $300 (i.e. no net change)

Transaction Assets = Shareholders’ Equity + Liabilities
(1) +10,000 (Motor Vehicle) +10,000 (Paid-in Capital)
(2) +3,000 (Cash) +3,000 (Bank Loan)
(3) +100 (Cash) +100 (Retained Earnings)
(4)

– 300 (Cash)

+ 300 (Machinery)

 

The next two articles will elaborate more on shareholders’ equity and liabilities respectively.

 

References:

Horngren, C., Sundem, G., Elliott, J., & Philbrick, D. (2014). Accounting: The Language of Business. In Introduction to Financial Accounting (Eleventh ed., p. 9).

 

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