In this video I'll attempt to explain the accounting equation in less than two minutes. Start the clock. What is the accounting equation?
The accounting equation is a formula that sets out the relationship between assets, liabilities and equity. It says that at any given moment, a business's assets must equal its liabilities plus equity. You could call this the backbone of bookkeeping because the accounting equation always has to balance.
The implication of this is that there are two sides to everything in accounting. Let me explain. The concept at the heart of the accounting equation is very simple.
The stuff that a business owns is equal to the stuff that a business owes. A business owns assets and it owes liabilities and equity. What are assets?
Imagine that you're the owner of a piggy bank. It's stuffed full of cash and all your prized possessions. Which have a total value of $50.
These are your business's assets. The stuff that it owns. In the real world, assets are things like cash, inventory and equipment.
Resources that a business uses to operate and generate profit. But what about liabilities? I said that liabilities and equity are the stuff that a business owes.
But to whom? Consider your piggy bank. Let's say that $20 of this cash was borrowed from a friend.
So it's not technically yours. It's still an asset to your business, but it also represents a liability because it's owed to someone else. So a business owes liabilities to third parties.
This could be money owed to a bank, a supplier or the tax office. Liabilities are the debts or obligations that it needs to repay in the future. But a business also owes equity.
Back to our example. Your piggy bank holds $50 in assets of which $20 are a liability owed to a friend. We know that the accounting equation has to balance.
So that means your business also owes $30. To you! This is your equity in the business.
So Equity is the stuff that a business owes to its owners. We can see this more clearly by rearranging the accounting equation. Equity is equal to assets minus liabilities, which we call net assets.
So equity is the owner's claim on the net assets of the business. It's what remains after all debts and obligations have been settled. Ooofh!
We went over time there. Dang it! So there you have it.
The accounting equation is assets equal liabilities plus equity. I've summarized all of this on my free accounting equation cheat sheet which you can download here. And if you'd like to learn more about accounting then why not watch this video next?
