Have you ever heard of the basic accounting equation or basic accounting formula? And do you know what this is? This equation is really, really important. In fact, all accounting entries are derived from this. If you really understand it, the rest of accounting is much easier. If you don't, you'll probably find the subject pretty hard. So listen up...
The whole of accounting is based on a single equation:
ASSETS = EQUITY + LIABILITIES
The word equation comes from the word equal.
For any equation, one side always equals another. Also, equations can be made out of anything.
For example: 1 Orange = $0,50 House = Walls + Doors + Windows + Roof 1 week = 7 days
So what does the basic accounting equation or basic accounting formula mean? Well, in order to answer that question we need to look at what each of the terms in the equation mean...
Assets are possessions of the business. They are things that add value to the business and will bring it benefits in some form. For example, furniture, machinery, vehicles, computers, stationery or cash.
Equity, or owner's equity, is the value of the assets that the owner owns. It is the value of the business assets that the owner can lay claim to.
Liabilities are basically debts. The amount of liabilities represents the value of the business assets that are owed to others. It is the value of the assets that people outside the business can lay claim to.
What the Basic Accounting Equation Means
In a nutshell, the accounting equation above shows us how much of the assets are owned by the owner (equity) and how much are owed to others (liabilities). It's as simple as that.
Does this equation and its meaning still seem a bit tricky right now? If so, don't worry, it will become easier as you continue along.
Read through the following lessons, where I will go into more details about each of the components of the basic accounting equation and give more examples of each one: