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Have you heard of the basic accounting equation or accounting formula?
Do you know what it is?
It's the fundamental equation that underpins all of accounting.
In other words, it's really important.
Why is it so important?
Because all accounting entries - all of them - are derived from it.
Let me say that again: All accounting entries. All of them.
So, if you really understand this equation, the rest of accounting becomes that much easier.
If you don't understand it, you'll probably find the subject very hard.
No pressure, right?
Okay, so pay attention...
The whole of accounting is based on one single equation:
ASSETS = OWNERS EQUITY + LIABILITIES
The word equation comes from the word equal.
For any equation, one side always equals another.
Also, equations can actually be made out of anything.
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 basically 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.
Click here for the full lesson on assets.
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.
Click here for the full lesson on liabilities.
Owners equity, or simply, equity, is the value of the business assets that the owner can lay claim to.
It is the value of the assets that the owner really owns.
Click here for the full lesson on owners equity.
In a nutshell, the accounting equation above shows us:
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 elements of the basic accounting equation, including examples for each one:
1. Assets 2. Liabilities 3. Owners Equity
Once you are done with these lessons be sure to check out the final lesson on the accounting equation and financial position, which will give you more info and certainty about this key concept.
Did you know?
Not only does the accounting equation underpin all accounting entries, but it also forms the exact structure of one of accounting's most important reports - the balance sheet.
To see this report showing the accounting equation, check out the lesson on the balance sheet.
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