The Accounting Equation
You can find a lot of materials on-line about what accounting is about and you will not miss them mentioning The Accounting Equation: –
ASSETS = LIABILITIES + OWNERS’ EQUITY
Assets are simply those things that are valuable to an entity and they include items such as the equipment bought and used in business, the trade receivables, cash kept at banks, inventories & etc. Generally, the entity must have some form of control over these items and enjoy the benefits that these items would bring to the entity. It is easier to understand the meaning of benefits to the owner if you could picture that by using the assets in your business, they would help generate the sales/revenue which is important to a profit orientated entity. (Mmm… leave your thoughts on profit to later discussions – How well an entity manage/use the assets and also the liabilities will have an outcome on the profit to be generated by the entity)
An entity does not own an asset out of nothing (Remember the old phrase – there is no free lunch in this world?). Yes, either you pay for it using your own money (i.e. Owners’ Equity) OR if you don’t have any money, borrow (i.e. Liabilities). Yes, that is the meaning of the accounting equation – All the assets of an entity must equal to the sum of all the liabilities plus the owners’ contributions to the business! Simple right? If you stick to this formula in recording EACH and EVERY transaction of an entity over a period of time, you would get a set of accounts in which the outcome of is what we call a BALANCE SHEET (Some refer to this as a Statement of Assets and Liabilities) and INCOME STATEMENT (Some refer to this as a Profit and Loss Account), which we will discuss in later topics.