Accounting Equation

Lesson:

How do you know if a company is successful?

If you're an accountant, you're probably going to take a look at its financial data.

At a very high level, accountants categorize financial data into three categories. Once we've done this, we can use a formula called the accounting equation to tell us if a company is successful or not.

Let's take a look at the three categories of financial data:

  • Assets - Things that a company owns that have value. Here are a few examples of assets: cash, machines, supplies, and patents.
  • Liabilities - Obligations that the company has to others. The most common type of liabilities are debts.
  • Owner's equity (sometimes called shareholders' equity instead) - The value of the company.

Now that we know that we can describe companies in terms of their assets (what they own), their liabilities (what they owe), and their owner's equity (what they are worth), we can put them all together in a formula.

ASSETS = LIABILITIES + OWNER'S EQUITY

In other words, to find the value of a company, all you just need to figure out everything it owns and subtract everything it owes.

  • All things being equal, as a company owns more "stuff" (assets), its value (owner's equity) increases.
  • All things being equal, as a company takes on more debt (liabilities), its value (owner's equity) drops.

This great thing about the accounting equation is that if you know two of the variables, you can figure out the third.

The accounting equation is very useful, and many important topics build upon it.

You're the head of accounting for Frank inc., the beloved ring exporter, and are trying to make sense of the firm's financials.

This is what you've been told:

  • The firm has $86 of liabilities.
  • The total asset value of the company is $388.
What should be recorded as the firm's owner's equity?

Answer:

  • The owner's equity is $302.

Explanation:

  1. Let's start with the accounting equation.
    ASSETS = LIABILITIES + OWNER'S EQUITY
  2. Since we're trying to calculate owner's equity, we need to move the terms around to get it by itself.
  3. Let's subtract the liabilities from each side..
    ASSETS - LIABILITIES = LIABILITIES + OWNER'S EQUITY - LIABILITIES
  4. And now, on the right side, we have a positive liabilities and a negative liabilities. These cancel each other out.
    ASSETS - LIABILITIES = OWNER'S EQUITY
  5. Next, let's plug in the numbers we already know.
    $388 - $86 = OWNER'S EQUITY
  6. Finally, let's subtract the liabilities from the assets.
    $302 = OWNER'S EQUITY
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