Accounting Equation

Lesson

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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.

Question

You're the head of accounting for Pepper corp., the trusted mug importer, and are trying to make sense of the firm's financials.

The only relevant information you've discovered is as follows:

The firm has $347 of assets.
The firm is worth $276.

What should be recorded as the firm's liabilities?

Answer

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👉 Answer:

The total liabilities are $71.

👩‍🎓 This is how we solve it:

Let's start with the accounting equation.
ASSETS = LIABILITIES + OWNER'S EQUITY
Since we're trying to calculate owner's liabilities, we need to move the terms around to get it by itself.
Let's subtract the owner's equity from each side..
ASSETS - OWNER'S EQUITY = OWNER'S EQUITY - LIABILITIES - OWNER'S EQUITY
And now, on the right side, we have a positive owner's equity and a negative owner's equity. These cancel each other out.
ASSETS - OWNER'S EQUITY = LIABILITIES
Next, let's plug in the numbers we already know.
$347 - $276 = LIABILITIES
Finally, let's subtract the liabilities from the assets.
$71 = LIABILITIES

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