Have you ever looked at your accounts – a cash flow statement, for instance – and thought you were looking at hieroglyphics? Or thought, “If only there was an English-Accounting dictionary, maybe more of us would have an idea about what’s going on in our financial statements?”
You’re not alone. We’ll try to explain the most basic accounting fundamentals here. Why do you have to know them? Because accounting is arguably the most important source of information in business. It records, analyses, plans and, in the end, controls your business transactions.
After all, if you know how to decipher the basics of accounting, you’ll know the real story of your business – how healthy it is and where you could be spending or saving more money to help it grow.
A basic accounting equation measures a company’s financial position using assets, liabilities and owner’s equity.
Accounting can seem impenetrable and mysterious. But it’s no dark art. In fact, a balance sheet follows a clear logical order. You just need to know how to decipher it.
Let’s start with the fundamentals: An accounting equation measures financial position using assets, liabilities and owner’s equity.
Here’s a refresher on what those terms stand for:
Everything a company owns, such as properties, inventory and cash.
All the company’s debts, such as loans.
The difference between the two, meaning the company’s ownership of assets, after paying off liabilities.
The accounting equation states that, no matter what, the following will be valid: Assets = Liabilities + Owner’s Equity. You can also write the equation like this: Assets – Liabilities = Owner’s Equity.
This equation is applicable for any kind of company, big or small. Imagine you run a lemonade stand. Your assets are lemonade, the stand, cups and uniforms – worth $100 in total. You took out $60 worth of loans from your sister and your mum – those are your liabilities. So here’s how we would figure out the Owner’s Equity: Assets ($100) – Liabilities ($60) = Owner’s Equity ($40).
You could use the same equation to measure your financial position when buying a home. If you want to purchase a property for $300,000, you probably wouldn’t pay it all up front. You might take a mortgage for $230,000. That means your home equity would be calculated as: $300,000 assets – $230,000 liabilities = $70,000 equity.
And a few years later, once you’ve paid off $30,000 of the mortgage, your home equity would be $300,000 assets – $200,000 liabilities = $100,000 equity.
One thing to remember about assets and liabilities is that your asset might be someone else’s liability, and vice versa. For instance, in the scenario above, the mortgage is your liability. But it’s the bank’s asset.
The accounting equation forms the basis of your balance sheet.
As we’ve just learned, the accounting equation is fundamental. But it serves a more important role as well. It forms the basis for your balance sheet.
Your balance sheet is your core financial statement. Building on the accounting equation, it uses assets, liabilities and owner’s equity to show your firm’s financial position at any given point in time.
Balance sheet assets include cash and cash equivalents, inventory, accounts receivable and property, plants and equipment. So, the balance sheet for our lemonade stand would include the following in the assets column: Money in our checking/savings accounts; soon-to-be mature investments, like our investment in the lemon farm; the lemonade itself; Mr. Smith’s payment for catering lemonade for his party last week; the lemonade stand; and your pitcher and strainer.
Liabilities refer to accounts payable and notes payable. Ours would be The amount we owe the grocer for buying us one hundred lemons and also the loan we took from our sister.
And finally, common stock and retained earnings would be listed as owner’s equity. That’s the $15 we saved to open the stand and also the sum of all our income that hasn’t been distributed to others as dividends.
So our balance sheet would look like this:
Cash and cash equivalents ($15)
Accounts receivable ($5)
Property, Plant and Equipment ($50)
Total = $100
Accounts payable ($20)
Notes payable ($40)
Total = $60
Common Stock ($15)
Retained earnings ($25)
Total = $40
Remember, the accounting equation holds that Liabilities plus Owner’s Equity must always equal Assets. And sure enough, here: $60 liabilities + $40 owner’s equity = $100 assets. Simple, right?
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