The Accounting Equation

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Under U.S. GAAP (generally accepted accounting principles) financial accounting revolves more or less around one very important but simple equation. And that is:

This equation is the basis by which accountants and bookkeepers keep track of and ensure business transaction integrity within a record keeping system that consists of journals and ledgers. It lends itself to what is known as “double-entry” accounting. Meaning,  that for every transaction, there are at least two entries that are recorded into the record keeping system.

At the least, one transaction has a debit value and the other a credit value that is equal to the debit, or vice versa (it’s very important that you don’t think of debits and credits in terms of +’s and -‘s, they don’t always coincide with that line of thought conceptually. Read the section on ‘normal balances’ for further explanation).

The purpose of doing it this way is to guarantee that the A=L+SE equation is balanced. If the equation is not balanced upon review of the recorded transactions at the end of an accounting period, then there has been a recording error which must be corrected.

 

So what does Assets = Liabilities + Shareholder Equity actually mean?

 

To put the equation in another way, one can think of all of the resources owned by a company which include things like furniture, machinery, computers, cash, real estate, copyrights, patents and investments among other things which are called ASSETS, is entirely made up of two possible broadly categorized elements called:

  •  [1] LIABILITIES, which refer to the debts that are owed by that company for the acquisition of its assets (the portion of total assets that can be claimed by the creditors) and
  • [2] the owner’s / shareholder’s claim to the portion of the total assets or EQUITY which include the economic contributions of the owners / shareholders and the portion of the profit that is retained by the company from the normal operations of that business called retained earnings.

As with any equality equation, the accounting equation can be restated in terms of both liabilities and shareholder equity. The two other variations to the basic aforementioned general equation are: (A)

That is, debt owed to creditors for the acquisition of any type of asset is equal to all the economic resources owned by the company less the shareholder’s claim to the portion of the total assets. And (B)

The wealth of the owner(s) / shareholders is measured by taking the company’s total economic resources and subtracting the value the company is utilizing to finance its operations from creditors.

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