The majority of accounting books concentrate on teaching you accounting principles. Rules are easy to learn, but they are also simple to forget. Because of this, it is our intention that you gain a fundamental understanding of how and why accounting "works." Understanding is more beneficial and more difficult to forget!
Basics of accounting equation
Instead of simply explaining "The Accounting Equation" to you, let's explore why the Balance Sheet balances. Considering the whole amount of money and other assets in your company at any one time, you will realize that they had to originate someplace. Then where?
There are just three possible sources of money in your company:
- The capital you, the owner, and any other co-owners or investors, have invested in the company.
- Revenue that the company has generated since it first opened.
- Debts, also known as liabilities, are sums of money or items the business owes to other people.
(Let's keep it easy and just count whatever presents your company receives in the form of government grants as "revenue!")
Now, if you had a "magic" company with no running expenses, all of the money from these three sources would be sitting in your bank account (a balance sheet asset). Alternatively, you could convert that cash into other assets, such as the stuff you had bought and kept for the company. However, in reality, at least some of that money will need to leave the company. Only two places might have received that outflow:
- It has been used to pay for supplies and services needed to run the firm (i.e., "Expenses").
- You, the owner, have withdrawn it.
What can we do with this knowledge if we know the only three sources of funding for your company and the only two destinations where it may have left? Let's look at this.
Even if it might not seem like tax is directly assisting you in running your business, it is still an expense! Let's pause the time and consider where the current assets in your company came from.
Can we all agree that every Riyal that has ever entered the company is still there today as an asset in some shape or form, that it has left the company to cover expenses, or that the owners have taken it out?
Read more about Understanding Company Assets On The Balance Sheet.
Accounting equation parts
Awesome! Let's start applying some math to this.
- All the money and worth of the "things" in the company today are its assets.
- Owner's Investment: The money the owners have contributed to the company since its inception.
- Lifetime Income: The total amount of money the company has ever made.
- Liabilities: Amounts owed to other parties for goods or services provided to the company.
- Lifetime Expenses: All costs the company has ever had.
- Owner's Withdrawals: Amounts that the owners have removed from the company since it began
With us? All right. Let's change this up a bit. Simply refer to the sum of all owner contributions minus all owner withdrawals as "owner's net investment." Naturally, the business's lifetime profit up to the present day is equal to all of its income minus all of its expenses. So with these modifications, here is the equation once more:
Assets = Liabilities + Lifetime Profit + Owner’s Net Investment
Do you notice how we added each profit we reported in the Profit & Loss Report to the "Retained Earnings" section at the bottom of the Balance Sheet? Retained Earnings simply refers to Lifetime Profit, which includes all profits made by the company from its inception to the balance sheet date. So that we may update our equation once more:
Assets = Liabilities + Retained Earnings + Owner’s Net Investment
*In an incorporated corporation, technically speaking, Owners' withdrawals often come from Retained Earnings rather than a decrease in Owner's Investment. Retained rather than "Paid Out" is what the "Retained" in "Retained Earnings" refers to.
However, this distinction is meaningless mathematically, so let's move on from it for the time being. Owner's Investment and Retained Earnings are parts of Owner's Equity (or "OE") in formal accounting terms.
The above is a poor choice of words that confuses many business owners because "Equity" is a form of capital that is part of the funding structure of an incorporated corporation.
But since we are stuck with it, let's simplify our formula one last time:
Assets = Liabilities + Owner’s Equity
The above is known as "The Accounting Equation" by accountants, and as you can see, it perfectly corresponds to the balance sheets that we have been using up to this point:
What's left over for me equals what my business owns minus what it owes.
Remember that the Accounting Equation is not a "rule" that we have studied here. Together, we came up with the solution by starting from scratch and considering all the potential sources of revenue and the potential destinations for it in a firm.
Because there is no other place for money to come from or go, the accounting equation must be accurate, and balances on balance sheets must always exist. You can use Wafeq for free now and start recording all your transactions and our innovative solution will do all the accounting equations in the background for you.