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The Accounting Equation and Basic Math Concepts
Many people fear math, myself included. Why did I go into accounting, you ask? My interest in business finances and the proper handling of cash overcame my fears. One thing I learned was the basic math principle by which all accounting ledgers and financial statements work. The accounting equation – known as the building block of accounting – is simply:
Assets = Liabilities + Equity
This formula works best for large corporations and those businesses with investors. Smaller companies and privately owned companies, such as partnerships, may swap owner’s capital for equity. Either way, the formula remains the same in its basic context.
The first basic accounting principle we see in this equation is assets must equal claims. Claims represent the two items on the right side of the equation: liabilities and equity (or owner’s capital). Liabilities include any claims made by outside individuals or entities against a company’s assets. For example, a company that buys inventory on account will result in a vendor having a claim against the company’s assets. Equity is the owner or stockholder’s claims against the company’s assets. In short, the portion of the company’s assets left over after deducting outside claims is the reward for being financially vested in the company. This leads us to different variations of the original accounting equation. The first variation is:
Assets – Liabilities = Equity
In math terms, subtracting liabilities from both sides of the equation gives us the above result. Accounting uses this formula to create net assets, which represents the final dollar amount a company has in assets after removing outside claims from the accounting equation. Another variation to the accounting equation is:
Assets – Equity = Liabilities
Again, this equation is the result of subtracting equity from both side of the original accounting equation. This formula helps find the amount of liabilities or outside claims a company has when certain bits of accounting information is missing from a ledger. Outside of using this formula for accounting homework, it may be less important than the second equation listed above.
With these basic accounting equations in mind, we can use the math principle of simplifying parts of the accounting equation. For example, the original accounting equation:
Assets = Liabilities + Equity
Can now become:
A = L + E
This shorter equation allows one to simply replace the letters with figures from an accounting problem. (AAAAAH! It’s algebra!) Let’s look at an example of this in practice in the table below.
While the above problem is rather basic, it lays the foundation for using the accounting equation. Many problems with much larger figures almost always break down into this format. Therefore, always think in the terms described to help simplify difficult accounting problems.
Footballs - $7,500 = $2,000 + $5,500
Cleats - $3,000 = $500 + $2,500
Jerseys - $10,000 = $7,500 + $2,500