2015-07-04
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The Fundamental Accounting Equation:
Assets = Liabilities + Equity
Businesses usually own assets. Assets are things that can be used to generate revenue through the sale of goods and services. Assets include cash, inventory, furniture and equipment, and accounts receivable. A business may also own intangible assets such as patents, trademarks and goodwill.
Generally Accepted Accounting Principles (GAAP) assumes that all assets of a business are either owned outright by the business owners or are subject to the claims of creditors. Creditors include anyone who has loaned money or extended credit to the business. Loans and other forms of extended credit are called liabilities. The portion of assets not subject to claims by creditors is called equity.
There must be a continuous equilibrium between assets on the one side and the total of liabilities and equity on the other side. This is represented by the fundamental equation of accounting:
Assets = Liabilities + Equity
This equation is also the basis for the most basic of accounting reports, the aptly named Balance Sheet. A balance sheet reports what a business owns (assets), what it owes (liabilities) and what remains for the owners (equity) as of a certain date. This equation must always be in balance. Always keep in mind the teeter totter illustration shown below.
Example. If a business has $1,000 of assets at a particular time those assets must be matched by the total of the claims of creditors and owners. Here is one example of an infinite number of acceptable balance sheets:
