What is the Basic Accounting Equation?
The foundation of accounting is that assets equal liabilities plus stockholders’ equity. This equation dictates the way that bookkeepers record financial transactions and the ways in which accountants and financial analysts report on a company’s financial health.
Basic Accounting Equation
Assets = Liabilities + Stockholders’ Equity
Assets
Cash is the first of a company’s assets. As the most liquid asset available, accountants list cash first on a company’s balance sheet. Next come assets that can be converted quickly to cash, such as accounts receivable. As people pay their bills to the company, accounts receivable notations will convert to cash.
Tangible property, such as land, buildings, and durable equipment come next. Balance sheet listings typically have tangible property listed by the largest to smallest value. Finally accountants report on consumable assets, such as office supplies.
Liabilities
Debts are the most obvious liabilities. When a company owes money to a supplier, advertising company, or other vendor, those debts are liabilities. The liabilities reduce equity in a company. Other liabilities include pre-payments from customers. When someone pays in advance, such as retainer fee for an attorney, this payment is an “unearned revenue,” meaning that the payment, while cash available, is a liability until someone actually provides the service. Other liabilities are the “payable” accounts. These payments are not debts, but are money owed to a certain person or vendor. Common payables include salaries payable, interest payable, and utilities payable.
Stockholders’ Equity
By far the most complicated piece of the basic accounting equation, stockholders’ equity has five components. Common stock is the money that people put into the company for operating expenses. In small businesses, the owners often are the only people who commit common stock. This money stays in the company’s bank accounts.
Retained earnings also are part of stockholders’ equity. Retained earnings, usually indicated with RE on financial statements, are the money left after expenses during the previous financial period. If a company earned $100,000 in revenues in its first accounting period and had expenses of $50,000, the net income, or retained earnings, for that period are $50,000. In future accounting periods, this $50,000 would carry forward for RE calculations.
Dividends are monies paid to shareholders in the company. With the case of small businesses, dividends are money paid to the company owners as “profit” from the company. With publicly traded companies, dividends represent money paid out to each shareholder based on the number of shares that person owned.
The final two portions of stockholders’ equity are revenues and expenses for the current accounting period. Revenues include money earned and billed during the current period, whether or not the person who billed the money paid or not. Expenses include any costs that the company paid for during the current accounting period.
Though the financial picture often looks far more complicated, this simple equation is the basis for recording and analyzing all financial transactions.
Brandi Rhoades - Brandi Rhoades is a freelance writer working on articles for the web, ranging from blog posts to marketing letters to keyword-driven ...
