Are you wondering what assets, liabilities, and equity are? Great! Your search stops here.
In the accounting world, you will come across these three terms pretty often. Let's dive in and give you a clear understanding of why and how these terms affect the balance sheets.
You may ask -- why the balance sheet? Every business works with financial statements that give them a precise analysis of their monthly and annual profits or losses.
There are four types of financial statements, and the balance sheet is one among them. It focuses on the assets, liabilities, and equity of a company’s working capital.
Let's dive in and understand more about each of these terms.
Generally, anything that adds value to a business is tagged under assets in accounting. Irrespective of the business' size, keeping track of assets is very important. Items like land, buildings, properties, accrued expenses etc., are primarily used as examples to define assets.
However, there could be plenty of other things. Assets can include tangible items like desks, computers, or lamps. It could also be intangible things like goodwill or patents. This primarily depends on the type of business you run.
Anything that a business owes to someone is a liability - bank loans, unpaid bills, mortgages, IOUs, etc. In simple terms, if your company has liabilities, it means whatever is liable needs to be repaid.
Liabilities are of two types:
Consider an example where you've taken a loan that you haven't paid yet. This means your business has a liability overhead. The idea is to get rid of any liabilities at the earliest. If not, they often invite penalties.
Now that you know what assets are and how much you owe, it’s time to understand how much is left. Equity in accounting is all about what you have left. The answer comes in the form of profits or losses.
Equity in accounting is often classified as retained earnings, treasury stocks, or a company’s book value. This figure is crucial to understand a business' economic condition.
All progress, decisions, and purchases depend on how much your equity is worth.
The equation to calculate equity (also called the assets and liabilities equation) is vital in accounting.
Equity is calculated as an asset. This is because the company can borrow against it when needed. This is why you get the value of equity in accounting by subtracting the liabilities from the assets.
However, the calculation of assets and liabilities has many other verticals associated. Hence, liabilities are calculated differently.
Take this example to get a better understanding of assets, liabilities, and equity.
A company’s total assets are valued at $1,000. It has a debt of $900 (liabilities). Here, the owner’s value in assets is $100, which is the company’s equity.
Equity has several variations. Here are a few:
Since assets are the most important element, this is the equation your business is most likely to use.
This is known as the accounting equation.
This is the most important equation in accounting. Modern accounting would be numb without this formula. It points to any errors in your accounting basics and keeps track of your assets, liabilities, and equity.
As we mentioned above, the accounting equation can indicate a mistake. The key indication you need to look out for is that your accounting equation is not balanced. This is how it goes.
The rule is to keep the equation balanced. Therefore, every increase in assets needs to be matched by an increase in equity or liability (sometimes both).
Once there is no balance, it means you have also lost track of data regarding assets, liabilities, or equity.
Here a simplified example.
You and your friend decided to start a creative business. You want to create an app that will focus on app designing, free templates, and attractive web design packages too.
You both decide to invest $15,000 each in cash. That makes the total initial investment $30,000.
You deposit this $30,000 (an asset) in your company’s business account. This is how your present accounting equation looks like:
Now, let’s say you want to buy a few high-end software for your designing needs worth $4000.
Here, your equipment account starts. Also, we know that every increase in assets needs a boost in liability or equity. Now,
After a few months, you and your friend decide to advertise and promote your app. For this, you approach the bank for a loan of $10,000. The bank grants you this loan. Now you have the assets and liabilities as,
In the next few months, you invest $10,000 for promoting and advertising. Your cash account goes down by $10,000. The equipment account increases by $10,000. This is how the equation looks now,
The change in assets is understandable. The assets and liabilities have increased by $10,000.
While investing in your business, you paid for an increase in the company’s assets with equity. While taking a bank loan, you paid it with debt. This is also how the balance sheet works.
If you have already gone through the example above, you know what the basic structure of the balance sheet comprises. The balance sheet works primarily with the accounting equation.
It also keeps track of your business' assets, liabilities, and equity and gives you the data at any given point in time. For this reason, it's also known as the statement of financial position.
Based on the example mentioned above, this is what your business' balance sheet will look like.
A business can’t identify its profits, losses, and progress without these three terms as they're critical to understanding your business' financial health.
They tell you how much you have, where you've spent your money, and how much you owe. Additionally, the accounting equation also indicates any mistakes made while recording your finances.
So, if you want to effectively track your business' financial health and improve it, make sure you are armed with enough information about assets and liabilities, and equity too. This is also effective in debt management.
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