16 September 2004

The accounting equation

Even though my knowledge of accounting is sketchy at best, there's one thing that is central to the practice: balance. Everything always seems to balance. In terms of an accounting entity (such as a company), assets always balance liabilities and owner's equity. Accountants like to write it like this, the so-called accounting equation:

Assets = Liabilities + Owner's Equity

This is the guide you can use to assess whether you're doing the right thing with any transaction.

Last night, I had a dilemma with income. When you earn income, that obviously increases your assets. What is the corresponding change on the right-hand side? To find the answer, let's take a look at other common transactions.

First, we buy with cash something we class as an asset. Let's say a new house. That's quite simple to do: we decrease our assets in cash, and increase those in property. No problems with the balance there. Assets goes up and down by the same amount, so everything in the equation stays the same.

As another example, let's say we buy another house. But instead of paying with cash, we take out a loan from a bank. This is simple as well, we increase the liability of the loan to the bank, and increase our assets in property. Looking at the equation, there's been an equal increase on both sides. Our equality still holds.

Now for an owner's equity example. Let's say the owner gives a contribution to the company of cash. The assets obviously increase as a result of this transaction, as does the owner's equity by the same amount. Our equation fits, so everything is okay.

Let's look closer at owner's equity. Transactions like the last one above typically happen when you first create the accounting records, since it is from the owner that all the assets are transferred to the new accounting entity. I find it useful to think about what owner's equity represents during the running of the entity: the owner would get whatever was left in the company if the company paid off its liabilities.

If you look back at the equation, it seems obvious that OE = A - L with some simple algebra. But putting it in the terms of what the owner actually "owns" helps make it clear for me.

To go back to my question about income, the answer now seems obvious. If the company earns money without taking on a corresponding liability, owner's equity has increased. This satisfies our equation, and the knowledge that the owner "owns" the assets less the liabilities.

One final note: although I've referred to "Owner's equity" as if there is only one owner, obviously there may be many owners with different amounts of equity in the accounting entity.