Accounting Equation: Assets, Capital & Liabilities
Accounting in Real Life
In my previous article, I told you that Principles of Accounts is not only a fun course but it is also a life course ~ something we use without even noticing. If we were more deliberate about noticing it and working with it, we would have greater wealth and more of a balance in our life.
Here’s today’s accounting quote of the day.
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| https://pbs.twimg.com/media/Dr5hMtfWsAAyyVc.jpg |
Introduction
Every builder knows that in building a house, one has to lay the proper foundation, or the house will fall. Many students fail accounts because they fail to set the right foundation. Today, we are going to lay the foundation in Accounts by looking at the Accounting equation “from which all financial practices emerge”, (Scofield & Dye, 2009, p. 127).
“The accounting equation is the criterion by which companies are valued and by which company performance is measured” (Scofield & Dye, 2009, p. 127) It shows the business’ assets, capital and liabilities at a particular point in time. Already, you can see that this equation is the backbone of the Balance sheet. And before I forget, the Accounting Equation, as it is with the Balance Sheet, must be balanced. That is both sides of the equal sign (=) must be equal to each other.
The Formula
The formula takes on three (3) different arrangements depending on which of the components you want to make the subject of the equation. These are:
Assets (A) = Capital (C) + Liabilities (L)
Capital (C) = Assets (A) - Liabilities (L)
Liabilities (L) = Assets (A) - Capital (C)
NB. If you are given any two totals, you can easily solve for the missing value.
For eg. Assets = $400; Capital = $250; what is the value of the Liabilities?
To solve this problem, we will use one of the concepts learnt in Mathematics -Transposing so as to make the missing value the subject of the equation.
Step 1: Rewrite the formula
Liabilities = Assets - Capital
Step 2: Replace the components with the corresponding figures
? = $400 - $250
Step 3: Solve for the missing value
$150 = $400 - $250
Thus, Liabilities = $150
World of Work Application: This is a simplified version of ho wit is done in businesses as well. Let's say Mrs. Richards' Business Lab has valued its Assets at $1 million. Of this $1 million, $350,000 came through a bank loan taken on a 2-year repayment plan. We can easily calculate the owners Capital. How? The Assets a business has came through one of two methods - what the owner invested (capital) and what you got through credit (liability). Thus
Assets - Liabilities = Capital
$1 million - $350,000 = $750,000
Let's Make It Personal: It can also be applied to your daily life. The Assets that your family own (land, house, furniture, car etc.) came through your income or savings and through different loans (mortgage, bank loan, loan from friends or family). Try to apply the equation to your personal life. Understanding your assets, capital and liabilities will help you to understand your financial position and thus be better able to manage your finances and thus manage your wealth.
Questions you may be asking
Can there be negative liabilities?
Answers: (Scofield & Dye, 2009, p. 127)
“Negative liabilities would only occur if a company overpaid its creditors.”
“Overpaid liabilities would result in an asset – money owed to the company – rather than a negative liability.”
Do we need liabilities?
Answers: (Scofield & Dye, 2009, p. 127)
“Some level of liabilities are unavoidable for any company because of normal business-to-business, business-to-employee, and business-to-customer transactions in which goods or services are obtained before paying for them.”
Now that you have an understanding of the accounting equation, we will now look at each component and thus understand how they fit into the equation.
Assets
Definition
Asset is “defined as something of value owned by a company that will be used to generate revenue or create value at some point in the future”, (Gadd, 2018, p. 2). Assets can also be defined as the economic resources owned and controlled by a business.
Simply put, assets are what the business owns.
Examples
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| pixabay.com Motor Vehicle |
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| pixabay.com Land & Building |
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| pixabay.com Inventory/Stock |
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| pixabay.com Cash in Hand |
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| pixabay.com Debtors |
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| pixabay.com Company Motorcycle |
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| pixabay.com Cash in Bank |
Liabilities
Definition
“Liability is an obligation that must be paid at some future date”, (Gadd, 2018, p. 2). Simply put, liabilities are what the business owes. Liabilities arise from the “purchase of an asset or a service that will be used or has been used by the company in its revenue‐generating process”, (Gadd, 2018, p. 2).
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| pixabay.com Creditors |
Examples
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| pixabay.com Loans |
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| pixabay.com Rent Owing |
Capital
Definition
“Owner’s Equity represents the measured value of the company to the owner or owners”, (Gadd, 2018, p. 2). Simply put, capital is what the owner invest in the business. Furthermore, “Owner’s Equity is the net value of the company’s assets remaining after paying the company's liabilities”, (Gadd, 2018, p. 2)
We are now through with this aspect of our topic. Leave us a comment on how you have been using the Accounting Equation. Join us in our next article where we will share, along with the different types of Assets and Liabilities, creative ways to teach the Accounting Equation.
Don't forget to click and watch the video below that reviews all that we have covered in this article.
Review:
References
Gadd, H. Robert Ph.D. (2018) "The Accounting Equation and Redemption," The Journal of Biblical Foundations of Faith and Learning: Vol. 3 : Iss. 1 , Article 18. Available at: https://knowledge.e.southern.edu/jbffl/vol3/iss1/18
Scofield, B. W., & Dye, W. (2009). Introducing the accounting equation with M&Ms. American Journal of Business Education (AJBE), 2(7), 127-138. https://doi.org/10.19030/ajbe.v2i7.4592
