In this explanation of the ABCs of Accounting, we will discuss assets, liabilities, and equity, including the Owner’s Equity Formula, the Statement of Owner’s Equity, the Balance Sheet Formula, and other helpful equations. Fundamentally, accounting comes down to a simple equation. Assets = Liabilities + Equity. It seems simple enough but let’s really break it down. What do these terms mean in relation to your business and how can they help you make sense of the books?
Ever heard the phrase “Tom is an asset to the company”? The meaning is clear. Tom is a good worker that brings value to the organization. In accounting terms, an asset is any item of value to the company: tangible (property, inventory, equipment) or intangible (patents, trademarks, copyrights, accounts receivable and even reputation).
Here’s how to calculate total assets:
Consider what assets you have, including any current, fixed, and even intangible resources that could be of financial value to your business. For example:
- Current assets (assets that can be converted into cash within one year or less) such as cash, outstanding invoices owed to you, and inventory that can be sold
- Fixed assets (things of value that are harder to convert into cash) such as real estate, heavy machinery, furniture, vehicles, etc.
- Long-term investments, like stocks and bonds
- Intangible assets that have value, such as your company’s brand, reputation, social media following, and your company’s or employees’ status as influencers
- Make a balance sheet—a financial statement that shows a company’s assets, liabilities and equity. (See “Assets = Liabilities + Equity” below.) To create this balance sheet, you can use a spreadsheet software like Excel, but you should consider using accounting software for such important statements.
Meet Michael. Tom’s friend. Unlike Tom, Michael is a liability to the company. Being an inherently negative term, Michael is not thrilled with this description.
Under the umbrella of accounting, liabilities refer to a company’s debts or financially-measurable obligations. Liability is also classified as current or long-term.
Current liabilities are obligations that the company should settle one year or less. They consist, predominantly, of short-term debt repayments, payments to suppliers, and monthly operational costs (rent, electricity, accruals) that are known in advance. And finally, current liabilities are typically paid with Current assets.
Long-term liabilities, on the other hand, include debt such as mortgages or loans used to purchase fixed assets. These are paid off over years instead of months.
Why is all this important?
Because a company’s working capital is the difference between its current assets and liabilities. And that’s important!
Equity and the Owner’s Equity Formula
Equity refers to the owner’s value in an asset or group of assets. Just like homeowners accumulate equity value as they pay off their mortgage, Owner’s Equity is defined as the proportion of the total value of a company’s assets that can be claimed by its owners (whether a sole proprietorship or a partnership). Equity is also referred to as net worth or capital and shareholders equity.
This equity becomes an asset as it is something that a homeowner can borrow against if need be. You can calculate it by deducting all liabilities from the total value of an asset: (Equity = Assets – Liabilities).
In accounting, the company’s total equity value is the sum of owners equity—the value of the assets contributed by the owner(s)—and the total income that the company earns and retains.
Let’s consider a company whose total assets are valued at $1,000. With a debt of $900 (liabilities). In this example, the owner’s value in the assets is $100, representing the company’s equity.
Assets = Liabilities + Equity
With an understanding of each of these terms, let’s take another look at the accounting equation. The basic accounting equation is fundamental to the double-entry accounting system common in bookkeeping wherein every financial transaction has equal and opposite effects in at least two different accounts.
This basic accounting equation “balances” the company’s balance sheet, showing that a company’s total assets are equal to the sum of its liabilities and shareholders’ equity. This formula, also known as the balance sheet equation, shows that what a company owns (assets) is purchased by either what it owes (liabilities) or by what its owners invest (equity).
If a company wants to manufacture a car part, they will need to purchase machine X that costs $1000. It borrows $400 from the bank and spends another $600 in order to purchase the machine. Its assets are now worth $1000, which is the sum of its liabilities ($400) and equity ($600).
It is important to pay close attention to the balance between liabilities and equity. A company’s financial risk increases when liabilities fund assets. This is sometimes referred to as the company’s leverage.
Statement of Owner’s Equity
A Statement of Owner’s Equity (also known as a Statement of Changes in Owner’s Equity) provides an accounting of how a company’s capital has changed during a specified period due to contributions, withdrawals, net income, or net loss. Net income is equal to income minus expenses.
Owner contributions and income result in an increase in capital, whereas withdrawals and expenses cause capital to decrease.
Net Change Formula
If you want to calculate the change in the value of anything from its previous values—such as equity, revenue, or even a stock price over a given period of time—the Net Change Formula makes it simple.
Net Change Formula = Current Period’s Value – Previous Period’s Value
You can also calculate this change in percentage terms using this formula:
Net Change (%) = [(Current Period’s Value – Previous Period’s Value) / Previous Period’s Value] X 100