Accounting Made Simple

A basic accounting equation measures a company’s financial position using assets, liabilities and owner’s equity.

Accounting can seem impenetrable and mysterious. But it’s no dark art. In fact, a balance sheet follows a clear logical order. You just need to know how to decipher it.

Let’s start with the fundamentals: An accounting equation measures financial position using assets, liabilities and owner’s equity.

Here’s a refresher on what those terms stand for:

• Assets: Everything a company owns, such as properties, inventory and cash.
• Liabilities: All the company’s debts, such as loans.
• Owner’s Equity (also called Shareholder’s Equity): The difference between the two, meaning the company’s ownership of assets, after paying off liabilities.

The accounting equation states that, no matter what, the following will be valid: Assets = Liabilities + Owner’s Equity. You can also write the equation like this: Assets - Liabilities = Owner’s Equity.

This equation is applicable for any kind of company, big or small. Imagine you run a lemonade stand. Your assets are: lemonade, the stand, cups and uniforms – worth $100 in total. You took out $60 worth of loans from your sister and your mom – those are your liabilities. So here’s how we would figure out the Owner’s Equity: Assets ($100) - Liabilities ($60) = Owner’s Equity ($40).

You could use the same equation to measure your financial position when buying a home. If you want to purchase a property for $300,000, you probably wouldn’t pay it all up front. You might take a mortgage for $230,000. That means your home equity would be calculated as: $300,000 assets - $230,000 liabilities = $70,000 equity.

And a few years later, once you’ve paid off $30,000 of the mortgage, your home equity would be: $300,000 assets - $200,000 liabilities = $100,000 equity.

One thing to remember about assets and liabilities is that your asset might be someone else’s liability, and vice versa. For instance, in the scenario above, the mortgage is your liability. But it’s the bank’s asset.