The Accounting Equation Demystified

By Michael Onuorah | 2 min read
11th June 2017
The Accounting Equation Demystified

Professor Matthew walked briskly into the classroom.

"Lend me your ears!", he bellowed as he stood between the table and the white board, resting both palms on the table, scanning the Class, as if counting the students to ensure that they are complete.

"Hello everyone. Sorry I am late." The students slowly turned towards the Professor.

"Today I want us to discuss, in practical terms, how to become a successful accountant in your business.

In a moment, I am going to show you how to become a successful business owner who understands finance and accounts.

As you build your skill around this area, then you will see the future benefit which includes prudent financial management and long term profitability. Professor Matthew Chanted.

During this discussion, I will request that we keep our minds open. Please feel free to interrupt me if you want to make any contributions. Any contributions!" He paused for the emphasis to sink in.

"Today is definitely not your normal, conventional class."

He concluded and slowly walked down the center aisle in the fifty seater-classroom, glancing left and then right at the students.

So then the professor bellowed, let us begin with the Accounting Equation.

I know Mathematics has a lot of equations queried Abdul, however I didn't know that accounting has equations.

How do we remember all these equations in order to become successful accountants? Chiwendu asked.

Not to worry said Professor Matthew. The accounting equation is easy and straight forward.

It goes as follows: Assets = Liabilities + Owners Equity   OR A = L + OE

Assets are everything says Professor Matthew.

Wealth is about physical assets. Assets must have both capital growth and must be income generating; else they are liabilities Professor Matthew chanted.

When you want to know how rich a company is, kindly go to their statement of accounts and look at their total assets, Professor Matthew chants.

When you want to know how much money the owners put in the business, kindly go to the owners' equity section of the financial statement or simply rewrite the accounting equation as follows:

Assets - Liabilities = Owners Equity OR A - L = OE

Finally, if you want to know what the debt profile of the company is, kindly check the total liabilities or rewrite your equation in the following format:

Assets - Owners Equity = Liabilities OR A - OE = L

Waow! This is very interesting shouts Busola.

Yes, it's very interesting and clear, Professor Matthew chants Chimezie and I think it's giving me some ideas.

Would you like to share some of your ideas, Chimezie asks Professor Matthew.

If I start a business with One Hundred thousand naira and at the end of the year, I make Three Hundred and Fifty thousand naira, and I owe my suppliers a mere fifty thousand naira that means that according to the accounting equation, my breakdown is as follows: A = L + OE

Asset = 350,000

Liabilities = 50,000

Owners' Equity= 100,000

350,000 = 50,000 + 100,000 (However, professor I noticed that 200,000 is missing in my calculation)

Yes, the professor comes in again. Your equation is very correct Chimezie, however, profit is not an asset and cannot be kept as an asset or a liability professor Matthew corrected the class.

So where does the money go to sir asks a worried Abdul.

Interestingly the professor responds, the two hundred thousand goes to the owners' equity column, however it is booked as retained earnings or dividends to be paid to shareholders.

So the corrected equation would be:

 350,000 = 50,000 + 100,000 + 200,000

Assets = Liabilities + Owners Equity + Retained Earnings or Dividends

Kindly note that as you fill in entries into your balance sheet, they can only go into these three entries: Assets, Liabilities and Owners Equity. And they must always balance chants Professor Matthew.

Thank you very much class, we will continue from where we stopped same time, next week.

 

 

Michael Onuorah
My name is Michael Onuorah. I am first and foremost a teacher, problem solver and a servant leader. I want to honestly state that what drives me in life is helping people to start their journey to self-discovery. I believe that is my primary purpose. My secondary purpose is to be a teacher that demystifies various areas of learning ranging from Database Administration, Entrepreneurship, Information Technology, Business Administration, Marketing, Logic and Problem Solving. And My tertiary purpose is to be a problem solver. I want to teach people how to solve problems relating to what we encounter every day.
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