Assets equal liabilities plus equity: this equation is the foundation of all the sophisticated financial reporting that we now have in the world.
- So let's talk about the balance sheet in a little more detail. The balance sheet is built around one of the most awesome creations of the human mind, the accounting equation. Assets equal liabilities plus equity. There it is. Assets equal liabilities plus equity. Now, I can tell you're a bit underwhelmed. You're expecting a little bit more, something like Einstein's famous equation E=mc2. Well, in its own way, the accounting equation is just as great as E=mc2.
Now, let me tell you where this accounting equation comes from. First, the asset side. Now, people have been listing assets for thousands of years. As mentioned previously, there's evidence that farmers were keeping lists of assets 7000 years ago in ancient Mesopotamia. The great insight behind this accounting equation was created a little bit over 500 years ago in Italy. The traders in Venice and other traders in Italy, they had this insight. They said, "Listen, let's keep a list of "our assets like we've always been doing, "but let's also, every time we get an asset, "let's write down where we got the money to buy that asset." We write down the asset, and we write down the source of the financing to buy that asset.
Did I borrow the money to buy the asset? Was it invested by owners? If I borrow the money, then liability is the name I give to the source of financing to buy the asset. If the money was invested by owners, I say equity was the source of the money to buy the asset. So we've got two sides to the accounting equation. The first side, the asset side, that's the real world. You can go touch a company's assets. It's cash, it's buildings, it's land. That's the real part of a company. The other half of the accounting equation just says, where'd you get the money to buy those assets? It's an awesome invention.
I tip my hat to those medieval accountants in Italy who invented the accounting equation. Assets equal liabilities plus equity. Keep track of the assets, and we've been doing for 7000 years, and we're also going to keep track of the sources of financing to buy those assets. That's the accounting equation.
- What is accounting?
- Working with balance sheets, income statements, and the statement of cash flows
- Determining the costs of products
- Performing break-even analysis
- Determining your tax rate
- Understanding tax deductions and credits