Accounting Equation Defined

Why People Get Confused with this Arrangement of the Formula

When you consider the first arrangement of the equation, i.e., assets – liabilities = equity, it makes intuitive sense that if you subtracted out the liabilities from the assets what remains is what is owned. Liabilities often hold a claim on companies. If the company defaults, lenders may recover some, or on rare occasions, all of the assets.

But the preferred arrangement of the equation, where assets = liabilities + equity, is not so intuitive. What does it even mean to add liabilities and equity?

To push past the confusion, you need to rethink what the equation is signifying. Remember that assets are used by companies to earn money. But these assets cost money to acquire, and often, to maintain ongoing.

How do companies pay for the assets? When you approach the equation with this question in mind, then you’ll see it makes much more sense. Companies can either pay for assets by borrowing money or by raising equity, or a combination of both.

Financing business operations are beyond the scope of this article. But a proper understanding of the accounting equation is a great start. Keeping in mind how assets are financed will go a long way in understanding how the accounting equation operates.

Note: the video above describes the accounting equation. It also gives an example of a typical real estate deal and shows how that is similar to business with respect to the acocunting equation. I encourage you check out the video for more information.

The Equation Deals in Aggregate Amounts

It’s not practical to view the accounting equation after every transaction. A balance sheet will contain the latest of all assets, liabilities, and equity, as of a certain date. It’s better to think of it as a running balance up to that given date.

For instance, companies could pay cash for an asset, but where did that cash come from? Did the owners infuse more cash (equity) or did the company decide to raise cash via loans or bonds? Or perhaps the cash was generated from normal business operations. In this last case, this would be a boost to equity.

The balance sheet is an application of the accounting equation. However, it would not be worthwhile to use the balance sheet to determine which individual assets were financed by equity or debt. You need to think of it more in terms of an aggregate of assets, liabilities, and equity.

Digital account systems certainly make it easy to answer the question of how each asset is paid. But that would be more a function of an audit task rather than using the accounting equation to determine the financing of individual assets.

Consider that accounts receivables are assets. When you make a sale and extend credit to the customer, you will not receive cash immediately for the transaction. You’ll receive an IOU to receive cash some day in the future. The company cannot readily buy more assets using that IOU.

Also consider inventory. When you sell the inventory for cash, then all is well. You can use that cash to purchase more assets to grow your business. But if the inventory doesn’t sell, or you extend credit via receivables, once again, you cannot spend immediately.

There are companies that will extend your company credit based on your receivables and to some extent, your unsold inventory. But these financing options are often expensive.

Should Companies Avoid Borrowing?

Some investors refuse to invest in companies that carry debt. However, responsible companies can (and should) use debt to invest in their operations. Debt financing is usually cheaper than equity financing due to tax advantages of borrowing vs. raising capital via equity channels.

What about cash generated from normal business operations? While it would be wonderful to finance all purchases using the cash received from revenues generated, it may not be enough to cover the costs of new assets, or you may not receive the cash until several weeks or months. Debt can help you continue your operations and expand until you receive the money or make more sales.

Companies cannot go hog wild with their debt financing, though. If a company overextends, it risks taking a hit to its credit rating. Once this occurs, financing via debt becomes more expensive. Also, creditors will be less willing to extend credit for companies with bad scores.

Finding the right balance of debt and equity financing takes skill and is why companies hire professional finance personnel to get it right.