The basic accounting formula is a very important tool in business. Almost all businesses use it to keep records, even though their specific accounting practices might vary slightly. It is important for investors and businesses to understand this basic principle of financial accounting; it can significantly affect their ability to plan for and evaluate their business performance.
History and Basics
The basic accounting formula lies at the core of the language of modern business, double-entry accounting. The basic accounting formula simply states that the owner's equity in the business must always equal the total of its assets minus liabilities. This equation was developed in its primitive form by Luca Pacioli in the late 15th century, and is still in widespread use today by small and large businesses alike. The basic accounting formula makes the preparation of financial statements possible, and helps investors and managers clearly understand what's going on in a business. The accounting equation should always be in balance, and is reported in detail on the company's balance sheet.
For an organization that reviews and establishes generally accepted accounting principles, the assets part of the basic accounting formula represent "future benefits obtained or controlled by a particular entity as a result of past transactions or events," according to the Financial Accounting Standards Board (FASB). In other words, assets have a quantifiable value that the company owns or otherwise controls. Assets usually include items such as cash, inventory, land and equipment, but they also can include intangible assets, such as receivables, intellectual property, or the promises of money owed to the company by customers.
In the accounting formula, liabilities are deducted from assets to arrive at the company's actual recorded value to its owner, called equity. This is because "liabilities are probable future sacrifices of economic benefits arising from present obligations," according to FASB. Liabilities represent money that the company owes to other people. Businesses often borrow from banks and other creditors to finance their operations, and must first pay these entities back before owners can receive a share of earnings.
In the accounting formula, assets minus liabilities must always equal owner's equity, which is the value of the company to its owners, or "residual interest in the assets," according to FASB. Owner's equity also represents the amount of capital that is invested in the business, plus any profits retained from past operations. In general, owners provide money to a business with a desire to see their equity grow.
- Principles of Accounting: The Fundamental Accounting Equation; Larry Walther; 2011
- IBM: Basic Accounting Concepts and Introduction to Punched Card Accounting Applications; 1961
- CliffsNotes: The Accounting Equation; 2011
- AccountingCoach: Liabilities; Harold Averkamp; 2011
- Financial Accounting Standards Board: Statement of Financial Accounting Concepts No. 6--Elements of Financial Statements; 1985
- Thinkstock/Comstock/Getty Images