Balance Sheet Equation: Introduction
Balance sheet equation will generally appear first in any accounting studies.
Accounting is regarded as a language in the business world.
Agreed by many, this language can be complicated.
These are some of the topics we teach in our tuition classes.
Let’s talk about the balance sheet equation.
The equation displays how the business’ assets are funded by money contributed by the business owners and/or with borrowings.
The balance sheet equation is the equation that provides the foundation of all double entry accounting.
It is also known as the accounting equation.
Like any other mathematical equation, the two sides of the equation must always be equal.
Why Assets Must Equals To Owners’ Equity Plus Liability?
Before we move further, lets just describe the elements first.
Assets = the resources that the business owns
Liabilities = the resources that the business owes
Owner’s Equity = the resources contributed by the business owner, also known as capital
As we can see from the equation above, there are two sides.
The left side (i.e. the Assets) of the equation will be known as the use of funds.
The right side will be known to be the source of funds.
It is important to understand that the source have to come first before a business is able to use them.
Let’s assume you would like to make a purchase worth $1000.
The purchase must be either fully funded by the owners themselves or partially with some borrowings.
Assuming the business owner contributed all his savings of $700 into the business, and borrowed $0.
The balance sheet equation will hence look like this:
In this case, the business will not be able to make the purchase that worth $1000.
The business need to borrow additional $300 in order to make a successful purchase.
The equation will hence look like this:
The more money is contributed by business owners and/or borrowed, the more assets the business could purchase.
For layman, the equation can be rewritten to:
Business Income, Expenses, Profit & Loss.
It is also important to know this.
Income refers to money earned by the business from selling goods and services.
Expenses refers to money spent by the business for buying goods and services.
Profits happens when a business’ income is greater than it’s expenses.
Losses happens when a business’ income is lesser than it’s expenses.
How does it relate to the balance sheet equation?
Assuming there is no liabilities.
When a business makes a profit , the owner’s equity will increase.
Similarly, if a business makes a loss, the owner’s equity will decrease.
To illustrate, if the owners of a business contributes $100,000 into the business with no borrowings, both assets and owner’s equity will be $100,000.
In Year 1, assuming the business makes a profit of say $30,000.
The owner’s equity will increase to $130,000 ($100,000 + $30,000).
As a result, assets will also increase to $130,000.
In Year 2, assuming the business makes a loss of $10,000.
The owner’s equity will decrease to $120,000 ($130,000 – $10,000).
As a result, the business’ assets will also decrease to $120,000.
More assets could be bought when more money are contributed by business owners and/or borrowed.
The more profit the business makes, the business’ capital will also be more.
As a result, the business’ total assets will also be more.
Similarly, when a business makes a loss, the capital of the business will be lesser.
As a result, the business’ total assets will also be lesser.
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