Basic accounting is considered to be an incredibly useful skill because businesses need it to grow and flourish. Knowing basic concepts such as assets and liabilities in accounting helps businesses summarize, analyze and record financial transactions.
What are Assets and Liabilities?
Assets add value to your business, such as cash, inventory, equipment/machinery, investments, or real estate. Assets can be tangible or intangible. Liabilities decrease the value of your business, such as bank debt, mortgages, accounts payable, unpaid wages, or unpaid taxes. It is the economic value of debt that your business has to pay, through the assets it owns. The assets of your business must outweigh its liabilities for it to be a profitable venture.
Current vs. Fixed Assets
The economic value of ant economic resources owned by the business is referred to as Assets. It helps pay business expenses or pay off debt. Assets are therefore categorized based on their liquidity, i.e. how quickly an asset (such as inventory, property, stock, equipment, or accounts receivable) can be turned into cash to pay a liability.
Why cash? It is the most liquid asset your business can have since you can use it immediately to pay a liability if you need to. A non-liquid asset will take time to liquefy before you can pay off liabilities (such as debt, unpaid wages, or income taxes). It will take time to convert illiquid assets to cash.
Liquid assets (also referred to as current assets) can be converted to cash in less than a year, as opposed to non-liquid assets (also referred to as fixed assets). You can convert current assets such as inventory into cash, but it will be much harder to convert fixed assets such as your office furniture into cash.
Also, check out A Short Guide to Intangible Assets
Current vs. Long-Term Liabilities
Liabilities are debts owed by the business. A business can owe money to suppliers, such as creditors or banks. Just like assets, liabilities can also be divided into two categories. Current liabilities are due in the next year, while you can take more than a year to settle long-term liabilities. If you owe money to employees (wages), suppliers (accounts payable), or the government (taxes), those are current liabilities. Long-term debt, on other hand, like a mortgage on your building, is a long-term liability.
Every business owner has to balance their books, which requires a solid understanding of basic concepts such as assets and liabilities, as well as the categories they can be broken down into. Every business needs to develop a bookkeeping system, set up a payroll system, track their expenses, determine their tax obligations, and calculate their profit margin. Bookkeeping helps businesses make good decisions. In order to do that, though, they first need to understand what the accounting formula is.
The Accounting Formula
Double-entry bookkeeping, created by the Romans, is an ancient method of bookkeeping in which you have to make two account entries for every financial transaction—a debit to one account, and credit to the other account. Without the accounting formula, double-entry bookkeeping would not work, because it is used as an error detection tool. The accounting equation, written as assets = liabilities + equity, must be satisfied in order to balance the ledgers. Double-entry book-keeping is so widely used around the world because it ensures the accuracy of financial reports.
The accounting formula represents the relationship between a company’s assets, liabilities, and shareholders’ equity. You already know what assets and liabilities are. Let us briefly explain what shareholders’ equity is. Shareholders’ equity (also known as share capital or net worth) is the amount that the owner can claim after total liabilities have been subtracted from total assets. It shows how the company has been financed through amounts invested by the owners and the retained business profits of the company.
If a firm has $10,000 in liabilities, $30,000 in assets, and $20,000 in shareholders’ equity the accounting formula would read:
Assets ($30,000) = Liabilities ($10,000) + Shareholders’ Equity ($20,000)
If you know the values of any two of the components in the accounting equation, it is easy to calculate the third one. A balance sheet is just a fleshed-out form of this equation.
The Accounting Equation in Action
When you start a new business, your accounting formula will look like this
Assets ($0) = Liabilities ($0) + Shareholders’ Equity ($0)
Once you decide to deposit, say, a $5,000 into the business to get it up and running and decide to use the double-entry bookkeeping system, your accounting formula will look like this:
Assets = Liabilities + Shareholders’ Equity
$5,000 = $0 + $5,000
Now, you will purchase some office equipment with $2,500 in order to begin creating and selling your products or services. Your accounting formula will look like this:
Assets = Liabilities + Shareholders’ Equity
$7, 500 = $2500 + $5000
In double-entry bookkeeping, an account must be debited and another credited. Here the asset account increased by $2500 because you bought some office equipment, but the liabilities increased as well because you used company cash to pay for it.
The Purpose of the Accounting Equation
You have ensured that the accounting equation stays in balance by recording it twice. As you can see, the accounting equation contains three components. A detailed account of your accounting equation, i.e. your assets, liabilities and capital, is written on your balance sheet. You can use the accounting equation to check whether every transaction has been recorded properly (i.e. all relevant accounts have received entries) thereby successfully balancing your books
Every accounting student is first introduced to these two basic concepts: assets and liabilities. It is from here that you begin to learn what accounting is and how it can help you run a business. This article is therefore an introduction to accounting. You understand the basics if you have read it completely. You are now ready to learn more!
Learn more What is Equity in Business?