The Accounting Equation
Financial accounting is an area which can be explained simply by using the accounting equation, which is assets = liabilities + capital.
But what does that really mean? To understand the significance of the equation, first we must explore the meaning of the three words; assets, liabilities and capital. These terms are often used in accounting but can have very different meanings.
In general, assets are something of value to the company but usually when we think of assets we think of current and fixed assets. However, in the accounting equation we should also take longterm and intangible assets into consideration as they all fall into the category of assets and thus add value to an entity. Intangible assets can be hard to quantify as we are often unable to compare them with the market. Intangible assets include such things as licenses, intellectual property and goodwill which may have a specific value to the entity.
The understanding of liabilities can be even more complicated as the numerous classifications can leave even an experienced accountant scratching his head. These classifications vary by region, but are based along the lines of: fixed, long-term, current, trade, financial and contingent. Many of these appear to be self-explanatory but when it comes to contingent liabilities it is important to remember that this is not an actual liability, it represents a possible liability in an uncertain situation. Of course, you can equate liabilities to negative assets.