The Accounting Equation
Financial accounting is an area which can be explained simply by
using the accounting equation, which is assets = liabilities +
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.
Capital is generally understood as the money invested in the
entity by the owner / owners, but it can be so much more. Capital
is divided into fixed capital which represents the excess between
the fixed assets and the fixed liabilities and working capital
which is the excess of current assets over current liabilities.
Having cleared up the terminology, we can start to explain the
purpose of the accounting equation.
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