Unit 6 Reading Activity

Listen to the recording as you read the text. Then complete the activities.

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.

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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