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What is the accounting equation and why does it matter?

“Accounting is the language of business.”

-Warren Buffet

There are several foundational concepts in accounting, that form the backbone of how an organization’s finances come together. These concepts have stood the test of time and are critical to creating a consistent and reliable view of an organization’s financials. As Warren Buffet famously said, when giving advice to an investment intern, “accounting is the language of business.”

Also, it’s important to note that when anyone is talking about accounting for organizations, you can generally assume they’re talking about double-entry accounting. This is the global standard.

Now you might know the first rule of double-entry accounting, debits must equal credits, those are the double entries. But when anyone refers to the accounting equation, this is what they mean:

Assets = Liabilities + Equity

There is so much packed into this simple equation. It is the inescapable balance that all companies must strive to achieve, that keeps them honest when there’s pressure to meet quarterly earnings, allocate costs, raise money, or do anything else that impacts their financials.

Essentially, here’s what each component of the equation represents:

  • Assets - Things like cash, land, furniture, equipment, amounts owed to the company.
  • Liabilities - The company’s obligations to others, such as loans, expenses incurred but not paid.
  • Equity - The remaining value retained by the owners after the two bullets above. As income accrues to the business, dividends are distributed, or losses are incurred, it all flows through equity.

So that’s it. It’s pretty simple at a high-level, but as organizations grow and their operations become increasingly complex, it gets harder and harder to figure out how certain transactions should be recorded. Be wary of anyone who proposes an idea for how to improve financial results, but can’t explain how that idea fits into the equation above. It is the the divining rod for numbers that don’t make sense.

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