One of the first things you are taught when studying bookkeeping or accounting is the accounting equation which is Assets = Liabilities + Equity. I had such a hard time getting this straight in my head because most people don’t ask what is the value of my assets? They ask how much is my company worth? Using some basic algebra, the accounting equation can answer this question as Equity = Assets – Liabilities. This equation makes so much more sense to me and I would think to many business owners.
In an earlier blog, I talked about breaking accounting rules. In that post, I cautioned that you need to understand and respect a rule before you can break it. So, let’s accept that the accounting equation is A=L+E. However, in my practice, I am going to turn that around when presenting information to my clients, so the equation is expressed as Equity (how much your company is worth) equals your Assets (what you materially own) less any liabilities (what you owe to others). Doesn’t that make more sense?
Admittedly I have not done a ton of research on why the equation is expressed as A=L+E, but I am sure the reason is along the same lines as to why debits and credits seem to be backwards from a client’s perspective. It may be as simple as this is the way the balance sheet is setup. In example, the traditional balance sheet might show $5,000 in Assets and $5,000 in Liabilities and Equity. Great the equation is in balance and all is good. Except, wouldn’t it be more informative to show the report as Equity is $-3,000 because your Assets are $8,000 but your Liabilities are $11,000. The net worth of the company is negative due to such high liabilities. This story does not come through on a condensed balance sheet.
What I am promoting is that we should understand the accounting basics, but we need to transform those principles into a form and language that makes sense to those we work for. So, for me, the accounting equation will be E=A-L so that I and my clients can better grasp the concept. However, I will be ready and willing to translate it back to A=L+E if you really need me to.