## The Accounting Equation

### Learning Outcomes

• Explain the basic accounting equation

One of the cornerstones of financial accounting is the accounting equation, which in its simplest form, looks like this:

$\text{A}=\text{L}+\text{OE}$

This equation has to always stay in balance.

### Balancing a New Business

An owner registers their new company with the state department of business licensing. They take their business license down to the bank and transfer $20,000 of their own money into a new business account. They have now “capitalized” their business, which means they made a contribution to capital, which increases owner’s equity. At the same time, they have increased the balance in their checking account. From a bookkeeping perspective, you have to make two entries for this one business transaction, and these two entries balance each other out. $\text{A}=\text{L}+\text{OE}$ $\20,000=\0+\20,000$ Now, suppose the owner also borrows$5,000 from the bank, which is then deposited into their account. A loan will not increase their equity. It is not a capital contribution. It is debt, which is a liability.

Now, the equation looks like this:

$\text{A}=\text{L}+\text{OE}$

$\25,000\left(\text{cash}\right)=\5,000\left(\text{bank loan}\right)+\20,000\left(\text{original capital contribution}\right)$

Assets are what the business owns. Liabilities are what it owes, and equity is the amount of the company that belongs to the business owner.

### Balance in a Home Loan

Think of the equation in terms of a house. Say the house costs $250,000 and you owe$200,000 to the bank. Your equity in the home is \$50,000.

$\text{A}=\text{L}+\text{OE}$

can also be stated as:

$\text{A}-\text{L}=\text{OE}$

$\text{Assets}-\text{Liabilities}=\text{Owner's Equity}$

In the case of the house cited above, the equation is $\250,000 - \200,000 = \50,000$.

Commit this important accounting concept to memory: Assets = Liabilities + Owner’s Equity