Have you heard of the 

basic accounting equation or accounting formula?

Do you know what it is?

It's the fundamental equation that underpins all of accounting.

In other words, it's really important.

Why is it so important?

Because all accounting entries - all of them - are derived from it.

Let me say that again: All accounting entries. All of them.

So, if you really understand this equation, the rest of accounting becomes that much
easier.

If you don't understand it, you'll probably find the subject very hard.

No pressure, right?

Okay, so pay attention...

The whole of accounting is based on one single equation: 

ASSETS = OWNERS EQUITY +

LIABILITIES

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The word equation comes from the word equal.

For any equation, one side always equals another.

Also, equations can actually be made out of anything.

For example:

 1 Orange = $0,50
 House = Walls + Doors + Windows + Roof
 1 week = 7 days

So what does the basic accounting equation or basic accounting formula mean?

Well, in order to answer that question we need to look at what each of the terms in the
equation mean.

Assets

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Assets are basically possessions of the business. They are things that add value to
the business and will bring it benefits in some form.

For example, furniture, machinery, vehicles, computers, stationery or cash. 

A Simpler Definition
The official definition is a bit complicated.

Let's put it in simpler terms:

An asset is a possession of a business that will bring the business
benefits in the future. 

An asset is anything that will add future value to your business.

Asset Recognition Criteria in Accounting

But the definition of assets above is not yet complete.

In accounting we have specific criteria which need to be fulfilled in order to recognize

an asset in our accounting records.

What is the test of whether something is considered an asset for your business?

Well, one asks: 

1. IS THE _______ SOMETHING I OWN OR CONTROL?
2. AND WILL IT BRING ME BENEFITS IN THE FUTURE?
FYI, with assets we're talking about spending on things which will provide
us continuing benefits into the future. But did you know that we can also spend on
things which provide us only immediate benefits? These are what we call expenses.

See the lesson on The Basic Accounting Equation - Another Viewpoint to learn about
the difference between assets and expenses.

Examples of Assets
Here are a few asset examples. Let's see if they meet the recognition criteria above.

Property
Let’s start with land.

If you owned some land, would it be an asset for your business?

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Not sure?

Well, do you expect to receive benefits for your business in the future from the land?
Of course.

What benefits will it bring?

 You could construct a building on it that you can use for business.
 Even selling it to someone else would bring benefits, in the form of cash. 

Equipment

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How about a computer that you own – is this an asset?

Will it bring you benefits in the future?

Well, amongst other things, you can store and retrieve large amounts of information and
use it to communicate with suppliers and customers.

So yes, a computer is definitely an asset. 

Vehicles

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What about a motor vehicle – is this an asset?

Does it have benefits for your business, and if so, what are they?

Answer: Yes, there are benefits for your business:

 You could use the motor vehicle to pick up and deliver goods.
 Or employees could use it to meet with a customer. 

So yes, this is also an asset. 

Cash

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Now let’s take something more tricky – what about cash? Is cash an asset?

Answer: cash is certainly an asset.

What are the benefits of having cash?

Simple: you can pay for things! That is certainly useful (and indeed essential) for a
business.
Debtors (or Accounts Receivable)

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Have you ever heard of debtors? 

Debtors are people that owe your business money.

Debtors also refers to the value of these debts as a whole.

Another name for debtors is accounts receivable.

The word receivable simply means "capable of being received," or "will be received."

So, would debtors or accounts receivable be an asset for your business?

Answer: In the case of debtors, we don't own the debts to us, but we do control them

(we have the enforceable right to claim these funds owed to us). 

Additionally, we will get benefits in future from having this money owed to our business.
The benefits are simple – we'll get paid!

So if you have $3,000 owed to you by Mr. Smith, you have a debtor, an asset, worth
$3,000.

Asset Definition - A Final Criterion

An additional requirement for an asset is that: 
You have to be able to measure its value somehow and you have to be
able to measure this accurately.
This is usually quite simple, as the value is equal to how much you paid for it.

Now, in our definition of assets above we said that an asset is anything that will add
future value to your business.

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So, what about employees?

Wouldn't they qualify under this definition? I mean, employees definitely add future
value to a business - they get the work done!

Interesting question, right?

There's only one problem with this...

How do you value an employee?

Can you put an accurate, reliable figure on how much an employee is worth to you,
bearing in mind that he or she can resign at any point?

Tricky, right?

As you can imagine, it's nearly impossible to place a value on people – consequently
employees are actually never included as assets in accounting - but only because we
can't really value them.

The Full Test for an Asset in Accounting

So the full test of whether something is recognized as an asset is:
1. DOES YOUR BUSINESS OWN OR CONTROL IT? 
2. WILL IT BRING YOUR BUSINESS BENEFITS IN THE FUTURE? 
3. CAN YOU VALUE IT ACCURATELY?
If these three criteria are met, then you have an asset that you can recognize according
to the accounting system.

Asset Valuation
There’s a basic rule about how one values any physical asset in accounting.

The rule is:

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The cost of an asset includes all costs necessary to get it to the business
premises and into a condition in which it can be sold (or used).

So the cost of an asset can include not only the purchase price, but also the following:

 Import duties,
 Transport costs to get it to your premises,
 Installation or set-up costs.

Liabilities
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Liabilities are basically debts.

The amount of liabilities represents the value of the business assets that are owed
to others. It is the value of the assets that people outside the business can lay claim to. 

Defining Liabilities
A liability is officially defined as:

A present obligation of the entity as a result of past events, the settlement of which is
expected to result in an outflow of the entity's resources (payment).

In other words, a liability is simply:

A debt of the business.

YOU  -------------------->  OWE  -------------------->  BANK 

The debt will result in assets, usually cash, leaving the business at some point in the
future.
In accounting, liabilities are shown as a certain monetary amount. For example, a
business is said to have $50,000 liabilities, meaning $50,000 debts to pay off.

Examples of Liabilities
Here are some of the most common liabilities you will find when studying and practicing
accounting:

Loans

The most common liability is a loan.

Most loans are from financial institutions like banks. However, it's also possible to
obtain loans from other organizations, or even individuals.

Loans are commonly used to finance major purchases, such as property, vehicles or

machinery.

Loans are classified as long-term liabilities, as we expect to pay them off over an
extended period, usually over a number of years.
Creditors

Another common liability is called creditors.

A creditor is any business or person that you owe (apart from a loan).

Suppliers, who you owe for products and services purchased on credit, would fall
under creditors.

Other examples of creditors are the telephone company that you owe or a printing shop
you owe for printing fliers. Even the tax authorities could be considered a creditor if you
owe them.

Creditors are also sometimes referred to as payables.

Creditors are short-term liabilities, as we usually expect to pay them over a period of

a few months or less.
Credit Card Debt

It is also fairly common for a business owner to take out a credit card and use this to
make purchases of products and services for the business.

Credit cards give an individual a certain amount of credit that can be used to make
purchases, usually at a higher interest rate than a bank loan. It enables the business to
pay for things when there is a temporary shortage of cash.

Credit cards usually require a minimum monthly payment.

When you pay back a loan, credit card or any of your creditors, some of

your assets (most often cash) will leave your business.

Owners Equity (or Equity)

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Owners equity, or simply, equity, is the value of the business assets that the owner
can lay claim to.

It is the value of the assets that the owner really owns. 

What the Basic Accounting Equation Means

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In a nutshell, the accounting equation above shows us:

 How much of the assets are owed to others (liabilities), and

 How much are owned by the owner (equity).

It's as simple as that.

What is owners equity?

It's a question many an accounting student has pondered.

Or just plain guessed at.

The official owners equity definition is:

The residual interest in the assets of the enterprise after deducting all its
liabilities.

But that's a pretty complicated definition.

Here's a simpler one:
The owners equity is simply the owner’s share of the assets of a business.

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You see, assets can only ‘belong’ to two types of people:

1. People outside the business who you owe money to (debts, known in

accounting as "liabilities"), 
2. The owner himself (owners equity).

Owners equity, often just called equity, represents the value of the assets that the
owner can lay claim to.

In other words:

It's the value of all the assets after deducting the value of assets needed to pay
liabilities (debts).
In the diagram above, the assets amount to $60,000, but the value of the assets the
owner can lay claim to is only $40,000. This is because there are liabilities (debts) of
$20,000, so $20,000 of the assets will be needed at some point to pay off these debts.

In the simplest terms, owners equity is:

The value of the assets that the owner really owns. 

Owners Equity and the Accounting Equation
Let's take a look at the basic accounting equation again:

ASSETS = EQUITY + LIABILITIES

Since we've now defined all three of the elements of the accounting equation,
including owner's equity, we can look at this equation now with a bit more insight.

So, what does the basic accounting equation really represent?

The accounting equation indicates how much of the assets of a
business belong to, or are owned, by whom.