Now You Know: Understanding the Basic Accounting Formula with Scott Meister
Do you know the Basic Accounting Formula and how it’s used to measure the health of your business?
In QuickBooks, it's easy to forget about all the accounting going on behind the scenes. Even if you're not an accountant (or, like me, you’re not keen on math), it’s worth taking the time to learn basic accounting principles so you get a sense of what’s actually going on with your bookkeeping.
Let's start with the Basic Accounting Formula, also known as the Balance Sheet Equation and the Accounting Equation. It's the foundation of Double-entry bookkeeping - the standard recordkeeping method used to minimize transaction errors and (as the name implies) keep accounts in balance.
For those interested in an essential accounting lesson, hop into QuickBooks, click the Reports Tab and pull up your Balance Sheet. We'll your QuickBooks to contextualize the Basic Accounting Formula.
Use your report to follow Scott’s comprehensive explanation. By the end, you'll know exactly what this report is telling you and be left wanting more, or glad that QuickBooks hides all the heavy accounting!
The formula in real-life
The Balance Sheet uses the Basic Accounting Formula to calculate your business’ net worth based on your assets, liabilities and equity at a given point in time. According to Scott, the information provided on the Balance Sheet answers several key questions:
What’s the balance in my bank account?
What do my receivables look like?
Or how much do I owe in payables?
Find your balance
The left and right sides of the Basic Accounting Formula must be balanced at all times. If they aren't balanced, there’s an error somewhere in the books.
Here's a very real-world scenario to illustrate. Let’s say your business has $100,000 in Assets (A), $75,000 in Liabilities (L) and $25,000 in Owners’ Equity (OE). Our formula looks like this: $100,000 (A) = $75,000 (L) + $25,000 (OE).
Now let’s imagine your business purchased a vehicle for $20,000 cash. Both the vehicle and cash are Assets, so in this instance, Assets stay at $100,000.
How does this happen? A decrease in the cash account of $20,000 takes the Asset balance down to $80,000, but an increase in the vehicle account brings the Asset balance back up to $100,000. Thus, the Basic Accounting Formula stays in balance: $100,000 (A) = $75,000 (L) + $25,000 (OE). Here’s a visual of what this transaction looks like in a spreadsheet format.
Assuming the same facts above, let’s say your business purchased a second vehicle for $20,000. This time, you pay $5,000 cash and finance the remaining balance of $15,000. Cash Assets decrease by $5,000, the vehicle account increases by $20,000 and the loan account increases by $15,000.
From the previous example, we know that cash and the vehicle are Assets, but what about the loan?
The loan is a Liability since it’s something your company owes to someone. So, the Liability increases by $15,000. For this transaction, Assets started at $100,000, were reduced to $95,000 by paying $5,000 cash and were then increased to $115,000 by acquiring the $20,000 vehicle. Liabilities started at $75,000 and increased to $90,000 thanks to the $15,000 loan.
After the purchase of the second vehicle, the Basic Accounting Formula looks like this: $115,000 (A) = $90,000 (L) + $25,000 (OE).
The Basic Accounting Formula from another perspective
This formula can also be written as Liabilities = Assets – Owners’ Equity or Owners’ Equity = Assets – Liabilities.
Reworking the left side of the equation gives you different insights. For instance, if want to evaluate your business from a perspective of what you actually own (i.e. owner’s equity ) to see what you’re making after all the dust settles, write the formula like this:
Owners’ Equity = Assets – Liabilities
What about beyond my books?
Additionally, bankers and investors use the information provided on Balance Sheets when contemplating lending money to or investing in a company – they’re interested in seeing what the company owns and owes prior making any sort of investment. Based on the three elements found in the Basic Accounting Formula; assets, liabilities, and owners’ equity.