Fundamental Accounting Equation - Online Tutor, Practice Problems & Exam Prep

The fundamental accounting equation is $\mathrm{Assets}=\mathrm{Liabilities}+\mathrm{Equity}$. Assets are owned resources, categorized as current (convertible to cash within a year) or long-term (used for over a year). Liabilities represent debts, also divided into current and long-term. Equity consists of initial investments and retained earnings, which are profits not distributed as dividends. Understanding these components is crucial for grasping financial statements and the accounting cycle.

Fundamental Accounting Equation

Alright. So now let's discuss the fundamental accounting equation, the foundation for everything you're going to learn in this class. You ready for the big reveal? It's already on your paper so I guess you've seen it already. Alright. Well, the equation is right here. Assets equal liabilities plus equity. How exciting is that, right? That is the big equation of accounting here. Assets equal liabilities plus equity. Alright? So let's discuss what each of these are and we'll see how this is always going to be true.

So let's start with assets. Assets are going to be anything tangible or intangible that is owned by the company. Okay? So this is anything that they own and we're going to break these up into 2 categories. We're going to call them current assets and current assets are going to be cash or anything that can be converted into cash in less than 1 year, okay? So typical things that we see in current assets are going to be cash. We're going to see accounts receivable, money that's owed to us by our customers, inventory, right? Merchandise that we're selling, things like that, right? Things that we're going to convert into cash pretty soon within 1 year. Compare that to our long term, our fixed assets, right? These are assets that we're going to expect to use for more than 1 year. So good examples of those are going to be things like land or machinery or if we buy a building, right? These are things that we're not just gonna use for 1 year, we're gonna use them for a long period of time. Alright? So we make this distinction at the 1 year mark. That's kind of the cutoff. Current assets, less than 1 year. If we're going to use it for multiple years, that's a long term asset.

Okay. How about liabilities? So now we're on the right hand side of the equation, right? Assets are going to equal liabilities plus equity. So liability, well this is money that the company owes to other people, right? We have a liability to pay this to other people. These are our liabilities. So current liabilities, well these, guess what? What do you think is going to be current? What's when we have to pay them in under 1 year, right? Just like with our current assets and long term assets, we have the same threshold of 1 year. So some common current liabilities like you see here is accounts payable. This is just general money that we owe to people. We had an invoice and we've got to pay that invoice to them. Well that's an account payable or short term debt. If we took out a loan that we're going to pay back in less than a year, just a short term kind of keep our money flowing, well that would be a current liability. Compare that with a long term liability which is payable in over 1 year, right? And these are going to be things like long term loans when we get a bank loan or bonds. Bonds is another way to raise money through loaning out through getting a loan, okay? So those are our liabilities and let's go on to equity.

So remember, assets equal liabilities plus equity. So here's equity and it has 2 main components. So, the first one, it's going to be the money. So, equity is going to have the money that the stockholders, the owners of the company put into it when they first started the company. So, when they first raised capital, they put money into the company, alright? This is going to be equity, right? This isn't money that the company owes to other people, this is money that the owners put in themselves, right? And then there's also going to be the earnings that accumulate over time. The earnings that are accumulated, but they're not distributed. So you think about a company making a ton of money, but they don't just take that money that they made and then give it back to the investors, right? They don't just pay a lot of dividends, we call the payments to investors. A lot of that money gets held by the company and reinvested to make the company grow bigger and make even more money, right? So this is the equity. The equity is going to have that money that you first raised and it's also going to have all the money that you made over time. So you can imagine as the company is in business years and it's earning profits years over years, well the equity in the company is going to grow, right? There's more money that's owned by the company rather than liabilities to outsiders. Okay?

So I want to go back up to this equation before we keep going into equity here and I just want to point out that assets, right? This is what's owned by the company and this is how we pay for it. How we pay for or how we finance it. Okay? How we finance assets. So we're either going to finance our assets with liabilities, money that we owe to other people or equity, money that is ours, part of the company already, okay? So let's go on with a few of these details about equity and let's talk about some of the main accounts that we see in equity. Okay? The first one is paid in capital. This has to do with that first investment that the company make that the owners make into the company. Well, this is the amount that the owners have invested, right? So just like we said, the paid in capital and it's just like the account sounds like, paid in capital, it's capital that's been paid in. Capital just being money, right? Retained earnings, well, this is income from previous years. So this is what we were just talking about above. Income from previous years that has not been distributed as dividends. Dividends being payments made to the stockholders, okay? So these retained earnings, you can imagine as we make money year over year, well, we're going to be retaining, right? We're retaining some of that money inside of the company rather than paying it out to the stockholders. So that retained earnings, that's also going to be part of our equity and then we're going to have the current year. When we talk about this year, when we're making money this year, we have revenues. Revenues is money coming into the company. So it's inflows of resources. So when we make a sale or something like that, we're going to get revenue from selling, right? And it's generally cash is going to be what we're getting as inflows, but there could be other things as well and we'll discuss that later when we dive into revenues and expenses. So expenses is the opposite, right? Revenues is the money coming in, Expenses, those are gonna be our outflows and it's generally cash again, but it could be whatever outflow, right? If the company needs something, if we need a service from an outsider, we're gonna have an expense when we have to pay for that, right? So we've got our revenues and our expenses, Okay? So now we're talking about revenues and expenses this year and then we've got dividends. Right? So dividends, these are going to be the payments to shareholders and these come out of our retained earnings. Right? So we have so much money in retained earnings and then we're going to say, hey, let's pay some of this off to the shareholders and that comes out of the retained earnings. So here we go, all caps here. Obviously, I don't want you to miss this. Dividends are not an expense, okay? Everyone say it together. Let's all say it out loud together. Dividends are not an expense. Great. Isn't it great when we talk in unison? How are we talking class? We're talking in unison. It's the best way to learn. I'm just kidding, but seriously dividends are not an expense, that's huge and this is like one of the biggest ways they love to trick you in your first accounting classes to put hey, how much is the dividends expense in this situation? No such thing. Okay? Dividends is just payments out of the retained earnings. Okay? This is money that the owners already own, but it's left in the company and then they pay a dividend to pay it out to the owner. Okay? Not an expense. So last is the income or the loss. So the income or the loss, well that's going to be a net amount. Income or loss, this is when we take our revenue minus our expenses. We're left with our income or our loss. Right? We would have a loss if the expenses were more than the revenue either way. So this is just the net amount and I just want to make a note that income and profit are the same thing. We use those terms interchangeably, but revenue is not the same as income. Okay, I see a lot of students when they start off in accounting courses, they don't make a distinction between revenue and income, they just don't know the difference, so just remember that revenue is all the money coming in, but income deals with the money that came in minus the expenses during that period as well. Okay? So we've got our revenue minus expenses to get to income. Cool?

So let's go ahead and pause here and we'll do a short example to just discuss the idea of equity a little more in the following video. Alright, let's do that now.

Fundamental Accounting Equation

Alright. So let's just discuss a simple example of gaining equity when you buy a house. Okay. So let's start here on the left-hand box, we say the home costs $150,000, and you make a $30,000 down payment, the remainder is a mortgage from the bank. Okay? So a lot of times when we're dealing with accounting, it's going to be a lot about analyzing sentences like this. Okay? So the home here, the $150,000, that's the asset, that's the value of the house, right? So remember our formula is assets=liabilities+equity. Right? That's our formula. Well, in this case, the asset is the $150,000, right? That is the value of the house, and how are we financing that house? How are we getting the money to pay for it? Well, we put $30,000 down, right? That is our equity. This is the money that we put into it. We have equity in that house of that $30,000, and the liabilities, what we owe the bank, the rest of the money, right? The house is worth $150,000. We took a loan for the remainder, which is $120,000, right? $150,000 minus $30,000 leaves us with $120,000 in liabilities. Okay? So this is how we would set up the equation when you first purchase the house.

Alright? And now let's say time is going by, and you pay off some of the principal on the loan, and you paid off $20,000. Right? So what happens when you pay off $20,000 of the loan? Well, the house in this case is still worth the same amount, right? So the house is still worth $150,000. Oops. Let me clean that up. But how are the liabilities and equity split up now? You no longer owe $120,000 to the bank, right? You've paid off $20,000 of that mortgage. You only owe now $100,000 to the bank, right? So what's happened? Your equity has increased by $20,000, right? It's up to now $50,000. So this is your assets, liabilities and equity here, right? And there you go. That's how it happens. So as you pay off the mortgage, your equity in the house keeps increasing. So the amount of the house that you own increases as you pay off those liabilities, and that's how we're going to see the relationship between assets, liabilities, and equity, where there's going to be transactions that happen, and then we have to adjust our equation, right? Maybe our assets go up, maybe our assets go down, right? We're going to have to adjust, but the same is always going to stay true that this equation is always going to balance. Assets=Liabilities+Equity, alright? Cool. Let's go ahead and move on to the next video.

A company has assets totaling $50,000 and equity of $20,000. What are their liabilities?

• A. $0
• B. $20,000
• C. $30,000
• D. $70,000

A company has liabilities of $25,000 and assets of $35,000. What is the company's equity?

• A. $10,000
• B. $20,000
• C. $30,000
• D. $60,000

If a company has liabilities of $65,000 and equity of $25,000, what are the company's assets worth?

• A. $25,000
• B. $40,000
• C. $60,000
• D. $90,000

Here’s what students ask on this topic:

What is the fundamental accounting equation?

The fundamental accounting equation is the foundation of double-entry bookkeeping. It states that $\mathrm{Assets}=\mathrm{Liabilities}+\mathrm{Equity}$. This equation ensures that the balance sheet remains balanced, meaning the resources owned by the company (assets) are always financed by either borrowing money (liabilities) or by the owners' investments (equity). Understanding this equation is crucial for analyzing financial statements and grasping the accounting cycle.

What are current assets and long-term assets?

Current assets are resources that a company expects to convert into cash or use up within one year. Examples include cash, accounts receivable, and inventory. Long-term assets, on the other hand, are resources that a company expects to use for more than one year. Examples include land, buildings, and machinery. The distinction between current and long-term assets is important for understanding a company's liquidity and long-term financial health.

What are current liabilities and long-term liabilities?

Current liabilities are obligations that a company needs to settle within one year. Examples include accounts payable and short-term loans. Long-term liabilities are obligations that are due in more than one year, such as long-term loans and bonds payable. Understanding the difference between current and long-term liabilities helps in assessing a company's short-term and long-term financial obligations.

What is equity in the fundamental accounting equation?

Equity represents the owners' claim on the assets of the company after all liabilities have been deducted. It consists of two main components: paid-in capital and retained earnings. Paid-in capital is the money that the owners invest in the company, while retained earnings are the accumulated profits that have not been distributed as dividends. Equity is crucial for understanding the financial health and value of a company.

How do revenues and expenses affect equity?

Revenues and expenses directly impact equity through retained earnings. Revenues are the inflows of resources from the company's primary activities, while expenses are the outflows incurred to generate those revenues. The difference between revenues and expenses results in net income or loss. Net income increases retained earnings, thereby increasing equity, while a net loss decreases retained earnings, thereby reducing equity.