The Accounting Equation I – “Oh, the words we use.”

Well, you have to admit, the math complexity of the classic Accounting Equation is modest, simple and easy!  It’s no more challenging than the classic 2+2 = 4 (in reverse).  However, I have learned over the years there are some interesting aspects of the actual words that give pause to the “non-financial” layman.  Here they are:

Slide9One should reasonably expect to have like-minded (similar) things on each side of the equation, right?  Well, we concede the word “Asset” has a positive bent as in “He is certainly an asset to the community.”  In contrast, the word “Liability” carries a negative impression (If I were your bridge partner, you would soon regard me as a liability.), while the word “Capital” implies several positive meanings … wealth, leadership, importance, center of influence, etc.  Why would two such opposites reside together on the same side of the equation?

The reason is a more subtle meaning behind the words … on both sides.  In most industries, there is a predictable relationship between sales and the assets needed to produce those sales. One of management’s first responsibilities is to assemble the optimal quantity and combination of resources necessary to conduct the desired volume of business. So the left side of the equation is simply a tally (measured at original cost) of all the assets management has acquired (cash, inventory, equipment, supplies, real estate, etc.).  These asset values will change over time as the business evolves, some naturally with ebbs and flows, others driven by the discretion of management.

Important! … while assets are positive resources, they actually represent commitments already made, funds expended, and in most cases difficult to reverse. Therefore, the “Asset” side tells you management’s opinion of the optimal mix of resources needed to do business. The important notion is that assets therefore represent a cummulative “use of funds”, the collective expenditure of money to acquire these assets. My next post will discuss the right-hand side of the equation, and how it differs and why!  Here is a hint of what’s to come …

Slide13

The key is at the bottom; assets are uses of funds, the right-hand side tells you who brought the funds to the table … sources!

 

 

 

 

DOUG DOWNS SM

 

 

 

 

Douglas K. Steele

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