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Accounting Equation
The basic accounting equation is assets = liabilities + shareholder's equity. The equation reflects that the value of the firm lies with its assets, but that these can be acquired using two different methods of financing. The methods of financing are essentially different types of claims on the firm's resources. Liabilities are credit claims on the company's resources that arise when the company borrows from somebody (a bank or a supplier, often) in order to acquire assets. Shareholder's equity arises from the money that the shareholders invest. The value of the shareholder's equity is derived from the value of the firm, net of the amount owing to the creditors. Therefore, new profits that the firm earns but does not pay out in dividends ("retained earnings") will often form the bulk of the shareholder's equity.
The accounting equation also reflects that accounting transactions need to balance when they are recorded. If the company adds an asset, this must be paid for either through the company's equity or via a liability. One example would be buying a new piece of equipment on credit from the equipment manufacturer. The new asset would be recorded on that side of the balance sheet, but there has to be a corresponding transaction as well. In this case, the short-term liabilities would increase because the company has made the purchase on credit. Another example would be if a firm issues stock. The owner's equity would increase, but the firm would also see the cash from the stock issue. Thus, the asset side of the balance sheet has increased (cash) and the shareholder's equity side has as well. Eventually, the cash will be converted into other assets, but that type of transaction does not change the value of the firm. The accounting equation is more important to remember when the value of the firm changes.
However, all transactions must balance, in order that the balance sheet remains balanced. When the transactions do not balance, the value of the company will not balance with its obligations and ownership. If the balance sheet becomes unbalanced, the error must be discovered and remedied.
Works Cited:
QuickMBA. (2010). Accounting equation. QuickMBA.com. Retrieved October 14, 2012 from http://www.quickmba.com/accounting/fin/equation/
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