From the course: Accounting Foundations

The accounting equation

From the course: Accounting Foundations

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The accounting equation

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- Let's talk about the balance sheet in a little more detail. The balance sheet is built around one of the most awesome creations of the human mind, the accounting equation, and there it is, Assets=Liabilities+Equity. Now, I could tell you're underwhelmed. You're expecting a little bit more. Something like Einstein's famous equation, E=MC squared. Well, in its own way, the accounting equation is just as great as E=MC squared. Let me tell you where this equation comes from, this accounting equation. First, the asset side. Now, people have been listing assets for thousands of years. As mentioned previously, there's evidence that farmers were keeping lists of assets 7,000 years ago in Ancient Mesopotamia. The great insight behind this accounting equation was created a little bit over 500 years ago in Italy, the traders in Venice and other traders in Italy, they had this insight. They said, "Listen, let's keep a list of our assets like we've always been doing, but let's also, every time we get an asset, let's also write down where we got the money to buy that asset." We write down the asset, and we write down the sources of the financing to buy that asset. Did I borrow the money to buy the asset, was it invested by owners? If I borrow the money, then liability is the name I give to the source of the financing to buy that asset. If the money was invested by owners, I say equity was the source of the money to buy the asset. So, we've got the two sides of the accounting equation. The first side, the asset side, that's the real world. You can go touch a company's assets, it's cash, it's buildings, it's land. That's the real part of a company. The other half of the accounting equation just says, "Where did you get the money to buy those assets?" Let me give you an example. I have a daughter, her name is Taraz. Let's say that I come home from work one day and she's standing there in the house with a $100 bill. Yeah, 100 US dollars. Now, if you were her father, what would your first question be? Of course, you'd exchange pleasantries, and then you would say, "I see you've got $100 there, where did you get that $100?" If you see an asset, you also want to know the source of the money to buy that asset. That's what the accounting equation tells us, and it seems so simple, but this discipline from the accounting equation is the foundation of all sophisticated financial reporting that we now have in the world, and we've been using this same model for 500 years. It's an awesome invention. I tip my hat to those medieval accountants in Italy who invented the accounting equation. Assets equal liabilities plus equity. Keep track of the assets as we've been doing for 7,000 years, but we're also going to keep track of where we got the money to buy those assets.

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