The Accounting Equation
The basic accounting equation is Assets = Claims
Assets are the cash, physical property, and other resources the entity controls that can be used to generate cash, provide future economic benefits or settle obligations.
Claims are the firm’s contractual and other obligations. There are two basic types of claims. Non-owners’ (creditors) claims are called liabilities. Claims held by the firm’s owners are called owners’ equity. Creditors have the primary legal claim against assets. Equity is a residual claim; should the company liquidate the business, anything remaining after obligations to creditors are settled belongs to the owners. For different types of entities, owners’ equity takes different forms. Corporations generally refer to it as stockholders’ equity. Unincorporated business with may call it proprietor’s capital or partners’ capital.
An expanded version of the basic accounting equation is often used to distinguish the two types of claims:
This is the essence of a balance sheet. The statement must always be “in balance” regarding the assets and claims against them.
For more information, see all articles on: Accounting, Financial Statement Analysis, Fundamental Analysis See also:
The Intelligent Investor: The Classic Text on Value Investing
Financial Statement Analysis: A Practitioner's Guide, 3rd Edition
Managing Investment Portfolios: A Dynamic Process (CFA Institute Investment Series)
Your mathematical expression of the accounting equation is wrong. The correct expression is.
Assets + Claims = 0
or
Assets = -Claims
Your expression is the orthodox version and is found in most textbooks, but it is actually impossible mathematically (except if the Assets are zero).
March 26th, 2007 at 7:52 am
The total amount of claims is not a negative number, so Assets – Claims = 0 and assets = claims.
I see the intuitive logic for looking at the claims as negative. If you were not “balancing” the equation you could treat the claims as a negative asset.
But in order for a balance sheet to “balance” the two sides have to have the same total. A scale with a five kilograms on one side needs five kilograms on the other (I haven’t seen a negative-5 kilogram weight) to balance properly.)
So as counter-intuitive as it may seem, we’ll side with the orthodox version.
March 26th, 2007 at 12:13 pm
The claims must go in the opposite direction as the Assets. If the Assets is debit (normal), the claims must be credit. You cannot mix things of a different nature in an algebraic equation unless you treat them as numeric opposites — a credit is a negative debit.
1. If two numbers are in balance they must be equal in magnitude and opposite in sign.
2. If two weights on a scale are in balance, the scale, which we use to find magnitude only,
has two forces on it of equal magnitude but of opposing torque on the scales pivot.
3. The original balance sheet was used to show how the credits exactly offset the debits.
4. The General Ledger must always have a balance of zero — each debit entry is matched by a credit entry, keeping the total balance at zero. Since the Assets and Claims represent the whole general ledger after the books are closed, they must also have a combined balance of zero.
In the words of an officer at Price Waterhouse, “accountants work with an implied negative multiplier on one side of the equation.”
March 26th, 2007 at 12:36 pm
There may be a negative number implied, but there is a positive number related to either the debit or the credit. When one firm debits cash to credit inventory, the counterpart to the transaction credits cash and debits inventory. I would argue that it is the two debits and two credits that offset each other and equal zero, not the ones on one firm’s ledger.
March 26th, 2007 at 1:03 pm
Your confidence in the accounting equation is understandable, it took me many years before I saw the problem. Bear with me, you are on the breaking wave of a revolution that must happen in te financial world. Fixing the accounting equation is the first step. To make it more obvious, let’s start with:
Assets = Claims
Now, according to the laws of math, both sides of an equation have to be exactly the same thing — substitutes for each other. That means that if the Assets has a balance of 100,000 debit, then the Claims must also have a balance of 100,000 debit.
But we know that this is impossible, the Claims must have a balance that is of a credit nature. We can say that the weights of the 2 balances is the same (just like your scale analogy), but we know the balances themselves are not exactly the same.
We can mix apples and oranges (or debits and credits) into the same math equation by saying that they are exactly the same thing (which is what accountants have done to a disastrous effect) or we can say that they are opposites of each other. The opposites fits because a credit is the opposite of a debit. But if we do that, the traditional formula says the following about the Assets debit balance and the Claims credit balancle:
100,000 = -100,000
This is what the accounting equation says and it is dead wrong. We can say the following however:
100,000= -(-100,000)
or:
Assets = -Claims
or:
Assets + Claims = 0
or:
100,000 + (-100,000) = 0
Recognizing this is the beginning of a revolution. The next step is to recognize that the accounting equation, even after it has been corrected, is information vacuous — it is simply a check upon the bookkeepers handiwork.
March 26th, 2007 at 2:40 pm