The accounting equation

The balance sheet is built around one of the most awesome creations of the human mind, the accounting equation. There it is. 

Assets = liabilities + equity. 

Now, I can tell you're underwhelmed, you were expecting a little bit more, something like Einstein's famous equation E equals MC-squared, well, in it's own way, the accounting equation is just as great as E equals MC-squared. Let me tell you where this accounting equation comes from. 

First, the asset side. People have been listing assets for thousands of years. There's primitive written evidence that farmers were keeping lists of assets 7000 years ago in Ancient Mesopotamia. The great insight behind the accounting equation was created a little bit over 500 years ago in Italy. The traders in Venice and other traders in Italy had this insight. Listen, let's keep a list of our assets like we've always been doing, but in addition, every time we get an asset, let's also write down where we got the money to buy that asset. 

Simply stated. We write down the asset and we also write down the source of the financing to buy that asset. Did I borrow the money to buy the asset? Was the money invested by the 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 or shareholders, 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 is 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 tells you where you got the money to buy those assets. Let me give you a simple example. I have a teenage granddaughter. Her name is Koby. She's a very good business person and a very good saver. Let's say that I come home from work one day and she's standing there in the house with $100 bill. If you were her grandfather, what would be your first question? Well, you'd exchange pleasantries and then you would say, I see you got $100 there, where'd you get the $100? If you see an asset, you also want to know the source of the asset. That's what the accounting equation tells us. For example, as of September 29th, 2018, Apple had total assets of $366 billion. Where did Apple get the 366 billion to buy these assets? Well, of this total, Apple got $94 billion from long-term loans, another $107 billion came from investments by shareholders, Apple's total sources of financing were $366 billion, enough to buy that $366 billion in assets. 

That is the accounting equation. It seems so simple. But this simple practice of writing down assets and where we got the money to buy the assets is the foundation of all the sophisticated financial reporting that we now have in the world, and we've been using this simple system for over 500 years. The accounting equation is an awesome invention. I tip my hat to those mid evil accountants in Italy who invented it. Assets equal liabilities plus equities. Continue to keep track of the assets as we've been doing for 7000 years, and thanks to the Italians of 500 years ago, we also keep track of the sources of financing to buy those assets.