Canada Assets = Liabilities + Equity ?! How?


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Hello,

I have a question regarding the formula, I'm new to accounting and I'm a smart guy but this equation eludes me. There's something terribly wrong with it and I'd like someone to clear it up please.

Assets = Liabilities + Equity

Example 1. Let's say I own a website that costs me $500 per month to run and $1000 income from ads. Profit is $500 per month. No payroll, I handle it all myself. Then liability would be $500 (cost of operation)? Let's assume it's not cost of operation and it's $0 for liabilities then please go to Example 2. If it is $500 Liability then how can I have $1500 Assets when I don't technically "own" that 500, it went away into operations? If that's not it, then let's consider $0 Liability in Example 2 bellow..

Example 2. I own a tractor and operate a farm. I'm using down payment on the tractor towards the dealership. This liability is not equal an asset (technically). Think about it... The value of my tractor is worth half what I payed for it initially just because it's used, so how can my assets be worth their original value as time passes? Same thing goes for printers, computers, etc... in a business... Let's look at it in reverse if you're confused. This equation is telling us that: All I owe (assets, that devalue with time) equals what I owe to others + Profit I make... What I owe to others cannot be what I own under assets, especially if the interest goes up on the tractor what the tractor value goes down, it's not equal... This addition doesn't work out in real life... It completely trumps the value of things and the real profit of a company.

This equation is not realistic at all... It's a recipe for disaster because it uses improper KPIs (key performance indicators) that do not match with the realistic life expectations... Is there something I don't understand here?

I'm new to accounting, please bare with me. Thank you.
 
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kirby

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Example 1
$500 to run website - but not paid yet
DR Website Expense $500
CR Accounts payable $500

$1,000 income from ads paid in cash
DR Cash $1,000
CR Revenue from Ads $1,000

At this point '
Assets Cash $1000

Liabilities Accts Payable $500
Equity (Ad Rev less Website Expense) $500

So -- Assets of $1,000 equals total of Liabilities $500 plus Equity $500 = $1,000

Guess what? Equation worked!! Score: Luca Pacioli -1 Unbelievers in acctg equation - zero

Example 2: You are equating "tractor value" with cost of tractor on the books. No can do. Put some numbers into the example if you wish to see how the entries work.

You can appreciate that the acctg equation is a given construct - just like we say there are 360 degrees in a circle. If you can accept the construct you can use it effectively. Else ....
 
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Example 1
$500 to run website - but not paid yet
DR Website Expense $500
CR Accounts payable $500

$1,000 income from ads paid in cash
DR Cash $1,000
CR Revenue from Ads $1,000

At this point '
Assets Cash $1000

Liabilities Accts Payable $500
Equity (Ad Rev less Website Expense) $500

So -- Assets of $1,000 equals total of Liabilities $500 plus Equity $500 = $1,000

Guess what? Equation worked!! Score: Luca Pacioli -1 Unbelievers in acctg equation - zero

Example 2: You are equating "tractor value" with cost of tractor on the books. No can do. Put some numbers into the example if you wish to see how the entries work.

You can appreciate that the acctg equation is a given construct - just like we say there are 360 degrees in a circle. If you can accept the construct you can use it effectively. Else ....


Thank for your reply Kirby. I realize I wasn't clear earlier but i'll shorten it.

How can assets (what I own) be part of liabilities (what I don't own)?
Take for example a car, computers, printers in a business that devalues as an asset yet you might still pay a liable interest rate that goes up. The asset in this case does not equal the liability.


Thanks in advance.
 
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ok... I understand now. Assets CAN go negative. Which means you're in trouble.

This equation is NOT literal, it's a benchmark.
 

kirby

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Ummm no. I explained this. The equation is a given construct. Try this: Go prove that there are NOT 360 degrees in a circle first --- then come back to disprove A=L&OE.
 
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Ummm no. I explained this. The equation is a given construct. Try this: Go prove that there are NOT 360 degrees in a circle first --- then come back to disprove A=L&OE.
I'm not sure what your problem is, I already thanked you for replying but I think it's obvious that the terminology "given construct" is not as clear to a person new to accounting than the word "benchmark". Obviously I know you already know that I didn't understand your terminology. Maybe you feel that your lack of clear communication to a layman needs to be over-inflated with an ego of technical expertise. May it's a self-esteem issue that you have. Maybe you feel that your communication was worth less so you're over-compensating with your ego. One way or another, using "Given construct" vs "Assets can go in the negative", is a nobrainer as to which one is better for a layman term.
 
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Lex, the short answer is probably that once you do some algebra it makes more sense.

A = L + E ... so ... A - L = E

Assets - Liabilities = Equity.

That should make more sense in a common sense way.
 
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Also, remember that the longer form of this equation includes dividends, revenue, and expense, all of which either add to or take away from the balance sheet. A, L, and Equity are balance sheet, Revenue, expense, and dividends are income/expense, so they are doing things to the balance sheet.
 

Triest123

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Hello,

I'm new to accounting, please bare with me. Thank you.

Assets = Liabilities + Equity
= Liabilities + ( Capital + Retained earnings)

In your example 1, the costs of $500 (paid for running the website) is the company's resources. As it will be fully consumed (or used up) at the end of the month, so it is treated as an expense. The $1,000 (income from ads) is the company's revenue.

In other words, the expense of $500 is used to generate the revenue of $1,000
So the company earn the profit of $500 at the end of the month.

(According to matching concept, revenue must be matched with the expenses they help earn where they are both recognized at the same accounting period)

Now suppose you receives cash $1,000 (i.e the revenue from ads) and then pays for the expense in cash $500 (i.e. running the website) at the end of the month, your company will have cash on hand $500 (i.e. the profit).

In this perfect situation, you don't need to invest money to start your business, so the capital of the company is "zero"

The cash on hand ($500) is the company's financial resource (i.e. the asset).


Now, look at the equation "Asset = Liability + Equity"
where Equity = Capital + Retained earnings

So Asset = Liability + (Capital + Retain earnings)

$500 = "0" + ( "0" + "$500")

You will earn $500 in the second month, the company's cash on hand will be accumulated to $1,000 (i.e. $500 + $500), and the company's accumulated profit will also be $500 + $500 = $1000

So, at the end of second month, the situation will become :

Asset = Liability + (Capital + Retain earnings)

$1,000 = "0" + ( "0" + "$1,000")



Example 2. I own a tractor and operate a farm. I'm using down payment on the tractor towards the dealership. This liability is not equal an asset (technically). Think about it... The value of my tractor is worth half what I payed for it initially just because it's used, so how can my assets be worth their original value as time passes? Same thing goes for printers, computers, etc... in a business...

=> It can be viewed that the devaluation of the tractor is due to the consumption when it is used to generated revenue. We call this process as depreciation (or impairment) and should be recognized as a company's expense.

The "devaluation in value" of the tractor is also called "impairment".

Suppose you invested $50,000 cash to your business. The company acquiring a tractor $100,000 with a down payment $50,000 paid in cash and $50,000 from a bank loan at 1 Jan 2015, the second hand market value of this tractor was $900,000 at 31 Dec 2015. The company would suffer a loss of $10,000 (which is due to the impairment of the tractor)

At 31 Dec 2015, the situation was

Asset = Liability + (Capital + Retain earnings) OR
Asset = Liability + (Capital - Retain loss )
($100,000 - $10,000) = $50,000 + ($50,000 - $10,000)


(p.s. the interest rate goes up result in increasing the borrowing costs of the company. The borrowing costs (i.e. the interest payment) is treated as the expenses of the company which in turn affect the company's profit)
 
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Do you have a mortgage?
This is a great example.

You own the house. The Mortgage is a separate financial agreement, a liability to repay a borrowed sum and this note is secured with collateral - your house.

If you use a credit card, the item you purchase would be considered an asset or an expense, which is technically an asset where the value has depreciated by the time you report it. You incur a liability of equal value.
 
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