Another tautology that accountants will agree is important is the proposition that assets equal liabilities plus equity - at least as long as I am not doing the arithmetic.”
Jensen, M., “Organizational Theory and Methodology,” The Accounting Review, Vol. LVIII, No. 2, April 1983 p. 330.
Let’s start by thinking about what financial snapshot of SOM Corp we would want. For example, we might want information to help us assess SOM Corp’s financial situation at July 31, 2020.
We can categorize the elements of a hypothetical entity’s (SOM Corp) financial position as being of two kinds: those that generate future benefits, and those that require future sacrifices. Things that generate future benefits are assets. Those that require future sacrifices are liabilities. If we assign financial values to the assets and liabilities, we can subtract them and name their difference net assets.
This last step might seem a bit pointless, but it is vital. It frames our task of displaying financial condition at a point in time in a very useful and practical way. To start appreciating this, you have to dive into particular cases. For example, all entities have assets and liabilities, but the way we characterize their difference depends on the type of entity we are dealing with. If SOM Corp was a not-for-profit, we would describe the net assets according to whether they are restricted by the terms of donors’ gifts or not (i.e., they are unrestricted):
Net Assets = Permanently Restricted Net Assets + Temporarily Restricted Net Assets + Unrestricted Net Assets
This forms the basis of running a not-for-profit in ethical manner by using its financial assets in accordance with the wishes of donors.
Because SOM Corp is a for-profit entity, we describe the net assets according to whether they have been earned by SOM Corp, are the result of investments by its owners or result from special accounting rules or conveniences. Further, we call the net assets equity:
Net Assets = Earned Net Assets + Net Assets Invested by Owners + Net Assets Arising from Rules & Conveniences
= Equity
We won’t get to the “Arising from Rules & Conveniences” category until we encounter more complex situations so let’s ignore it for now and think of this special case:
Equity = Earned Net Assets + Net Assets Invested by Owners
At the conceptual level, this special case focuses attention on an issue of vital concern in a for-profit entity: net assets generated by investments from owners versus those that the accounting system has recognized were generated by its efforts to create value through its activities. We should be careful, though, because using the name “Equity” instead of “Net Assets” invites confusion. Most people think their equity in say, a house they own, as the amount of money they would end up with if the house was sold. For a business entity, “Equity” suggests that it is the amount that the owners could get by selling their stake in the entity. This is true if and only if the accounting for assets and liabilities is perfect. That is, all assets and liabilities must be recorded and valued without error. This is only possible in rare circumstances, for example when the entity has no liabilities and only cash as an asset. Gaining an appreciation of the imperfections in accounting is an important reason to study it.
At any rate, we are stuck with the label “Equity” in for-profit entities, and we should work with it a bit to get the accounting identity in its most commonly used form.
Equity = Assets - Liabilities
Recall that this is an identity because it is a tautology - that is, it is simply a definition. Changing the name of Assets - Liabilities from Net Assets to Equity does not magically make it more meaningful. It is still the difference between assets and liabilities, and rewriting lit eaves us with the typical form of the Fundamental Accounting Identity:
Assets = Liabilities + Equity.
Using the Fundamental Accounting Identity
As with any tautology, the valueof the Fundamental Accounting Identity depends on how it is used. Using it requires taking three steps for every contemplated change in the balance sheet:
- Recognition –is the act of deciding that an action or transaction needs to be recorded on the financial statement. Obviously, if you determine that something should not be recognized, there is no need to take the next two steps.
- Classification –comes from looking at the action and deciding which of the three elements need to be changed and, if we subcategories of these three main ones, which of the subcategories need to be changed.
- Valuation - is the process of settling on the numbers that will be used in the change.
As you will see, classification and valuation are often intertwined in practice.
Working through some concrete examples will be helpful at this point. Before watching the video that walks you through it, download this Excel worksheet:
Accounting Identity (For-Profit)
Here is the video:
Here are an Excel file and a video that shows how the accounting identity is used in a not-for-profit:
Accounting Identity (Not-for-Profit)
These two videos show how the accounting identity is used to discipline the keeping of financial records by requiring that every entry into the system preserves the identity. To come at this a different way, suppose we observe that an entity’s cash increased by $50. We record that as Assets going up by $50. But the accounting identity makes us do more. It makes us decide why cash went up by $50. Here are our choices:
- Another asset went down.
- A liability went up.
- Equity (or Net Assets) went up.
The identity does not require that we choose only one of these reasons. It just requires that the sum of them equals (the accounting term is balances) the increase in cash. The situation might be complex and, for example, another asset went down by $10, liabilities went up by $25 and equities (or Net Assets) went up by $15. Don’t let this complexity scare you - we will start with less complex transactions and work our way up. But note that using the accounting identity to keep our records forces us to enter a consistent depiction of the transaction or event.
In addition to exploring more complex transactions as we proceed, we will see how additional detail under the general categories of assets, liabilities and equities (net assets) are used to provide a richer description of the financial condition of an entity at a point in time. This raises more issues of classification than are suggested by the worksheet exercises. We will also encounter transactions in which some of the numbers are less obvious; i.e., where valuation is more tricky. Finally, we will see how making finer distinctions in equity (net assets) helps us separate changes generated from transactions with owners (in a for-profit) or outsiders. Only transactions with outsiders have the possibility of reflecting value added to the economy from value being redistributed in the economy.
Before we start to layer in more complexity, we will first develop some very handy notation for handling financial transactions: the famous (or infamous) debits and credits.