The Balance Equation Explained using the Teenage World
The Balance Equation Explained using the Teenage World
As a teenage boy scout, one merit badge that was problematic on the road to earning my Eagle Scout award was the personal management merit badge. This badge required me to keep a record of income and expenses for three months. While I laugh at the thought of the simple calculations now, at the time this was a real challenge. So, in order to maximize my productivity, I created an excel sheet of my own. Little did I know I would return to my scouting ways some seven year later to analyze my records using the balance equation.
At the time my "balance sheet" was created, I had two accounts. One was for income, the other for expenses. While I was only making $6.25 per hour at a local pool and earning some extra income on the side for babysitting, a set a goal to reach two hundred dollars. But, if I am going to look at this by using the accounting equation, assets = liabilities + owner's equity, I need to start thinking of myself as the entity and organize my balance sheet and see if I missed any accounts.
I realize that a balance sheet is a listing of the organization's assets, liabilities, and owners' equity at a point in time. It is also sometimes called the statement of financial position because it summarizes an entity's resources (assets), obligations (liabilities), and owners' claims (owners' equity). But if this equation does not equal on both sides, I must be making a mistake.
Asset accounts are broken into two different subcategories, current assets and plant and equipment. However, my assets started very simply. My current assets primarily came from my paycheck: 100 dollars every two weeks. This would go into my cash account. Cash account shows exactly what the entity (me) has available in the bank to make immediate transactions with. Every Friday my cash would show up on my balance sheet so I would know exactly what I would have to work with over the weekend. What my entity lacked was other means of income. So I started doing favors for people. "Hey dad, I will clean your car for 20 bucks?" "Hey mom, do you need me to run any errands? All I would need is gas money." They both would agree but never gave me the money up front (and I always got more money for gas then what was necessary). While this is not a typical accounts receivable account since it typically represents amounts due from customers over merchandise on credit that will pay the amount by a certain date, I look at it as my parents were going to pay me by the end of week thus assets I could depend on to get deposited into my account at a later date. Continuing down the asset spectrum, merchandise inventory represents the cost of merchandise not sold. I could try to make up an elaborate story on how I started making and selling t-shirts, but that would not be the scouting way. I did not use this account at the time. Getting away from the current assets, the equipment account represents the value of the equipment purchased by the entity. Realize I had one true item of value I owned: my bike. This six speed mountain bike got me places I needed to go without having to work out any car schedule or bug my mom for gas money. This and my bathing suit made up the entirety of equipment account which gave me $150 in the equipment account. The combination of my current assets and plant and equipment made up the assets on my balance sheet.
On the other side of the balance equation, I had many liabilities. Liabilities come in different forms, current liabilities and long term debt. At 16 years of age, I did not have any long term debt which is to say I did not have borrowed money that needed to be paid off by the end of the year. However, I had a lot of current liabilities. These accounts are those liabilities that are likely to be paid with cash within one year of the balance sheet date. Accounts that are included in this category include accounts payable, accrued liabilities, and short-term debt. As many people are aware, girlfriends are often times expensive. My girlfriend wanted to see a movie, get dinner, go mini-golfing, eat some ice cream; the list goes on and on. While accounts payable represent payments made on merchandise that was paid by credit and needs to be paid off at a specific time, for all intensive purposes, I could nickname this account "girlfriend." Everything seemed to go towards the girlfriend, at least $40 per week. I now appreciate the dates where it is movie night on FX just so my accounts payable does not go any higher. Accrued liabilities represent payments that need to be made to different creditors and services provided by employees. Since I was the sole owner and employee, this account always stayed very low: zero. The short-term debt account represents borrowed money that needs to be paid off within the year. I always made sure to stay out of debit at a young age so I did not have a balance in this account either. Once these three accounts are added together, current liabilities is the sum. When current liabilities and long term debt are added, the entire liabilities amount is determined.
What does this all mean for the owners' equity account? By definition, owners' equity is the ownership right of the owner(s) of the entity in the assets that remain after deducting the liabilities. It is also sometimes called net assets which can be determined as assets minus liabilities. To understand how much equity the owner(s) of an entity, liabilities are deducted from assets. Basically, once all my assets are added up which include the pool job, babysitting, and getting paid for the miscellaneous tasks my parents made me do, I would subtract all of my liabilities to compute owner's equity. I have determined that there was only one true overall liability, girlfriend. This made my owner's equity not very high.
What could be determined from this information at first glance could be very obvious: dump the girlfriend and your owner's equity or net worth will go through the roof. However, what is not to say I would have gone and done these things without her? What if I stopped working since I did not have any more liabilities? What if started dating two girls at once, essentially doubling my liabilities? These questions are why balance statements cannot always be trusted when determining how an entity will fair in the future. So, while my merit badge earning, happily dating teenage self has now become more knowledgeable, the balance equation will always remain the same but the future is unpredictable.
Marshall, David H., Wayne W. McManus, and Daniel F. Viele. Accounting: What the Numbers Mean. Boston: McGraw-Hill Irwin, 2008. Print.