Understanding Accounting Basics (ALOE and Balance Sheets)

In accounting, the math usually isn’t worse than multiplication. But accounting isn’t about math — it’s about concepts, and some had me confused. Accounting has simple and surprisingly elegant ways to track a business.

So What’s Accounting About, Anyway?

To be blunt, accounting is about tracking stuff (yes, there’s more to it, but hang with me). What kind of stuff can we track?

Assets: “Stuff” inside the company
Liabilities: “Stuff” that belongs to others
Owner’s Equity (aka Capital): “Stuff” that belongs to the owners

Simple enough. Now how are these related?

Assets = Liabilities + Owner’s Equity

In layman’s terms, everything the company has belongs to the owners or someone else. Think of the equation like this:

assets = liabilities + owner’s equity
stuff the company has = other people’s stuff + owner’s stuff

This formula (also called ALOE) might seem strange at first. Why do we add liabilities? Because we’re looking from the point of view of the company, not the shareholders. If the company has something, it could be owed to someone else.

From the owner’s point of view, owner’s equity = assets – liabilities. This equation looks more natural, but often we aren’t interested in the owner’s point of view. We want to know about the company.

What’s a balance sheet?

A balance sheet is a document that tracks a company’s assets, liabilities and owner’s equity at a specific point in time. As you know, if the company’s has something, it belongs to someone. The sides must balance. So let’s do an example.

Suppose we start a company with $100 cash:

Assets:
  Cash: 100 
Liabilities:
  None
Owner's Equity:
  Stock: 100

The company has $100 in short-term investments, and the owners have $100 worth of stock (how ownership is represented in a company).

Now suppose we take a bank loan for $150. The balance sheet becomes this:


Assets:
  Cash: 250 
Liabilities:
  Loans: 150
Owner's Equity
  Stock: 100

Now our company has $250, but $150 belongs to the bank and $100 belongs to the owners. Sorry guys — you can’t take out a loan and make your share of the company more valuable.

Next, let’s buy a building for $200:


Assets:
  Cash: 50
  Building: 200
Liabilities:
  Loans: 150
Owner's Equity
  Stock: 100

Buying a building doesn’t make our company more valuable: we re-arranged our assets. Instead of $250 in cash, we have $50 in cash and $200 in “building”. Our share of the company ($100) didn’t change a lick. And we still owe the bank $150.

That’s not how it really works, is it?

It is. Well, real accountants use fancier terms (”accounts receivable” vs “deadbeats who owe me”), and have a bigger, badder balance sheet. But the core idea is the same: show what the company’s worth, and who owns what.

Take a look at the balance sheet for a small internet company:

Assets are broken into short-and long-term categories; the company is worth about $18 billion on the books (as of Dec 2006). This is up from $10B in 2005.

There’s many, many reasons why assets may be over or under-valued on the books. How do you measure momentum? Employee morale? A brand? Customer loyalty?

Accountants try to quantify items like this with intangible terms like “Goodwill”, but it’s not easy. In reality, most companies are worth several times their reported assets; Google’s market cap is over 10x the book value (but read more about stocks to see why market cap is not quite right).

Now examine the other side of the equation, liabilities and owner’s equity:

Wow — Google doesn’t have many liabilities! Only $1.4B (of the total $18B) and there’s no long-term debt. What it does owe are ”accounts payable” — the equivalent of a credit-card bill (usually paid within a short timeframe).

Now you can examine a company and see what it’s worth (on paper) and where the value lies. Google has no “inventory” (ever bought an off-the-shelf product from them?) but has a lot of cash, investments, and equipment. There’s very little debt and other liabilities, so it seems like a very stable company on paper; they won’t be going bankrupt anytime soon (there’s other documents that show how profitable the company is).

Blockbuster, for example, has 2.5B in assets but 1.9B is owed to others (saved balance sheet here). Shareholders aren’t left with much. In fact, it has 700M in “intangible assets”, so it actually has a negative amount of real, tangible assets. Not a good sign — if you liquidated the company today, it couldn’t pay off its debt.

The Rules of the Game

Accounting has many rules, but a basic one is this: use double-entry bookkeeping.

This fancy term means that all changes happen in pairs:

If assets go down, liabilities or owner’s equity should decrease also
If assets go up, liabilities or owner’s equity must increase as well

Every change to assets must have a corresponding change to keep the equation in balance. There’s a formal system of “debits and credits” that describes these changes, but the concept is simple: if you make a change to one side, you must make one on the other as well.

There’s More to Learn

There’s much more to accounting, but you’ve got an idea of the basics:

If a company has something, someone had better own it
A balance sheet lists assets, liabilities and owner’s equity at a point in time; everything must add up
Changes must be made in pairs: if assets, liabilities or owner’s equity changes, something else much change as well

Any system can be interesting (even “fun”) if you look at the reasons it was created and the problem it’s trying to solve. Could you have made a simpler way to report what a company is worth and who is owed what?

Enjoy.

24 Comments

Posted November 20, 2007, under Business
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Comments

That was a nice quick summary.

You might add that if assets and liabilities are stuff you either own or owe, then income and expense track the movement of stuff in or out of the company. Cash from a sale increases assets and the off-setting double entry is to income. But the sale might also reduce inventory which shrinks assets and that adjustment would be recorded as an expense. The difference in the two adjustments is your gross profit on the sale.

Looking at a balance sheet shows you where a company stands financially at any given moment, the stuff they own and owe. Income and expense reports show movement and trends over time and break out the asset/liability changes into a variety of categories and types.

jim in austin — November 21, 2007 @ 10:20 am
I might also add that debits and credits are not pluses or minuses. They are simply two different categories that are associated with account types. Assets and expenses carry a debit balance. That means to increase them you make an entry in the debit column and to decrease them, a credit column entry. Liabilities, equity and income carry a credit balance. Credit column entries increase them and debit column entries decrease their value.

No matter how long or convoluted an entry might be the only governing rule is that the debit column total and the credit column total must be the same. That is why assets=liabilities+equity is true. Quite literally, the only math in accounting is addition.

jim in austin — November 21, 2007 @ 10:58 am
Hi Jim, thanks for the great comments! Yes, it took a while to realize that debits weren’t always “bad” and credits weren’t always “good”. One confusion is the common terms (credit or debit balance) get confused with the more specific accounting ones. Appreciate the thoughts!

Kalid — November 21, 2007 @ 3:46 pm
Why doesn’t the balance balance? 15B$ Liabilities is less than 18B$ Assets… Where do the 3B$ benefits fit in?

GUI Junkie — November 27, 2007 @ 8:03 am
Banks and other financial institutions have sort of a reverse or at least non-intuitive usage of the terms debit and credit since they carry your deposit on their books as a liability, not an asset. The money does belong to you after all. That is why a deposit is “credited” to your account and why a debit card transaction reduces your balance. In your own books a deposit is a debit to a cash asset and a withdrawal a credit.

jim in austin — November 27, 2007 @ 8:15 am
GUI Junkie:

18,473,351 – total assets
1,433,511 – total liabilities
17,039,840 – total stockholder equity

jim in austin — November 27, 2007 @ 8:22 am
@Jim: Thanks for the clarifications!

@GUI Junkie: This example is a bit more complicated because Google reported “intangible assets” like Goodwill (things like brand recognition, etc.). As Jim said, their total reported assets, liabilities and equity add up.

The 15B number is reported after intangible items have been removed.

Kalid — November 27, 2007 @ 11:19 am
A “hypothetical” question: my wife has trouble keeping track of her spending. I’ve considered buying an accountant’s notebook and tracking spending (with her) there, but I don’t know how to do the double-entry bookkeeping. I know it’s not strictly necessary – basic add/subtract is easy enough to get right – but it seems that doing it more thoroughly might help her understand things better.

How do I do that? I guess that’s basically asking how double-entry bookkeeping would work in a checkbook, eh?

Dan — February 7, 2008 @ 8:58 am
Hi Dan, good question. These double-entry accounting systems are more for financial reports than personal finance — when keeping track of your own expenses, a simple add/subtract will probably do the trick.

One method is to keep all the receipts for a week (and write down any cash transactions) to see where the money is going. You can then check your credit card / debit card statements to make sure the amounts match. The simple dollar is a great finance blog and has more on this topic:

http://www.thesimpledollar.com/2007/08/13/how-to-balance-your-checkbook-in-the-era-of-the-debit-card/

Kalid — February 7, 2008 @ 10:04 am
it still amuses me from reading other posts here that one could claim to have 1B in the first year in OE and 3B in the fifth year yet the fifth year would be worth less due to inflation and competition.

I happily await zero inflation – the physicists tunnelling.

Ken — March 31, 2008 @ 4:12 pm
These explanations are very clear and easy. Helped out a lot.

thx.

Nigel — April 6, 2008 @ 4:31 pm
Thanks Nigel, glad they were helpful.

Kalid — April 6, 2008 @ 7:14 pm
i’m in school to become an accountant i found this information to be helpful for my test in payroll and fundementals of accounting…

stewart — October 23, 2008 @ 9:37 pm
@stewart: Glad you found it helpful.

Kalid — October 23, 2008 @ 9:50 pm
Great explanation. I’d be interested in income statements and cash flow too!

Matt — February 4, 2009 @ 2:45 pm
@Matt: Thanks, those would be nice follow-ups.

Kalid — February 4, 2009 @ 3:26 pm
Thanks, good explanation. I’d also recommend this article for beginners:

http://www.myhowtoos.com/en/at-work-howtoos/80-understanding-accounting-basics

davide1982 — April 19, 2009 @ 9:15 am
Hi!

I’ve got to say I am a sophomore in college and am taking my first accounting class. The first and second day of class, I was utterly confused I was almost in tears from frustration! LOL…I even started getting a headache from having to think too much!

However after reading your tips, I’m feeling a little better. We’re currently working on “T” accounts and changing balance sheets (i think thats what its called) I’m feeling a little more confident know! THANK YOU!!! I was this close to dropping the class and trying again later!

Eureka Collins — November 4, 2009 @ 9:05 pm
@Eureka: Awesome, glad it was useful! Good luck in your class!

Kalid — November 4, 2009 @ 9:24 pm
It is great , This is the way to explain anything.

sarvjeet verma — November 12, 2009 @ 6:47 am
@sarvjeet: Glad you liked it!

Kalid — November 13, 2009 @ 10:20 am

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