UNDERSTANDING ACCOUNTING BASICS (ALOE AND BALANCE SHEETS)

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:

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:

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:

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: