Lesson 3: Golden Rule of Accounting;
Assets = Liabilities + Equity
The golden rule of accounting was one of the first things I learned in an accounting class and it's become the lens through which I have viewed the world ever since.
Assets = Liabilities + Equity is the golden rule I'm referencing. It is the foundation of finance and the global definition of financial worth. They call accounting "the language of business" because all businesses and all individuals' finances are measured using this formula. Every single financial transaction you make in your life involves this formula and every single financial transaction that is entered into a company's books is recorded in accordance with it just the same. No matter what the business sells, no matter the amount of employees or zeroes in the bank account, every single company (and individual) measures their value, or Net Worth, through this formula.
When you hear the investing "experts" mention a company's Balance Sheet or hear the term "balancing the books," this formula is essentially what they are referring to. Since the left side (Assets) of the books must equal the right side (Liabilities + Equity), everything must balance. The Balance Sheet also represents a running Net Worth tracker, containing every single transaction a company has ever had. You too have a Balance Sheet whether you know it or not. You too have a Net Worth whether you know how to track it or not. After you complete this crash course, I guarantee you will understand the components of Net Worth (Equity) and know how to calculate & focus on your own.
The Balance Sheet is the result of double-entry accounting; which means every single transaction requires at least two entries to ensure balance in accordance with the golden rule. If an accountant/bookkeeper attempts to record a transaction in a way that violates this formula, he/she will cause the company's books to be imbalanced. An imbalanced Balance Sheet means the books are off and the amounts do not reflect true events. If done properly, however, the golden rule keeps Balance Sheets of all sizes in check and translates important metrics about a company's Net Worth. If applied towards a regular ol' person's finances, it works just the same and is a million times less complicated than that of a big business.
If you apply some algebra to the golden rule's formula, you can express it as Equity = Assets - Liabilities
Net worth = Assets - Debt
Through various real world scenarios and practical examples, I will explain how this formula tracks your finances and determines value. My goal is to show you that knowing the basics of accounting can help you better understand, and maximize, your Net Worth. Click here to go to the next lesson and learn how accounts drive accounting systems.