Introduction of the Accounting Equation
The statement of financial position reflects the
accounting equation. It reports a company’s assets, liabilities, and owner’s
(or stockholders’) equity at a specific point in time. Like the accounting
equation, it shows that a company’s total amount of assets equals the total
amount of liabilities plus owner’s (or stockholders’) equity.
Every business transaction will have an effect
on a company’s financial position. The financial position of a company is
measured by the following items:
1.
Assets (what it owns)
2.
Liabilities (what it
owes to others)
3.
Owner’s Equity (the
difference between assets and liabilities)
The accounting equation (or basic accounting equation) offers us a
simple way to understand how these three amounts relate to each other. The
accounting equation for a sole proprietorship is:
Assets = Liabilities + Owner’s Equity
The accounting equation for a corporation is:
Assets = Liabilities + Stockholders’ Equity
Assets are a company’s resources—things the company
owns. Examples of assets include cash, accounts receivable, inventory, prepaid
insurance, investments, land, buildings, equipment, and goodwill. From the
accounting equation, we see that the amount of assets must equal the combined
amount of liabilities plus owner’s (or stockholders’) equity.
Liabilities are a company’s obligations—amounts the company
owes. Examples of liabilities include notes or loans payable, accounts payable,
salaries and wages payable, interest payable, and income taxes payable (if the
company is a regular corporation). Liabilities can be viewed in two ways:
(1) as claims by creditors against the company’s assets, and
(2) a source—along with owner or stockholder equity—of the company’s assets.
(2) a source—along with owner or stockholder equity—of the company’s assets.
Owner’s equity or stockholders’ equity is the amount left over after liabilities are
deducted from assets:
Assets – Liabilities = Owner’s (or Stockholders’) Equity.
Owner’s or stockholders’ equity also reports the
amounts invested into the company by the owners plus the cumulative net income of the company that has not been withdrawn or
distributed to the owners.
If a company keeps accurate records, the
accounting equation will always be “in balance,” meaning the left side should
always equal the right side. The balance is maintained because every business transactionaffects at least two of
a company’s accounts. For example, when a
company borrows money from a bank, the company’s assets will increase and its
liabilities will increase by the same amount. When a company purchases
inventory for cash, one asset will increase and one asset will decrease.
Because there are two or more accounts affected by every transaction, the
accounting system is referred to as double entry accounting.
A company keeps track of all of its transactions
by recording them in accounts in the company’s general ledger. Each account in the general ledger is
designated as to its type: asset, liability, owner’s equity, revenue, expense,
gain, or loss account.