Accounting Introduction Part 2

The Basic Accounting Equation

Basic Equation :

Assets           =          Liabilities + Owner Equity

This relationship is the basic acoounting equation. Assets must equal the sum of liabilites and owner’s equity. Liabilities appear before owner’s equity in the basic accounting equation because they are paid first if a business is liquidated.

There are three catogeries in the basic accounting equation

     1.     Assets

Assests are resources a business owns. The business uses its assets in carrying out such activities as production and sales. The common characteristic possessed by all assets is the capacity to provide future services or benefits.

    2.     Liabilities

Liabilities are claims against assets that is exisiting debts and obligations. Business of all sizes usually borrow money and purchase merchandise on credit. All of the persons or entities to whom a company owes money are its creditors. Creditors may legally force the liquidation of business that doesn;t pay its debts. In that case, the law requires that creditor claims be paid before ownership claims.

     3.     Owner’s Equity

The ownership claim on total assets is owner’s equity. It is equal to total assets minus total liabilities.

Increase in Owner’s Equity

-    Investments by Owner. They are the assets the owner puts into the business. These invesment increase owner’s equity. They are recorded in a category of owner’s capital.

-  Revenues. Revenues are the gross increase in owner’s equity resulting from business activities entered into for the purpose of earning income. Generally, revenues result from selling merchandise, performing services, renting property and lending money. Common sources of revenue are sales, fees, services, comissions, interest, dividens, royalties and rent.

            

Decrease in Owner’s Equity

-   Drawings. They are withdrawal of cash or other assets from an unincorporated business for the personal use of the owner(s).

-    Expenses. They are the cost of assets consumed or services used in the process of earning revenue.

In summary, owner’s equity is increased by an owner’s investment and by revenues from business operations. Owner’s equity is decreased by an owner’s withdrawals of assets and by expenses. This format is referred to as the expanded accounting equation.

Expanded Equation :

Assets     =  Liabilites + Owner’s Capital – Owner’s Drawings + Revenues - Expenses