Accounting Equation

 

The two fundamental elements of business are what it owns and what it owes. Assets represent the resources of a business that a business owns. For example “Patrick & Sons” company has total assets of approximately $ 34.6 billion. And liabilities and owner’s equity are the rights and claims against their resources that a business owes. Likewise, “Patrick & Sons” company has 34.6 billion of claims against its 34.6 billion of assets. Liabilities are called creditors claim on total assets and the ownership claim on total assets are called owners’ equity. Thus “Patrick & Sons” company has a liability of billion and owners’ equity of billion.

It means: Assets = Liabilities + (Owner’s Capital + Revenues – Expenses – Owner’s withdraws). This equation is known as Expended Accounting Equation. We can combine these elements by relating with an equation which is basic accounting equation:

A = L + Q

Accounting equation used in business describes an organization’s financial position. An asset always equals the sum of liabilities and owners’ equity. As liabilities are paid first so it appears before owner’s equity. The accounting equation implemented to all economic entities regardless the form and nature and also the shape of business. Let’s take a close look on the accounting equation:

Assets: assets are the economic resources that business uses to carry out organizational activity to get benefit in future such as production, sales. Examples of assets are furniture, land, office supplies, merchandise, cash etc. The service possessed by assets will eventually affect in cash inflows. For example: The pastry house owns a delivery van that provides financial support from delivering pastries. Other assets of the pastry house are table, chairs, jukebox, cash register, oven, tableware and of course cash.

Liabilities: Claims against assets comes from two sources, liabilities are outsider claims which called creditors are existing economic obligations debt. All form of business either big or small generally borrows money and purchase merchandise on credit. These kinds of transactions lead to payable of various sorts:

For example: the pastry house purchases cream, butter, flour, egg, sugar etc. and all beverages from suppliers on credit. These obligations are called accounts payable. The pastry house could have a note payable to Bank for the transactions of borrowing money for buying a delivery van. The pastry house may have salaries payable to workers and takes and sales payable to local government. If any business is liquidated then liabilities pay first.

Owners’ Equity: Owner’s equity is insider claims on total assets. This owners’ equity is measured by subtracting total assets from total liabilities. It means:

OE=TA-TC, here OE= Owner’s Equity, TA= Total Assets and TC=Total Claims

Claims on assets can come from either creditors or owners as liabilities paid firsts so to find out what belongs to owner, the total assets are subtracted from total liabilities. The reminder is the ownership claim. For this reason owner’s equity often referred to as net assets.

In accounting equation ownership claim to business assets is residual as it calculates from remain after liabilities are paid off. In proprietorship owner’s investment and revenues increase owner’s equity and owner’s withdrawal and express decreases owner’s equity. For instance the owner of the pastry house invested in the business that increase the owner’s equity. Revenues resulting gross increase which come from business transactions for the purpose of carrying income. For example, the pastry house can earn revenues by selling pastry, beverage.

Withdrawals: It is opposite of investment. Withdrawals measured by those amounts for assets which are withdraw by the owner for personal case.