Traditional accounting equation – assets, liabilities and owners’ equityAssets are all resources owned or controlled by the business. The business uses these items to operate its activities, expecting a future benefit called profit. Without these resources, a business wouldn’t exist and generate a profit. Depending on how long the business intends to use an asset, there are two groups of assets: current assets and non-current assets.Current assets are items that the business intends to keep for less than 12 months. The best examples of current assets are inventory, cash, and accounts receivable. Non-current assets are resources that the business expects to keep more for more than 12 months. Plants, machinery, buildings and land are good examples of non-current assets.We can also divide assets into tangible and intangible assets.Tangible assets are all current and non-current assets that have physical substance and can be touched. In contrast, intangible assets have no physical substance. For example, trademarks, software and patents are such assets. The assets can be funded by creditors or by the owners.The amount of all assets funded by creditors is known as liabilities. Liabilities are obligations to third parties that must be paid back. Typical liabilities are a bank loan and account’s payable. The amount of the assets funded by the owners is known as owners’ equity. Owners’ equity consists of paid-in-capital, which shows all investments by the owners and retained earnings, which show the profit.The traditional accounting equation expresses the relationship between assets, liabilities and owners’ equity. The main idea behind the equation is that the total amount of all assets should equal the sum of the amount owed to third parties and the amount invested by the owners. Thus, the accounting equation provides a clear picture of the business's financial situation. That’s why every business needs to understand the accounting equation’s meaning and know what it shows.Suppose the value of owners’ equity is higher than the value of liabilities. In that case, the business is in an excellent financial position because more assets are acquired by business funds rather than by debt.On the other side, if the value of liabilities is higher than the value of owners’ equity, the business is in a critical financial position because more assets are acquired by debt rather than by capital. This is a typical situation for companies that start out.
Let's go through the following illustration:Business “XY” owns machines, office equipment, inventory and money in the bank account. The total value of all these items of the business is $350,000. The entity buys its machines and office equipment with a bank loan of $140,000. The owners provide the inventory and the money in the bank account. The amount of liabilities, in this case, is $140 000 and the value of owner’s equity is $210 000.$350 000 Assets = $140 000 Liabilities + $210 000 Owners’ EquityIn this case, more assets are acquired by business funds rather than by debt and this shows that the business is in an excellent financial position. Expanded accounting equation – revenues and expensesEvery business’ operating its activities incurs expenses and generates revenues. When a business produces goods to be sold or prepares services to be delivered, it either decreases its assets or increases its liabilities - it makes payments to suppliers or expects to make payments to suppliers. This decrease in assets or increase in liabilities leads to a decrease in owner’s equity. This decrease in owners’ equity is called expense. Typical examples of expenses are rent expenses, insurance expenses, electricity expenses, and wages expenses. When a business sells goods or delivers services, it either increases its assets or decreases its liabilities - it gets payments from customers or expects to get payments from customers. This increase in assets leads to an increase in owner’s equity called revenue. The expanded accounting equation is similar to the traditional accounting equation, but it shows all revenues that increase the owner’s equity and all expenses that decrease the owner’s equity.Assets = Liabilities + Owner’s Equity + Revenues - ExpensesLet’s look at the following illustration:An entity produces clothes. To produce the products, it pays wages of $ 54 000, byes fabric material with a price of $14 000, pays $11 000 for electricity. The business pays the wages immediately and will pay later the amount of materials and electricity. The payment of $54 000 is a cash decrease, and it decreases the owner’s equity by $54 000 in the form of expenses. The remaining total amount of $15 000 is a liability, and this increase in liabilities causes another decrease in owners’ equity in the form of expenses.The business sells part of the clothes produced for a total price of $89 000 cash. This positive money flow increases assets and leads to an $89 000 increase in the owner’s equity in revenues.
TransactionsTransactions are business events that affect the business’s financial position and can be reliably recorded in money terms. There are different types of transactions. Some transactions affect only the left side of the accounting equation. Such transactions only transform one asset into another, but the total amount of assets remains the same. Other transactions affect only the right side of the accounting equation. These transactions transform one source of resources into another, and the total amount of sources of a business’s assets remains the same. Let’s see some examples:A business acquires inventory for $6 000 cash.This business event increases the inventory by $6000 and decreases the money by $6000. Both affected objects are assets, and we can say that the form of the assets changes but the total amount of assets is unchanged.A business makes a payment of $4 000 to one of its creditors.This business event decreases both assets and liabilities by $4 000. The business’s money decreases by $4 000, and its obligation to the supplier falls by $4 000.A business borrows a loan of $10 000 from a bank. This business event increases both assets and liabilities by $10 000. The money of the business increases by $10 000, and its obligations to third parties increases by $10 000.
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