The Fundamental Accounting Equation ‘The basic features of the accounting model we use today trace their roots back over $00 years. Luca Pacioli, a Renaissance era monk, developed a method for tacking the success of failure of wading ‘ventures. The foundation of that system continnes to serve the modem business world well, and is the entrenched cornerstone of even the most elaborate computerized systems, The nucleus of that system Is the notion that a business entity can be described as a collection of assets and the corresponding ‘claims against those assets, The claims can be divided info the claims of creditors and owners (Le.. abilities and owners’ equity). This gives rise to the fundamental accounting equation: Assets = Liabilities + Owners” Equity Assets Assets are thie economic resources of the entity. and incinde sueh items as cash. accounts receivable (amounts owed fo a firm by its customers). inventories. land, butidings. equipment, and even Intangible assets like patents and other legal rights and claims. Assets are presumed to entail probable future economic benefits to the owner Liabilities Liabilities are amounts owed to others relating to loans, extensions of credit, and other obligations arising in the course of business. Owners’ Equity ‘Owners’ equity is the owner's “interest” in the business. It is sometimes called net assets, because it is ‘equivalent to assets minus liabilities for a pasticular business. Who are the “owners?” The answer to ‘this question depends on the legal form of the entity: examples of entity types include sole proprietorships. partnerships, and corporations. A sole proprietorship is a business owned by one person, and its equity would typically consist of a single owner's capital account. Conversely, a partnership is a business owned by more than one person, with its equity consisting of a separate ‘capital aceount for each partner, Finally, a corporation is a very common entity form, with its ‘ownership interest being represented by divisibie units of ownership called shares of stock, These shares are easily transferable, with the current holeer(s) of the stock being the owners. The total ‘owners’ equity (.e., “stockholders’ equity”) of a corporation usually consists of several amounts, ‘generally corresponding to the owner investments in the capital stock (by shareholders) and additional ‘amounts generated throush carnings that have not been paid out to sharcholders as dividends (@ividends are disuibutions to sharcholders as @ return on their investment). Earnings give rise t© increases in “retained earings.” while dividends (and losses) eause decreases. Balance Sheet The fundamental accounting equation is the backbone of the accounting and reporting system. Tis central to understanding a key financial statement known as the balance sheet (sometimes called the statement of financial position). The following illustration for Edelweiss Corporation shows a variety of assets that are reported at a total of $895,000, Creditors are owed $175,000, leaving $720,000 of Stockholders’ equity. The stockholders’ equity section is divided into the $120,000 that was originally. invested in Edelweiss Corporation by stockholders (ic., capital stock), and the otlcr $600,000 that ‘was eatned (and retained) by suecessfill busittess performance over the life of the company.ASSETS: LIABILITIES + | STockHoLbeERs’ Equity $895,000 $175,000 $720,000 Does the stockholders’ equity total mean the business is worth $720,007 No! Why not? Because ‘many assets ate nor reported ar current value, For example, although the land cost $125,000, the balance sheet does not report its current worth. Similarly, the business may have unrecorded resources to its credit, such as a trade secret or a brand name that allows it to eam extraordinary profits. If one is looking to buy stock in Edelweiss Co:poration, they would surely give consideration to these important non-financial statement based valuation considerations. This observation tells us that accounting statements ars important in investment and credit decisions. but they are not the sole source of information for making investment and credit decisions. How Transactions Impact the Accounting Equation ‘The preceding balance shect for Edelweiss was static, This means that it represented the financial condition at the noted date. But, each passing transaction or event brings about a change in the overall financial condition. Business activity will impact Various asset. lability. and/or equity accounts: but, they will not disturb the equality of the accounting equation. So, how does this happen? To reveal the answer to this question, let’s look at four specific tansactions for Edelweiss Corporation. You will See how each transaction impacts the individual asset, liability, and equity accounts, without upsetting the basic equality of the overall balance sheet. Edelweiss Collects an Account Receivable If Edelweiss Corporation collected $10,000 from a customer on an existing account receivable (Le. not a new sale, just the collection of an amotmt that is dite from some previows transaction), then the balance sheet would be revised as follows: Liabilities ta abies and ay ‘The illustration plainly shows that cash (an asset) increased from $25,000 to $35,000, and accounts receivable (an asset) decreased from $50,000 to $40,000. Ax a result total assets did not change, and. Liabilities and equity accounts were tnaffected. Thus, assets still equal abilities plus equiThis itlustration shows that equipment (an asset) increased from $250,000 to $280,000, and loans payable (a liability) increased trom $125,000 to $155,000. As a result, both total assets and total abilities increased by $30,000, but assets still equal liabilities plus equity. 4.3 Edelweiss Provides Services to a Costumer on Account ‘What would happen if Edelweiss Corporation did some work for a customer in exchange for the customer's promise to pay $5,000? This requires further explanation: try to follow this logic closely! ‘You already know that retained earnings is the income of the business that has not been distributed to the owners of the business, When Edelweiss Corporation eamed $5,000 (which they will collect later) by providing a service to a customer, it can be said that they generated revenue of $5,000. Revenue is the enhancement to assets resulting from providing goods or services to customers. Revenue will bring about an increase to income, and income is added to retained earings. Can you follow that? As you examine the balance sheet on the top of the next page, notice that accounts receivable and retained earings went up by $5,000 each, indicating that the business has more assets and more retained earings. And, guess what: assets still equal liabilities plus equity. Edelweiss Pays Expenses With Cash Te would be nice if you could ran a business without incurring any expenses. However, sich is not the ‘case. Expenses are the outflows and obligations that arise from producing goods and services. Imagine that Edelweiss paid $3,000 for expenses. The lower set of balance sheets on the following: page shows this impact. Generalizing About the Impact of Transactions ‘There are countless types of transactions that ean occur, and each and every transaction ean be “described in terms of its impact on assets, abilities, and equity. What is important to know is that no ‘transaction will upset the fundamental accounting equation of assets = Liabilities + owners’ equity.Services to a customer on account: Lsbilities ‘Accounts payable Loans payable “Total iailities ers eauity Capital stock $120,000, Retin ening on. BOD.O0D “otal labvities anc eauty Liabilities Accounts payable Capital stock «Reine earn ‘dial abies and equity. $120,000 ee.) ‘Pays expenses: Aseots Cash Aesounts receivable Inventories Und Building Equipment th Liabilities, ‘Accounts payable ab Capital stock Retained earnings. Retained earaibgs, $120,000, —saz.o00