The two basic elements of a business are what it owns and what it owes. Assets are the resources a business owns. Liabilities and owner’s equity are the rights or claims against these resources.
For example, Google has total assets of approximately
$93.8 billion. Thus, Google has $93.8 billion of claims against its $93.8 billion of assets. Claims of those to whom the company owes money (creditors) are called liabilities. Claims of owners are called owner’s equity. Google has liabilities of $22.1 billion and owners’ equity of $71.7 billion.
We can express the relationship of assets, liabilities, and owner’s equity as an
equation, as shown below:
This relationship is the basic accounting equation. Assets must equal the sum of liabilities 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.
The accounting equation applies to all economic entities regardless of size, nature of business, or form of business organization. It applies to a small proprietorship such as a corner grocery store as well as to a giant corporation such as PepsiCo. The equation provides the underlying framework for recording and summarizing economic events.
Let’s look in more detail at the categories in the basic accounting equation.
3.1 Assets
As noted above, assets 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. In a business, that service potential or future economic benefit eventually results in cash inflows (receipts). For example, consider Campus Pizza, a local restaurant. It owns a delivery truck that provides economic benefits from delivering pizzas. Other assets of Campus Pizza are tables, chairs, jukebox, cash register, oven, tableware, and, of course, cash.
3.2 Liabilities
Liabilities are claims against assets—that is, existing debts and obligations. Businesses of all sizes usually borrow money and purchase merchandise on credit. These economic activities result in payables of various sorts:
• Campus Pizza, for instance, purchases cheese, sausage, flour, and beverages on credit from suppliers. These obligations are called accounts payable.
• Campus Pizza also has a note payable to First National Bank for the money borrowed to purchase the delivery truck.
• Campus Pizza may also have salaries and wages payable to employees and sales and real estate taxes payable to the local government.
All of these persons or entities to whom Campus Pizza owes money are its creditors. Creditors may legally force the liquidation of a business that does not pay its debts. In that case, the law requires that creditor claims be paid before ownership claims.
3.3 Owner’s Equity
The ownership claim on total assets is owner’s equity. It is equal to total assets minus total liabilities. Here is why: The assets of a business are claimed by either creditors or owners. To find out what belongs to owners, we subtract the creditors’ claims (the liabilities) from assets. The remainder is the owner’s claim on the assets—the owner’s equity. Since the claims of creditors must be paid before ownership claims, owner’s equity is often referred to as residual equity.
The Accounting Equation - Conceptual Analogy
Accounting Equation - Technical Explanation
Recommended text/reading:
- Sangster, A., & Wood, F. (2019). Business accounting volume 2 (14th ed.). Pearson.
- Sangster, A., & Wood, F. (2018). Business accounting volume 1 (14th ed.). Pearson.
- Weagant, J.J., Kimmel, P.D., & Keiso, D.E. (2018). Accounting principles (12th ed.). Wiley. (for this ebook you need to join this channel >> accounting <<
ENJOY LEARNING ACCOUNTING !!!
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Sanisah Hanim Jiman
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