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The basic features of the accounting model we use today trace their roots back over 500 years. Luca Pacioli, a Renaissance era monk, developed a method for tracking the success or failure of trading ventures. The foundation of that system continues to serve the modern business world as well, and is the entrenched cornerstone of even the most elaborate computerized systems. The nucleous 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 into the claims of creditors and owners (i.e. liabilities and owners' equity). This give rise to the fundamental accounting equation:
ASSETS: Assets are the economic resources of the entity, and include such items as cash, accounts receivable (amounts owed to a firm by its customers), inventories, land, buildings, 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 loands, extensions of credit, and other obligations arising in the course of the business.
OWNERS' EQUITY: Owners' equity is the owner's "interest" in the business. It is sometime called net assets, because it is equivalent to assets minus liabilities for a particular business. Who are the "owners"? The answer to this question depends on the legal for of 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 account for each partner. Finally, a corporation is a very common entity form, with its ownership interest being represented by divisible units of ownership called shares of stock. These shares are easily transferable, with the current holder(s) of the stock being the owners.
BALANCE SHEET
The fundamental accounting equation is the backbone of the accounting and reporting system. It is central to understanding a key financial statement known as the balance sheet (sometimes called the statement of financial position). The following illustration for America 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 is divided into the $120,000 originally invested in America Corporation by stockholders (i.e., capital stock), and the other $600,000 that was earned (and retained) by successful business performance over the life of the company.
| AMERICA CORPORATION Balance Sheet December 31, 2008 |
||||
| Assets |
|
Liabilities |
|
|
|
Cash |
$25,000 |
Accounts
Payable |
$50,000
|
|
|
Accounts
Receivable |
50,000 |
Loans Payable |
125,000 |
|
|
Inventories |
35,000 |
Total Liabilities |
$175,000 |
|
|
Land |
125,000 |
Stock Holders Equity |
||
|
Buildings |
400,000 |
Capital Stock |
$120,000 |
|
|
Equipment |
250,000 |
Retained
Earnings |
600,000 |
|
|
Other Assets |
10,000 |
Total Stockholders' Equity |
$720,000 |
|
| Total
Assets |
$895,000 |
Total Liabilities and Equity |
$895,000 |
|
|
ASSETS=
$895,000
|
LIABILITIES
$175,000
|
+ |
EQUITY
$720,000
|
|