Accounting: The Language of Business (Part 7)

“Proper accounting is like engineering. You need a margin of safety. Thank God we don’t design bridges and airplanes the way we do accounting.” —Charlie Munger

Introduction to Accounting and Business

(Part F)

by

Charles Lamson

Assets, Liabilities, and Owner's Equity

The resources owned by a business are its assets. Examples of assets include cash, land, buildings, and equipment. The rights or claims to the properties are normally divided into two principal types: (1) the rights of creditors and (2) the rights of owners. The rights of creditors represent debts of the business and are called liabilities. The rights of the owners are called owner's equity. The relationship between the two may be stated in the form of an equation, as follows:

Assets = Liabilities + Owner's Equity

This equation is known as the accounting equation. It is usual to place liabilities before owner's equity in the accounting equation because creditors have first right to the assets. The claim of the owners is sometimes given greater emphasis by transposing liabilities to the other side of the equation, which yields:

Assets - Liabilities = Owner's Equity

To illustrate, if the assets owned by a business amount to $100,000 and the liabilities amount to $30,000, the owner's equity is equal to $70,000 as shown below.

Business Transactions and the Accounting Equation

Paying a monthly telephone bill of $168 affects a business's financial condition because it now has less cash on hand. Such an economic event or condition that directly changes an entity's financial condition or directly affects its results of operations is a business transaction. For example, purchasing land for $50,000 is a business transaction. In contrast, a change in a business's credit rating does not directly affect cash or any other element of its financial condition.

All business transactions can be stated in terms of changes in the elements of the accounting equation. You will see how business transactions affect the accounting equation by studying some typical transactions. As a basis for illustration, we will use a business organized by Chris Clark.

Assume that on November 1st, 2022, Chris Clark begins a business that will be known as NetSolutions. The first phase of Chris's business plan is to operate NetSolutions as a service business that provides assistance to individuals and small businesses in developing web pages and in configuring and installing applications software. Chris expects this initial phase of the business to last one to two years. During this period, Chris will gather information on the software and hardware needs of customers. During the second phase of the business plan, Chris plans to expand NetSolutions into a personalized retailer of software and hardware for individuals and small businesses. 

Each transaction or group of similar transactions during NetSolutions' first month of operations is described in the following paragraphs. The effect of each transaction on the accounting equation is then shown.

Transaction a Chris Clarke deposits $25,000 in a bank account in the name of NetSolutions. The effect of this transaction is to increase the asset cash (on the left side of the equation) by $25,000. To balance the equation, the owner's equity (on the right side of the equation) is increased by the same amount. The equity of the owner is referred to by using the owner's name and "Capital," such as "Chris Clark, Capital." The effect of this transaction on NetSolution's accounting equation is shown below.

Note that since Chris Clark is the sole owner, NetSolutions is a proprietorship. Note, too, that the accounting equation shown above relates only to the business, NetSolutions. Under the business entity concept, Chris Clark's personal assets, such as a home or personal bank account, and personal liabilities are excluded from the equation.

Transaction b If you purchased a book by paying cash, you enter into a transaction in which you exchanged one asset for another. That is, you exchanged the cash for the book. Businesses often enter into similar transactions. NetSolutions, for example, exchanged $20,000 cash for land. The land is located in a new business park with convenient access to transportation facilities. Chris Clark plans to rent office space and equipment during the first phase of the business plan. During the second phase, Chris plans to build an office and warehouse on the land.

The purchase of the land changes the makeup of the assets but does not change the total assets. The items in the equation prior to this transaction and the effect of the transaction or shown next, as well as the new amount, or balances, of the items.

Transaction c You have probably used a credit card at one time or another to buy clothing or other merchandise. In this type of transaction, you received clothing for a promise to pay your credit card bill in the future. That is, you received an asset and incurred a liability to pay a future bill. During the month, NetSolutions entered into a similar transaction, buying supplies for $1,350 and agreeing to pay the supplier in the near future. This type of transaction is called a purchase on account. The liability created is called an account payable. Items such as supplies that will be used in the business in the future are called the prepaid expenses, which are assets. The effect of this transaction is to increase assets and liabilities by $1,350 as follows:

Transaction d You may have earned money by painting houses. If so, you received the money for rendering services to a customer. Likewise, a business earns money by selling goods or services to its customers. This amount is called revenue.

During its first months of operations, NetSolutions provided services to customers, earning fees of $7,500 and receiving the amount in cash. The receipt of cash increases NetSolution's assets and also increases Chris Clark's equity in the business. Thus, this transaction increased cash and the owner's equity by $7,500, as shown here.

Special terms may be used to describe certain kinds of revenue, such as sales for the sale of merchandise. Revenue from providing services is called fees earned. For example, a physician would record fees earned for services to patients. Other examples include rent revenue (money received for rent) and interest revenue (money received for interest).

Instead of requiring the payment of cash at the time services are provided or goods are sold, a business may accept payment at a later date. Such revenues are called fees on account or sales on account. In such cases, the firm has an account receivable, which is a claim against the customer. An account receivable is an asset, and the revenue is earned as if cash had been received. When customers pay their accounts, there is an exchange of one asset for another. Cash increases, while accounts receivable decreases.

Transaction e If you painted houses to earn money, you probably used your own ladders and brushes. NetSolutions also spent cash or used up other assets in earning revenue. The amounts used in this process of earning revenue are called expenses. Expenses include supplies used, wages of employees, and other assets and services used in operating the business.

For NetSolutions, the expenses paid during the month were as follows: wages, $2,125; rent, $800; utilities, $450; and miscellaneous, $275. Miscellaneous expenses include small amounts paid for such items as postage, coffee, and magazine subscriptions. The effect of this group of transactions is the opposite of the effect of revenues. These transactions reduce cash and owner's equity, as shown here.

Businesses usually record each revenue and expense transaction separately as it occurs. However, to simplify this illustration, we have summarized NetSolution's revenues and expenses for the month in transactions (d) and (e).

Transaction f When you pay your monthly credit card bill, you decrease the cash in your checking account and also decrease the amount you owe to the credit card company. Likewise, when NetSolutions pays $950 to creditors during the month, it reduces both assets and liabilities, as shown below.

You should note that paying an amount on account is different from paying an amount for an expense. The payment of an expense reduces owner's equity, as Illustrated in transaction (e). Paying an amount on account reduces the amount owed on a liability.

Transaction g At the end of the month, the cost of the supplies on hand (not yet used) is $550. The remainder of the supplies ($1,350 - $550) was used in the operations of the business and is treated as an expense. This decrease of $800 in supplies and owner's equity is shown as follows:

Transaction h At the end of the month, Chris Clarke withdraws $2,000 in cash from the business for personal use. This transaction is the exact opposite of an investment in the business by the owner. Cash and owner's equity are decreased. The cash payment is not a business expense but a withdrawal of a part of the owner's equity. The effect of the $2,000 withdrawal is shown as follows:

You should be careful not to confuse withdrawals by the owner with expenses. Withdrawals do not represent assets or services used in the process of earning revenues. The owner's equity decrease from the withdrawals is listed in the equation under capital. This is because withdrawals are considered a distribution of capital to the owner.

Summary The transactions of NetSolutions are summarized as follows. They are identified by letter, and the balance of each item is shown after each transaction.

In reviewing the preceding summary, you should note the following, which apply to all types of businesses:

1. The effect of every transaction is an increase or a decrease in one or more of the accounting equation elements.

2.  The two sides of the accounting equation are always equal.

3.  The owner's equity is increased by amounts invested by the owner and is decreased by withdrawals by the owner. In addition, the owner's equity is increased by revenues and is decreased by expenses. The effects of these four types of transactions on owner's equity are illustrated in Exhibit 5. 

EXHIBIT 5

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