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The accounting equation denotes the basic elements of what the business owns and what it owes. The resources that will yield probable future benefits are the assets, and those rights or claims are the liabilities and owners’ equity.
Stated simply:
Assets = Liabilities + Owners’ Equity
This relationship is the basic accounting equation. Assets must equal the sum of liabilities and owners’ equity. If a business is liquidated, the liabilities are paid first and then the equity. This equation holds true for any business of any size. If you are familiar with debits and credits, assets increase on the debit side and decrease on the credit side. Remember that debit is the left side of an account. Liabilities and owners’ equity increase on the credit side and decrease on the debit side. Credit is the right side of an account.
When the owner invests in the business, assets increase and owners’ equity increases; remember that the equation will always balance. If the owner draws cash or other assets, then it decreases owners’ equity and the related asset.
The Operations:
Revenues and expenses are the operational side of the business.
Revenues are the gross increase in owner’s equity resulting from business operations, and expenses are the cost of assets used in the process of earning revenues.
Stated simply:
Revenues – Expenses = Gain or Loss in Operations
The gain or loss becomes the result of operations and directly affects owners’ equity. Thus we can say that the owners’ equity equation is:
Owners’ equity = investment by owner – drawings by owner + revenues – expenses
Financial Statements:
These are the basic elements of accounting; the assets, liabilities, and owners’ equity become the balance sheet, and the revenues and expenses with the results become the income statement or profit and loss statement.
At the end, businesses prepare four financial statements:
- Income Statement—presents the revenues and expenses with corresponding results, either gain or loss.
- Balance Sheet Statement—reports assets, liabilities, and owner’s equity at a specific date.
- Owners’ Equity Statement—reports the changes in owners’ equity for a period of time.
- Statement of Cash Flows—report about the inflows and outflows of cash for a specific period.
There is a direct connection between all four statements. Thus, if you check into the accounts, you will notice its relationship. Transactions will affect both balance sheet accounts and income statement accounts; at the end of the period, the income statement will result in a gain or loss that will be applied to the owners’ equity side of the equation. Any owners’ drawings will decrease the owners’ equity side and the related asset on the assets side. The balance sheet reports on the asset side the cash account, and at the end of the period we prepare a statement of cash flows that explains the sources and uses of cash by segregating it into operating, investing, and financing activities.
In Conclusion:
The foundation for understanding the accounting elements’ relationship is the accounting equation. Do not confuse the simplicity of the equation; you must learn it very well and apply it correctly if you want to pursue a career in accounting. In the end, the purpose of balancing the accounts and showing each group correctly is the presentation of the financial statements.
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