accounting equation and Basic Elements of Financial Position

Classification of accounts

( Basic Elements of Financial Position )

Basic Concepts of  Financial Accounting

Two types of accounts: The financial condition or position of a business enterprise is represent­ed by the relationship of assets to liabilities and capital.  

First: Accounts belong to the Balance Sheet and represent the basic accounting equation. 

These accounts are:

1. Assets       2. Liabilities          3.Owners Equity 

These three basic elements are connected by a fundamental rela­tionship called  the accounting equation. This equation expresses the equality of the assets on one side with the claims of the creditors and owners on the other side: 

( Remember : Assets must be equal to the sum of Liabilities and Owners equity) 

It should balance after every transaction. 

This relationship - which is called the accounting identity or basic accounting equation, is expressed in equation form as:

A = L + E
Assets = Liabilities + Owners Equity
 

where A = Total assets, L = Total liabilities, and E = Equity. Because creditor claims are paid before equity claims if a healthcare organization is liquidated - liabilities are shown before equity both on the balance sheet and in the basic accounting equation.

Note that the accounting identity can be rearranged as follows:

E = A − L

This format reinforces the concept that equity represents a residual claim against the total assets of the business and the fact that equity can be negative.
If a business writes down (decreases) the value of its assets, its liabilities are unaffected because these amounts are still owed to creditors and others. If total assets are written down so much that their value drops below that of total liabilities - then the equity reported on the balance sheet becomes a negative
amount.

The basic accounting equation is simply an algebraic form of the balance sheet.

1. Assets
  Assets are the cash and non cash resources owned by a business and have economic value, and
  used in carrying out future services or benefits to the entity using them.

Classification of assets:
-  Current assets
   Current assets are cash and other types of assets that are reasonably expected
   to be converted into cash, sold, or used up during the normal operating year.

Examples of current assets include:
  Cash, Bank, Goods, Accounts Receivable, Prepaid expenses, Inventory and
  Marketable securities etc.

-  Fixed assets
   Fixed assets are those assets that are used in the normal operations of the
  entity to produce and sell goods or perform services for customers.  Fixed assets
  are expected to service for a number of years are not for re-sell.

Examples of fixed assets include:
  Lands, cars, buildings, equipments, and furniture etc.

-  Intangible assets

  Intangible assets are those assets that have no physical substance but they
  are expected to provide benefits to the entity for several years.

Examples of intangible assets include:
  Patents, trade marks, copyrights, goodwill, franchise fees, and trade name.




2.  Liabilities  
Liabilities are claims against assets, Amounts owed to outsiders, such as notes payable, accounts
payable, bonds payable.
 
Classification of Liabilities: 
-  Short-term Liabilities   
   Short-term liabilities are obligations of the entity that are reasonably
   expected to be paid or settled in the next year or the normal operating cycle.

Examples of short-term liabilities include:
  Short-term notes payable, accounts payable, salaries and wages payable and
  other types of accrued liabilities for services received but not yet paid for.

-  Long-term Liabilities 
   Long-term liabilities are those obligations that do not require payment within
   the next year or the normal operating cycle.  In other words, liabilities not classified
   as short-term are reported in the Long-term liabilities section of the balance sheet.

Examples of long-term liabilities include:
  Loan, bonds, and any other obligation that mature in a period more than one
  year beyond the balance sheet date is reported as long-term.


3.  Owner’s Equity 
  Owner’s equity represents the owner’s interest in the assets of the entity.
  It is equal to total assets minus total liabilities, also known as Capital.

There are two main sources of owner’s equity:
(١)  Amounts contributed by  the owner (Capital)
(٢) Amount earned by the entity but not yet taken by the owner.


Second:  Accounts belong to the Income Statement and involve in the determination of
net income or net loss of a business entity for a specific period of time. These accounts
are:

1. Expenses                         2. Revenues

1.  Expenses
  Expenses are the cost of assets consumed or services used in the process of earning revenue in other words; expenses are outflows or other uses of assets resulting from the sale or delivery of goods or the provision of services by the entity during specific time period.  

Examples of expenses include:  
Utility expenses (electric and water), telephone bill expense, rent expense, wages and salaries expense and depreciation expense etc. 

2.  Revenues
  Revenues are cash in-flow result from the sale of goods or the rendered of services.

To illustrate the affect (increase & decrease) of a financial transaction on the above classified accounts, study the following chart:
 

Basic Accounting Equation

  You have already learned the basic accounting equation. However, in the above illustration note the expansion of the basic accounting equation to show the accounts that comprise owner’s equity besides expenses and revenues with their effect (increase, decrease) of the debit /credit rules on each type of account.


To student
  Please study the above diagram carefully; it will help you understand the fundamentals of the double-entry system.

------------------------------- Example -------------------------------

During the month of January, Mr. Tom Banana, lawyer,
1.  Invested $6,000 to open his law practice.
2.  Bought office supplies on account, $500.
3.  Received $3,000 in fees earned during the month.
4.  Paid $100 on the account for the office supplies.
5.  Withdrew $500 for personal use.

These transactions could be analyzed and recorded as follows: 

                                  Assets  =        Liabilities         +           Capital 

                                   Cash                                              Tom, Capital 

                        1.  + $6,000  =                                              + $6,000

                               Supplies         Accounts Payable 

                        2.  + $500     =          + $500 

                                  Cash 

                       3.   + $3,000  =                                              Fees Income 

                                                                                              + $3,000 

                                  Cash

                       4.    − $100     =  Accounts Payable 

                                                       − $100

                                  Cash 

                       5.    − $500     =                                               Tom, Capital 

                                                                                                − $500 

Notice that for every transaction, two entries are made. After every trans­action, the accounting equation remains balanced.


Notice that for Preparing a new equation A = L + C after each trans­action would be cumbersome and costly, especially when there are a great many transactions in an ac­counting period. Also, information for a specific item such as cash would be lost as successive transactions were recorded. This information could be obtained by going back and summarizing the trans­actions, but that would be very time-consuming. Thus we begin with the account, Account which records the accounting transactions so you must know what the accounting transactions and how to post accounting transaction (Double-entry bookkeeping system)


Quiz -Tested yourself

1.  The accounting equation is _______ = ________ + ________.
2.  Items owned by a business that have monetary value are ______.
3.  _________ is the interest of the owners in a business.
4.  Money owed to an outsider is a(n) _________.
5.  The difference between assets and liabilities is ___________.
6.  An investment in the business increases _______ and ________.
7.  To purchase “on account” is to create a ___________.



Answers: 1. Assets, liabilities, capital; 2. Assets; 3. Capital; 4. Liability;
5. Capital; 6. Assets, capital; 7. Liability

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