Accounting Equation

Describe the relationships expressed in the accounting equation.

The resources that a business uses to produce earnings are called assets. Examples of assets include land, buildings, equipment, materials, and supplies. Assets result from historical events. For example, if a business owns a truck that it purchased in a past transaction, the truck is an asset of the business. A truck that a business plans to purchase in the future, however, is not an asset of that business, no matter how certain the future purchase might be.

The assets of a business belong to the resource providers (creditors and investors). These resource providers have claimsOwners' and creditors' interests in a business's assets. on the assets. The relationship between the assets and the providers’ claims is described by the accounting equationExpression of the relationship between the assets and the claims on those assets.:

Creditor claims are called liabilitiesObligations of a business to relinquish assets, provide services, or accept other obligations. and investor claims are called equityPortion of assets remaining after the creditors' claims have been satisfied (i.e., Assets Liabilities Equity); also called residual interest or net assets.. Substituting these terms into the accounting equation produces the following expanded form:

Liabilities can also be viewed as future obligations of the enterprise. To settle the obligations, the business will probably either relinquish some of its assets (e.g., pay off its debts with cash), provide services to its creditors (e.g., work off its debts), or accept other obligations (e.g., trade short-term debt for long-term debt).

As indicated by the accounting equation, the amount of total assets is equal to the total of the liabilities plus the equity. To illustrate, assume that Hagan Company has assets of $500, liabilities of $200, and equity of $300. These amounts appear in the accounting equation as follows:

The claims side of the accounting equation (liabilities plus equity) may also be viewed as listing the sources of the assets. For example, when a bank loans assets (money) to a business, it establishes a claim to have those assets returned at some future date. Liabilities can therefore be viewed as sources of assets.

Equity can also be viewed as a source of assets. In fact, equity represents two distinct sources of assets. First, businesses typically acquire assets from their owners (investors). Many businesses issue common stockBasic class of corporate stock that carries no preferences as to claims on assets or dividends; certificates that evidence ownership in a company.³ certificates as receipts to acknowledge assets received from owners. The owners of such businesses are often called stockholdersOwners of a corporation., and the ownership interest in the business is called stockholders’ equityStockholders' equity represents the portion of the assets that is owned by the stockholders..

Don Farrall/Getty Images

Second, businesses usually obtain assets through their earnings activities (the business acquires assets by working for them). Assets a business has earned can either be distributed to the owners or kept in the business. The portion of assets that has been provided by earnings activities and not returned as dividends is called retained earningsEquity account that includes all earnings retained in the business since inception (revenues minus expenses and distributions for all accounting periods).. Since stockholders own the business, they are entitled to assets acquired through its earnings activities. Retained earnings is therefore a component of stockholders’ equity. Further expansion of the accounting equation can show the three sources of assets (liabilities, common stock, and retained earnings):

Check Yourself 1.2

Gupta Company has $250,000 of assets, $60,000 of liabilities, and $90,000 of common stock. What percentage of the assets was provided by retained earnings?

Answer

First, using algebra, determine the dollar amount of retained earnings:
Assets = Liabilities + Common stock + Retained earnings
Retained earnings = Assets – Liabilities – Common stock
Retained earnings = $250,000 – $60,000 – $90,000
Retained earnings = $100,000
Second, determine the percentage:
Percentage of assets provided by retained earnings = Retained earnings/Total assets
Percentage of assets provided by retained earnings = $100,000/$250,000 = 40%

Exercises 1-6A, 1-7A, 1-8A, 1-9A, 1-10A, 1-12A, 1-13A, 1-15A, 1-18A, 1-19A, 1-20A, 1-6B, 1-7B, 1-8B, 1-10B, 1-12B, 1-13B, 1-15B, 1-18B, 1-19B, 1-20B

Problems 1-30A, 1-32A, 1-34A, 1-30B, 1-32B, 1-34B

³ This presentation assumes the business is organized as a corporation. Other forms of business organization include proprietorships and partnerships. The treatment of equity for these types of businesses is slightly different from that of corporations. A detailed discussion of the differences is included in a later chapter of the text.

Log In
You must be a registered user to view the premium content in this website. If you already have a username and password, enter it below. If your textbook came with a card and this is your first visit to this site, you can use your registration code to register, or purchase access.
Username:
Password:
	Forgot your password?

Site Preferences	(Log out)

		Send mail as:

TA email:
Other email:

"Floating" navigation?
Drawer speed:

Notes		(What is this?)

Add a note
1.	(optional) Enter a note here:
2.	(optional) Select some text on the page (or do this before you open the "Notes" drawer).
3.	Highlighter Color:
4.

Search
Search for:
Search in:

Home > Chapter 1 > Accounting Equation

	Course-wide Content
		Glossary Net Tutor Spreadsheet Tips Study Guide Sample Annual Report Projects CYGL Video Guide Text Updates

	Quizzes
		Multiple Choice Quiz
	More Resources
		Check Figures Excel Templates TopicTackler Plus Review Problems Flashcards PowerPoint Presentations Narrated Slides iPod Content
	eBook
		Chapter Opener Role of Accounting in ... Reporting Entities Elements of Financial ... Accounting Equation Recording Business Eve... Historical Cost and Re... Recap: Types of Transa... Summary of Transactions Preparing Financial St... The Horizontal Financi... Careers in Accounting Importance of Ethics Real-World Financial R... A Look Back A Look Forward Self-Study Review Prob... Key Terms Questions Exercises-Series A Problems-Series A Exercises-Series B Problems-Series B Analyze Think Communic... Comprehensive Problem

	Instructor Resources
		IM Intro Text Updates Transition Notes Text Exhibits Using the IRCD Using the OLC Using Topic Tackler Plus Using CYGL Using ALEKS PageOut MH Homework Manager CPS Download CYGL Solutions Annual Report Project ...

	Course-wide Content
		Glossary Net Tutor Spreadsheet Tips Study Guide Sample Annual Report Projects CYGL Video Guide Text Updates

	Instructor Resources
		Instructors Manual Solutions Manual Solutions to Excel
	Quizzes
		Multiple Choice Quiz
	More Resources
		Check Figures Excel Templates TopicTackler Plus Review Problems Flashcards PowerPoint Presentations Narrated Slides iPod Content
	eBook
		Chapter Opener Role of Accounting in ... Reporting Entities Elements of Financial ... Accounting Equation Recording Business Eve... Historical Cost and Re... Recap: Types of Transa... Summary of Transactions Preparing Financial St... The Horizontal Financi... Careers in Accounting Importance of Ethics Real-World Financial R... A Look Back A Look Forward Self-Study Review Prob... Key Terms Questions Exercises-Series A Problems-Series A Exercises-Series B Problems-Series B Analyze Think Communic... Comprehensive Problem