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The resources that a business uses or will use to produce earnings are called assetsEconomic resource used by a business for the production of revenue.. Examples of assets include land, buildings, equipment, materials, and supplies. In order to recognize assets in the financial statements, generally accepted accounting principles (GAAP) require that the assets must result from historical events. For example, if a business owns a truck that was 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 equation:Expression of the relationship between the assets and the claims on those assets.
Since the creditors have first claim on the assets, claims of the investors (owners) are described as a residual interestPortion of the assets remaining after the creditors’ claims have been satisfied (Assets - Liabilities - Residual Interest); also called equity or net assets. This means that in the case of a business liquidation, the owners receive whatever assets are left after the debts to creditors have been paid. The following expanded accounting equation recognizes the relationship among the assets, the creditors’ claims (called liabilitiesObligations of a business to relinquish assets, provide services, or accept other obligations), and the investors’ claims (called equityPortion of assets remaining after the creditors’ claims have been satisfied (i.e., Assets - Liabilities - Equity); also called residual interest or net assets.
Liabilities can also be viewed as obligations of the enterprise. In the future, 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). Algebraically, the amount of total assets minus total liabilities equals the equity. Since equity equals the net difference between assets and liabilities, equity is also called net assetsPortion of the assets remaining after the creditors’ claims have been satisfied (i.e., Assets - Liabilities - Net assets); also called equity or residual interest. Equity, net assets, and residual interest are synonyms for the ownership interest in a business. 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:
Using algebra, the equity (net assets or residual interest) can be computed as follows:
The claims side of the accounting equation (liabilities plus equity) can be viewed as listing the sources of assets. For example, consider the liability created when a business borrows assets (money) from a bank. The bank loan represents the source of the assets (money), and the bank has a claim for the future return of those 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 company2 certificates 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.. 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 is named retained earningsIncrease in equity that results from the retention of assets obtained through the operation of the business.. 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):
2 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 Chapter 11. |
