Basic Concepts of Financial Accounting

The Basic Accounting Equation

•Financial accounting is based upon the accounting equation.

Assets = Liabilities + Owners’ Equity

–This is a mathematical equation which must balance.  If assets total $300 and liabilities total $200, then owners’ equity must be $100

The balance sheet is an expanded expression of the accounting equation

Assets

•Assets are valuable resources that are owned by a firm. 

They represent probable future economic benefits and arise as the result of past transactions or events.

Liabilities

•Liabilities are present obligations of the firm. 

They are probable future sacrifices of economic benefits which arise as the result of past transactions or events.

Owners’ Equity

Owners’ equity represents the owners’ residual interest in the assets of the business. 

Residual interest is another name for owners’ equity. 

Owners may make a direct investment in the business or operate at a profit and leave the profit in the business. 

•Yet another name for owners’ equity is net assets.

–Indicates that owners’ equity results when liabilities are subtracted from assets.

Owners’ Equity = Assets – Liabilities

The Basic Accounting Equation

•Both liabilities and owners’ equity represent claims on the assets of a business.

•Liabilities are claims by people external to the business.

•Owners’ equity is a claim by the owners.

Analyzing Transactions

•Transaction analysis is the central component of the financial accounting process.  Remember that every transaction must keep the accounting equation in balance.

The Entity Assumption

•The entity assumption dictates that business records must be kept separate and distinct from the personal records of the owners.

–If a person owns more than one business, then each business must have its own set of records.

A transaction may do one of several things:

•It may increase both the asset side and the liabilities and owners’ equity side.

•It may decrease both the asset side and the liabilities and owners’ equity side.