Reading: Lesson 3 - The Accounting Equation and the Description of its Components

There are two basic elements that a business is made up of.  1.)  What it owns.  2.) What it owes. Assets are resources that a business owns.  Liabilities are the obligations that the business owes.  

These two elements are part of the basic accounting equation. 

Part of the equation is the Owner's equity.  The owner's investment into the business, their withdrawals of assets from the business and the business's income and losses make up the owner's equity.  

ASSETS

Assets are made up of cash, land, buildings, vehicles, furniture, and fixtures, accumulated depreciation (a contra-asset account), short and long-term investments, accounts receivable, allowance for doubtful accounts (a contra-asset account), accrued revenues/receivables, inventory, prepaid expenses, and supplies.    

A brief description of assets are:

Cash items include currency, coins, checking account balances, petty cash funds, and customer's checks that have not been deposited.

Land, buildings, vehicles, and furniture and fixtures are documented based on the cost of the item.  These type of assets are depreciated based on their useful lives, except for land.  Land lasts indefinitely; therefore, the cost is not depreciated.  

Accumulated depreciation (contra-asset account) is a way to determine the value of an asset over time. This value is noted as book value.  Example:  Vehicle costs $20,000 less accumulated depreciation of $8,000 equals $12,000 the book value of the vehicle.  Depreciation is simply an allocation technique derived by the IRS.  The book value is not the market value.

What is the difference between book and market value?  The book value is simply the cost and the adjustments such as depreciation of an asset.  The market value is the price one would receive if they were to sell the asset.  

Short-term investments are investments that will mature in less than one year.  Certificates of deposit, bonds, notes, common or preferred stock of another corporation that can be easily sold are all examples of short-term investments.  

Long-term investments are investments that are held longer than one year.  Examples included investments in common or preferred stock and bonds of another company. Monies that are restricted for use because of a building project. 

Accounts Receivable is the amount of merchandise sold on account to a customer.   The amount of the sale is recorded at the time of the credit sale, not when the funds are received.  

Allowance for Doubtful Accounts is an amount in the accounts receivable that is uncollected from customers.  This is another contra-asset account.  

Accrued Revenues/Receivables are the amounts that represent goods or services that have been delivered to the customer and the invoice has not been generated yet.   

Inventory represents the cost of the purchasing or manufacturing of goods.  These goods have not been sold at this point.  

Prepaid expenses are future expenses that have been paid in advance. The most common is Insurance.  This asset is recorded as an expense once it is used for a certain period.  

Supplies are assets on hand for use.  They are office supplies, manufacturing supplies, packaging supplies or other supplies that are available for use. 

What is a Contra-asset account?  This is an asset account reduces the balance of a normal asset account.  It carries an opposite balance (credit) or normal assets balances.  The net amount of the asset account and the contra-asset account is considered the book value of the asset. The most common are Accumulated Depreciation and Allowance for Doubtful Accounts.   

  LIABILITIES 

Liabilities are the amounts that a business owes. Examples include the following:  Short-term loans payable, current portion of Long-term debt accounts payable, accrued expenses, unearned or deferred revenues, installment loans payable, and mortgage loans payable.  Creditors are the entities that a business owes liabilities to. 

Short-term Loan payables are loans payable in less than one year of the date of the balance sheet.  

Current portion of Long-term Debt accounts represents the principal amount of the long-term debt that will be due in less than one year of the date of the balance sheet.  

Accrued Expenses are amounts owed by the business but is not recorded.  This could include salaries and wages due to employees, employee benefits and vendor invoices that have not been processed.  

Unearned or Deferred Revenues are monies received for services that have not been earned. A retainer fee for an attorney considered unearned revenue.  The retainer cannot be recorded as earnings until the attorney actually earns the money.

Installment Loans Payable are loans that have a series of payments and the principal amount is due in less than one year of the date of the balance sheet.  A vehicle loan for a four-year period is a good example.  

Mortgage Loans Payable is a loan for real estate that is backed up by collateral.  Only the amount due in less than a year of the date of the balance sheet is recorded in this account.  

OWNER'S EQUITY

Assets belong to either the owners or the creditors.  Once the creditor's claims have been subtracted from the assets, the remainder belongs to the owner or owners.  Creditor's claims on assets are always paid before the owner's claims.  

During the course of business operations, the Owner's Equity will increase or decrease.  It is either increased by revenues or owner's investments.  It can be decreased by drawings or expenses.  

When owners make an investment in the business, the assets are recorded in the Owner's Capital account.  Revenues sources are sales, fees services, commissions, interest, dividends, royalties, and rent.  

Equity is decreased when owners take a withdrawal of cash or other assets from the business.  This account is called the Drawing account. They are further reduced by expenses in the course of business operations.  

The accounting equation is expanded with the owner's capital and drawing accounts and revenue and expenses giving us the Expanded Accounting Equation.