Basic Accounting Equation
Two basic elements of a business is what it owns and what it
owes.
Assets
Assets are resources a business owns. The business uses
assets to carry out production activities. Asset possess the capacity to
provide future benefits or services. In a business these future services or
benefits eventually results in future inflows.
Liabilities
These are claims against assets i.e. existing debt and
obligations. All businesses usually borrow money and purchase merchandise on
credit. Every economic activities performed result in payables of various
sorts:
Account payable: purchase of goods on credit from suppliers.
Note payable: it includes money borrowed from the banks.
Salaries and wages payable to employees sales and real estate taxes payable to the local government.
All these people are creditors to whom business owes money.
Creditor’s claims are paid before ownership claims.
Stockholder’s equity
The ownership claim on a corporation’s total assets is
stockholder’s equity. Stockholder’s equity is equal to liabilities (creditor’s
claims) subtracted from the assets.
Stockholder’s equity is divided into common stock and
retained earnings.
Stockholder’s equity = common stock+ retained earnings
Common stock
Corporation sell shares of stocks (a piece of business) to
investors in return for funds or money. The total amount paid by investors/
shareholders for the shares they purchase.
Retained earnings
Retained earnings are calculated when expenses and dividends
are subtracted from revenues.
Retained earnings = Revenues – Expenses - Dividends
Revenues
Revenues are money earned by sale of merchandise, performing
services, renting out property, and lending money. Revenues increases assets.
Sources of revenues are sales, fees, service revenue, and interest on lending.
Expense
Expense are the cost of assets consumed or services used in
the process of earning revenue.
When expense increases stockholder’s equity decreases.
Dividend
Net income (net profit) increases the net assets which are
then distributed to stockholders. Distribution of cash or other assets to
stockholder is dividend. Dividends reduces retained earnings.
Corporation first determines revenue and expenses. Then the
corporation decides upon the net income (net profit) or net loss incurred. If the
corporation incurs net income, and it has no better use for that income then
the corporation decides to distribute a dividend to its owners (stockholders).
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