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BASIC ACCOUNTING EQUATION/ ASSETS, LIABILITY, STOCKHOLDER'S EQUITY and its Components

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).

The basic accounting equation states that assets is equal to the sum of liabilities and stockholder’s equity.

Assets = liabilities + stockholder’s equity


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