FUNDAMENTAL OF ACCOUNTING

The basic features of the
accounting model we use today
trace their roots back over 500
years. Luca Pacioli, a
Renaissance era monk,
developed a method for tracking
the success or failure of trading
ventures. The foundation of that
system continues to serve the
modern business world well, and
is the entrenched cornerstone of
even the most elaborate
computerized systems. The
nucleus of that system is the
notion that a business entity can
be described as a collection of
assets and the corresponding
claims against those assets. The
claims can be divided into the
claims of creditors and owners
(i.e., liabilities and owners'
equity). This gives rise to the
fundamental accounting
equation:
Assets = Liabilities + Owners'
Equity
ASSETS: Assets are the economic
resources of the entity, and
include such items as cash,
accounts receivable (amounts
owed to a firm by its customers),
inventories, land, buildings,
equipment, and even intangible
assets like patents and other
legal rights and claims. Assets
are presumed to entail probable
future economic benefits to the
owner.
LIABILITIES: Liabilities are
amounts owed to others relating
to loans, extensions of credit,
and other obligations arising in
the course of business.
OWNERS' EQUITY: Owners'
equity is the owner's "interest" in
the business. It is sometimes
called net assets, because it is
equivalent to assets minus
liabilities for a particular
business. Who are the
"owners?" The answer to this
question depends on the legal
form of the entity; examples of
entity types include sole
proprietorships, partnerships,
and corporations. A sole
proprietorship is a business
owned by one person, and its
equity would typically consist of
a single owner's capital account.
Conversely, a partnership is a
business owned by more than
one person, with its equity
consisting of a separate capital
account for each partner.
Finally, a corporation is a very
common entity form, with its
ownership interest being
represented by divisible units of
ownership called shares of
stock. These shares are easily
transferable, with the current
holder(s) of the stock being the
owners. The total owners' equity
(i.e., "stockholders' equity") of a
corporation usually consists of
several amounts, generally
corresponding to the owner
investments in the capital stock
(by shareholders) and additional
amounts generated through
earnings that have not been paid
out to shareholders as dividends
( dividends are distributions to
shareholders as a return on their
investment). Earnings give rise to
increases in " retained earnings,"
while dividends (and losses)
cause decreases.
BALANCE SHEET: The
fundamental accounting
equation is the backbone of the
accounting and reporting
system. It is central to
understanding a key financial
statement known as the balance
sheet (sometimes called the
statement of financial position).
The following illustration for
Edelweiss Corporation shows a
variety of assets that are
reported at a total of $895,000.
Creditors are owed $175,000,
leaving $720,000 of stockholders'
equity. The stockholders' equity
section is divided into the
$120,000 originally invested in
Edelweiss Corporation by
stockholders (i.e., capital stock),
and the other $600,000 that was
earned (and retained) by
successful business performance
over the life of the company.
Does the stockholders' equity
total mean the business is worth
$720,000? No! Why not?
Because many assets are not
reported at current value. For
example, although the land cost
$125,000, the balance sheet does
not report its current worth.
Similarly, the business may have
unrecorded resources to its
credit, such as a trade secret or
a brand name that allows it to
earn extraordinary profits. If
one is looking to buy stock in
Edelweiss Corporation, they
would surely give consideration
to these important non-financial
statement based valuation
considerations. This observation
tells us that accounting
statements are important in
investment and credit decisions,
but they are not the sole source
of information for making
investment and credit decisions