Assets = Liabilities + Owner’s Equity
This relationship is the basic accounting equation. Assets must equal the sum of
liabilities and owner’s equity. Liabilities appear before owner’s equity in the basic
accounting equation because they are paid first if a business is liquidated.
The accounting equation applies to all economic entities regardless of size,
nature of business, or form of business organization. It applies to a small proprietorship
such as a corner grocery store as well as to a giant corporation such as
PepsiCo. The equation provides the underlying framework for recording and summarizing
economic events.
Let’s look in more detail at the categories in the basic accounting equation.
Assets
As noted above, assets are resources a business owns.The business uses its assets in
carrying out such activities as production and sales. The common characteristic
possessed by all assets is the capacity to provide future services or benefits. In a
business, that service potential or future economic benefit eventually results in
cash inflows (receipts). For example, Campus Pizza owns a delivery truck that provides
economic benefits from delivering pizzas. Other assets of Campus Pizza are
tables, chairs, jukebox, cash register, oven, tableware, and, of course, cash.
Liabilities
Liabilities are claims against assets—that is, existing debts and obligations.
Businesses of all sizes usually borrow money and purchase merchandise on credit.
These economic activities result in payables of various sorts:
• Campus Pizza, for instance, purchases cheese, sausage, flour, and beverages on
credit from suppliers.These obligations are called accounts payable.
• Campus Pizza also has a note payable to First National Bank for the money
borrowed to purchase the delivery truck.
• Campus Pizza may also have wages payable to employees and sales and real estate
taxes payable to the local government.
All of these persons or entities to whom Campus Pizza owes money are its creditors.
Creditors may legally force the liquidation of a business that does not pay its
debts. In that case, the law requires that creditor claims be paid before ownership
claims.
Owner’s Equity
The ownership claim on total assets is owner’s equity. It is equal to total assets minus
total liabilities. Here is why:The assets of a business are claimed by either creditors
or owners. To find out what belongs to owners, we subtract the creditors’
claims (the liabilities) from assets. The remainder is the owner’s claim on the
assets—the owner’s equity. Since the claims of creditors must be paid before ownership
claims, owner’s equity is often referred to as residual equity.
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