The Accounting Equation

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The Accounting Equation is an essential notion in financial accounting.

The equation derives from assets and claims on assets.
Assets are what a company owns, such as equipment, buildings and
inventory. Claims on assets include liabilities and owners' equity.
Liabilities are what a company owes, such as notes payable, trade
accounts payable and bonds. Owners' equity represent the claims of
owners against the business.
Assets
Assets:
What a company owns.
Claims on Assets
Liabilities:
What a company owes.
Owners' Equity:
Claims of owners against the business.
The basic equation that expresses the relationship of assets and claims
on assets is called the accounting equation:
Assets = Liabilities + Owners' Equity
Some basic assets and claims on assets are listed below.
Assets
ASSETS
CASH
I N V E N T OR I E S
BUILDINGS
LAND
E QUIPMENT
ACCOUNTS RECEIVABLE
MARKET ABLE SECURIT IES

=
Claims on Assets
LIABILITIES
A C C O U N T S P AY A B L E
WAGES PAYABLE
TAXES PAYABLE
NOTES PAYABLE
BONDS PAYABLE
I N T E R M ED I A T E T E R M D E BT

+
OWNERS' EQUITY
PR EFERR ED ST OCK
COMMON ST OCK
CAPITAL SURPLUS
R E T A I N E D E AR N I N G S

In other words, the equation illustrates that the assets of the company
must equal the claims against the company. Those claims arise from
both creditors of the company and owners of the company.
Using the accounting equation, if two of the three components are
known, the third can be solved. For instance:
Assets

Liabilities

Owners' Equity

$200,000

$50,000

Owners' Equity must be $150,000

($200,000 $50,000)

The Accounting Equation

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Assets = Liabilities + Owners' Equity

Practice Excercise
The following excercise should aid in understanding The Accounting
Equation. Please answer the questions below and proceed by clicking
the Check My Answers button located at the bottom of the page.

1. A share of stock in General Motors that your company owns would be:

A liability
Owners' equity
An asset
None of the above
All of the above

2. A company has $1,000,000 Owners' Equity and $75,000 in liabilities. What are the assets for the company?

$1,000,000
$75,000
$925,000

None of the above

3. A company has cash in the bank of $850,000, inventory of $50,000 and a building worth $100,000. These are the
has liabilities that amount to $925,000. How much is owners' equity in this company?

$1,000,000
$75,000
$925,000
None of the above

4. Which of the following is not an asset:

Retained earnings
A roto-tiller
A stapler
20 kilos of fertilizer
All of the above
Check My Answ ers

Double Entry Accounting

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For every transaction that is recorded in a business, there have to be

two components that make up an entry, a debit and a credit.
Debit:
A debit is an increase in an asset item;
a decrease in a claim or expense item.
Credit:
A credit is an increase in a claim item;
a decrease in an asset or revenue item.
Debits and credits arise whenever a "transaction" occurs, such as a
change in assets or a claim on assets.
Debit

$525
Credit

$525

Assets and Claims on Assets

Debits increase assets or decrease claims on assets (liabilities and
owners' equity). Credits increase claims on assets or decrease assets.
To illustrate, consider the following transaction and journal entry
reporting the transaction:
A business owner spends cash to purchase a piece of equipment which
is to be used in the business. To record this transaction, the owner
debits the equipment account because an asset was increased. The
offsetting credit would be to cash.
Generally, debits are listed first and credits second. The dollar amount
of the debit appears on the left and the dollar amount of the credit
appears on the right. If the piece of equipment illustrated in the
transaction above cost $1000, the journal entry to record the
transaction would appear as:
Equipment
Cash

$1000
$1000

Double Entry Accounting

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Revenues and Expenses

The concept of revenues and expenses is often a little more difficult to
understand when first examining the double entry accounting system.
One reason for this difficulty is the fact that revenues are treated
as credits while expenses are treated as debits. This concept often
seems contrary to the logical notion that revenue means more money;
and more money means more assets. The term expenses logically
means a drain on one's assets. Perhaps when we examine the
illustration below, the rationale will seem a little more clear.
Recognize, as you examine the illustration, that the assets of a
company represent everything that has value, e.g., the cash, the
fixtures, the intangibles; everything. These assets are subject to
claims by the creditors and the owners. Revenues, however, allow the
owners to seek a higher claim in the assets because their profits have
increased. Therefore, think of revenues as credits that increase the
owner's equity. Alternatively, expenses are expired assets. They
represent contra revenues and reduce the amount of profit to which an
owner lays claim.
Revenues and Expenses
D EBITS
C REDITS

A SSETS
E VERYTHING
O F V ALUE I N
T HE C OMPANY

E XPENSES
E XPIRED A SSETS

LEFT
L IABILITIES
C LAIMS B Y C REDITORS

O WNERS ' E QUITY

C LAIMS B Y O WNERS

R EVENUES
C LAIMS B Y O WNERS

RIGHT
Double Entry Accounting

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Revenues and Expenses

To illustrate the concept of double entry accounting related to
revenues and expenses, consider an example of a company that sells a
service for which the owner charges and receives $300. The journal
entry to record the transaction would be:
Cash

$300
Income-Sales

$300

The cash the owner receives increases the value of the assets, while
the revenue account allows the owner to increase his claim against
those assets.

Now suppose that in order to earn that $300 in the above example,
the company incurred a utility bill of $100. As the company writes a
check, it will make the following journal entry:
Utilities Expenses

$100

Cash

$100

In this example, the company has exhausted $100 (an expired asset)
and it reduces cash accordingly. The expense is reflected as a contra
revenue and reduces the owners claim against the remaining assets of
the company. Note that if the utility bill had not been paid, the credit
would not reduce cash (the assets have not yet been exhausted),
instead, the credit would have gone to a liability (showing that the
creditors have a claim of $100 against the company's assets).
To review, the following table shows what might be considered debits
and credits.
Debit:
Increases in Assets

Decreases in Claims

Expense Items

Credit:
Decreases in Assets

Increases in Claims

Revenue Items

Double Entry Accounting

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Double Entry Accounting and The Accounting Equation

In double entry accounting, for every debit there must be an offsetting
credit. One helpful tool to understanding debits and credits might be to
think in terms of the left and right side of the accounting equation. The
left side represents the assets of the company and the right side
represents the claims on those assets; i.e., liabilities and owners'
equity. Generally, anything that increases the left side or decreases
the right side would be considered a debit and anything that increases
the right side or decreases the left would be considered a credit.
As previously illustrated, revenues and expenses may also be thought
of in terms of the accounting equation. Since owners' equity is a claim
on assets, it would therefore fall on the right-hand side of the
equation. Revenues would be considered credits because, in essence,
they would eventually tend to increase ownership in the business.
Expenses would take away from the ownership and so they would fall
on the left-hand side of the equation.
Debits and Credits, and the LeftRight Notion
ASSETS
DEBITS
INCREASES IN ASSETS
D ECREASES IN CLAIMS
E X P E N S E I T EM S

=
LIAB ILITIES + OWNERS' EQUITY
CREDITS
D ECREASES IN ASSETS
INCREASES IN CLAIMS
R E V E N U E I T EM S

This "leftright" notion carries through into journal entries where the
debit is recorded on the left side of the transaction and credits are
recorded on the right. An example of this "leftright" thinking may be
constructed using an example where a $500 materials expense which
was charged on a trade account is to be recorded. The expense would
eventually decrease ownership in the company when it is paid. It

therefore would impact on the left side of the accounting equation, so

it would be a debit.
The charging of the materials would be an increase in a liability
(accounts payable). That increases the claims on the company, so it
would be considered a credit. The journal entry to record this
transaction would be:
Materials Expense

$500

Accounts Payable

$500

Note that the debit appears first and the dollar amount appears on the
left side of the journal entry. The credit is listed second and appears
on the right-hand side.

Practice Excercise
The following excercise should aid in understanding Double Entry
Accounting. Please answer the questions below and proceed by clicking
the Check My Answers button located at the bottom of the page.
1. Your company buys a new forklift for $500 cash. The entry for this transaction should be:
A debit of $500 to cash and a credit of $500 to sales
A debit of $500 to cash and a $500 credit to equipment
A credit of $500 to cash and a debit of $500 to equipment
None of the above

2. You borrow $750,000 on a 90-day note. The money is deposited into checking. The entry for this transa
A debit of $750,000 to cash and a credit of $750,000 to notes payable
A credit of $750,000 to cash and a debit of $750,000 to notes payable
A debit of $750,000 to cash and a debit of $750,000 to interest expense
None of the above

3. A customer buys a product from you for $350 and promises to pay you in 30 days. The customer already
The entry for this transaction is:
A credit of $350 to sales and a debit of $350 to cash
A credit of $350 to sales and a debit of $350 to accounts payable
A debit of $350 to sales and a credit of $350 to accounts receivable
None of the above

4. Your company buys some materials to use in producing a product that it sells. The cost of the materials
vendor in 30 days. The entry for this transaction is:
A debit of $350 to materials expense and a credit of $350 to accounts payable
A credit of $350 to materials expense and a debit of $350 to accounts payable
A debit of $350 to materials expense and a credit of $350 to accounts receivable
A credit of $350 to materials expense and a debit of $350 to accounts receivable
None of the above
Check My Answ ers

The Balance Sheet

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The Balance Sheet is a statement detailing what a company owns

(assets) and claims against the company (liabilities and owners'
equity) on a particular date. Some analysts liken the balance sheet to
a snapshot illustrating a company's financial health.
Keeping in mind the assets and claims, it is helpful to remember the
"leftright" accounting equation orientation; assets on the left side,
claims on the right. In addition, there are a number of other
characteristics of the balance sheet that are noteworthy, such

as balancing, order of listing, valuing of items, and definitions of items.

These items are discussed with an example balance sheet to illustrate
the points.
Balance Sheet
Products, Inc.
January 1, 2013

ASSETS
Current Assets
Cash
Marketable Securities
Accounts Receivable
Inventories

$123,000
$200,000
$345,000
$100,000

Total Current Assets

Long-Term Assets
Building (Gross)
Accumulated Depreciation
Net Building
Land

$768,000

$350,000
$50,000
$300,000
$325,000

Total Long-Term Assets

$625,000

Total Assets

$1,393,000

CLAIMS ON ASSETS
Current Liabilities
Accounts Payable
Notes Payable
Total Current Liabilities
Long-Term Notes

$100,000
$150,000
$250,000
$300,000

Total Liabilities

$550,000

Owners' Equity

$843,000

Total Claims

$1,393,000

The Balance Sheet Balancing

The balance sheet must balance; that's why it's called a balance sheet.
In other words, the assets must equal the claims on assets. The
concept of balancing relies on the accounting equation which was
discussed earlier in this lesson.
Assets = Liabilities + Owners' Equity
Balance Sheet
Products, Inc.
January 1, 2013

ASSETS
Current Assets
Cash

$123,000

Marketable Securities

$200,000

Accounts Receivable

$345,000

Inventories

$100,000

Total Current Assets

$768,000

Long-Term Assets
Building (Gross)

$350,000

Accumulated Depreciation

$50,000

Net Building

$300,000

Land

$325,000

Total Long-Term Assets

Total Assets

$625,000

$1,393,000

C L AI M S O N A S S E TS
Current Liabilities
Accounts Payable

$100,000

Notes Payable

$150,000

Total Current Liabilities

$250,000

Long-Term Notes

$300,000

Total Liabilities

$550,000

Owners' Equity

$843,000

Total Claims

$1,393,000

The Balance Sheet

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The Balance Sheet Order of Listing

Items on a balance sheet are listed in order of liquidity. Liquidity takes
on a slightly different meaning for assets and for claims on assets. For
assets, liquidity means nearness to cash. For this reason cash is the
first item on the balance sheet.
After cash, the other current assets are listed in order of liquidity.
Marketable securities (which can be converted to cash by selling
them), accounts receivable (which may be factored), and finally

inventories make up the rest of the current assets. Inventories, which

are considered current assets, are listed last because it is generally
harder to convert to cash a half-finished item in production than it
would a U.S. Treasury bond, for example.
Following current assets come those assets that would take more time
to convert to cash. Buildings, land, and equipment would all be
considered long-term or fixed assets.
When ranking claims on assets, liquidity refers to how quickly the
claim against the company matures. Short-term or current liabilities
mature quickly. Intermediate, and then long-term liabilities would be
listed next. Sometimes as longer-term liabilities move toward
maturity, the portion that matures is moved into current liabilities.
Last on the claims portion of the balance sheet would be the equity
accounts. For a corporation, the preferred stock accounts would be
listed before common equity accounts. The last claimants on a
company's assets are the common stockholders.
Balance Sheet
Products, Inc.
January 1, 2013

ASSETS
Current Assets
Cash

$123,000

Marketable Securities

$200,000

Accounts Receivable

$345,000

Inventories

$100,000

Total Current Assets

$768,000

Long-Term Assets
Building (Gross)

$350,000

Accumulated Depreciation

$50,000

Net Building

$300,000

Land

$325,000

Total Long-Term Assets

$625,000

Total Assets

$1,393,000

C L AI M S O N A S S E TS
Current Liabilities
Accounts Payable

$100,000

Notes Payable

$150,000

Total Current Liabilities

$250,000

Long-Term Notes

$300,000

Total Liabilities

$550,000

Owners' Equity

$843,000

Total Claims

$1,393,000

The Balance Sheet

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The Balance Sheet Valuing Balance Sheet Items

Items on the assets side of the balance sheet are generally valued at
cost. There are two exceptionsmarketable securities and inventories.
The rule that applies to marketable securities and inventories is lower
of cost or market. That means that current market value or original
cost, whichever is lower, is the appropriate value for marketable
securities and inventories. For instance, if a share of stock was
originally purchased for $80 three years ago and its value has fallen to
$60, the value that would appear on the balance sheet is $60.
One note that should be made is in reference to accumulated
depreciation. The accumulated depreciation account is what is called
a contra-asset account. That means that even though accumulated
depreciation is reflected on the assets portion of the balance sheet, it
in essence carries a minus sign. Therefore, if Gross Fixed Assets are
$1,000,000 and Accumulated Depreciation is $200,000, Net Fixed
Assets would be $800,000.
Balance Sheet
Products, Inc.
January 1, 2013

ASSETS
Current Assets
Cash

$123,000

Marketable Securities

$200,000

Accounts Receivable

$345,000

Inventories

$100,000

Total Current Assets

$768,000

Long-Term Assets
Building (Gross)

$350,000

Accumulated Depreciation

$50,000

Net Building

$300,000

Land

$325,000

Total Long-Term Assets

$625,000

Total Assets

$1,393,000

C L AI M S O N A S S E TS
Current Liabilities
Accounts Payable

$100,000

Notes Payable

$150,000

Total Current Liabilities

$250,000

Long-Term Notes

$300,000

Total Liabilities

$550,000

Owners' Equity

$843,000

Total Claims

$1,393,000

The Balance Sheet

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Definitions of Balance Sheet Items Assets

Balance sheets may be quite detailed depending on the nature and complexity of a
business. Regardless of their complexity, however, the same basic notions of
construction apply. Again it is helpful to keep in mind the "leftright" balance
sheet orientation. An illustration of a somewhat complex balance sheet may help
understand the different types of accounts. Assets will be covered first on this
page, and then claims on assets will follow.
Balance Sheet
Products, Inc.
January 1, 2013

Scroll over account names for definitions

A S S ET S
Current Assets
Cash

$50,000

Marketable Securities

$70,000

Accounts Receivable

$95,000

Notes Receivable

$50,000

Inventories

$90,000

Total Current Assets

$355,000

Long-Term Assets
Tangible Assets
Land

$89,000

Buildings

$99,000

Machinery

$35,000

Accumulated Depreciation
Net Tangible Assets

$5,000
$218,000

Intangible Assets
Goodwill

$20,000

Patents

$19,000

Trademarks

$13,400

Organizational Costs

$22,900

Total Intangible Assets

$75,300

Other Assets
Investments

$23,000

Deferred Charges

$53,000

Total Other Assets

$76,000

Total Long-Term Assets

$369,300

Total Assets

$724,300

The Balance Sheet

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Definitions of Balance Sheet Items Claims on Assets

Claims on assets arise from debt and from ownership claims on the
company. As the number of liabilities and ownership items increase,
the complexity of the balance sheet increases.
Balance Sheet
Products, Inc.
January 1, 2013
Scroll over account names for definitions

C L A I MS

ON

A SS ET S

Liabilities
Current Liabilities
Long-term Debt : 1 Yr.

$18,000

Notes Payable

$39,000

Accounts Payable

$15,000

Taxes Payable

$13,000

Accrued Expenses

$43,000

Other Current Liabilities

$11,000

Total Current Liabilities

$139,000

Long-Term Liabilities
Notes Payable

$18,000

Bonds Payable

$99,000

Total Long-Term Liabilities

$117,000

Other Liabilities
Pension Obligations

$98,900

Deferred Taxes

$72,000

Minority Interest

$12,400

Total Other Liabilities

$183,300

Total Liabilities

$439,300

Owners Equity
Preferred Stock

$12,000

Common Equity
Common Stock

$118,000

Capital Surplus

$110,000

Retained Earnings

$100,000

Treasury Stock

$55,000

Total Common Equity

$273,000

Total Owners' Equity

$285,000

Total Claims on Assets

$724,300

RIGHTThe Balance Sheet

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Overview of the Balance Sheet

Practice Excercise
Please answer the questions below and proceed by clicking the Check
My Answers button located at the bottom of the page.

1. Accounts receivable would be considered:

A liability
A fixed asset
A current asset
None of the above

2. Common equity includes:

Common stock
Capital surplus
Retained earnings
All of the above

None of the above

3. Preferred stock would be considered:

A current liability
A long-term liability
Owners' equity
None of the above

4. Intangible assets would include:

Goodwill
Patents
Trademarks
Organizational costs
All of the above
None of the above

5. Long-term liabilities are those that:

Are due in 1 year or more

Are due in 5 years or more

Are due in 10 years or more
None of the above
Check My Answ ers

The Income Statement

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The Income Statement shows a firm's revenues and expenses, and

taxes associated with those expenses for some financial period. Where
the balance sheet may be thought of in terms of the "leftright"
orientation previously discussed, the income statement would be
thought of in "topdown" terms.
Income Statement
Products, Inc.
January 1, 2013

Sales
Cost of Goods Sold

$540,000.00
$319,680.00

Gross Profit
Selling & Administrative Expenses

$220,320.00
$132,300.00

Earnings Before Interest & Taxes

Interest

$88,020.00
$10,356.00

Taxable Income
Taxes

$77,664.00
$35,726.00

Net Income
Dividends

$41,938.00
$33,108.00

Transfer to Retained Earnings

$8,830.00

The Income Statement

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A basic overview of income statement items shows how a

manufacturing company might present an income statement. Income
statements for other companies may appear to be slightly different,
but in general the construction would be the same.
An important concept in understanding the income statement is
Earnings Per Share (EPS). The EPS for a company is net income
divided by the number of shares of common stock outstanding. It
represents the bottom line for a company.
Companies continually make decisions on how their bottom line will be
impacted since shareholders in the company are concerned with how
management decisions affect individual shareholder position.
Income Statement
Products, Inc.
January 1, 2013
Scroll over ? for definitions

Sales 125,000 units @$125 each

Cost of Goods Sold

$ 15,625,000
10,000,000

Gross Profit
Selling, General, Administrative Costs

5,625,000
2,350,000

Operating Income Before Depreciation

Depreciation, Amortization, Depletion

3,275,000
10,500

Operating Profit

3,264,500

 Interest Expense
Non operating Income
Non operating Expenses
Pretax Accounting Income
Income Taxes

90,000
40,000
50,000
3,164,500
1,550,000

Income Before Extraordinary Items

Preferred Stock Dividends

1,614,500
90,000

Income Available for Common Stockholders

Extraordinary Items
Discontinued Operations

1,524,500
20,000
500,000

Adjusted Net Income

Earnings Per Share (900,000 shares of stock)

$ 1,004,500
$ 1.12

\\\

RATIO ANALYSIS
Self-Paced Overview
Ratio Analysis
Classification of Ratios
One of the ways in which financial statements can be put to work is
through ratio analysis. Ratios are simply one number divided by
another; as such they may or may not be meaningful. In finance,
ratios are usually two financial statement items that may be related to

one another and may provide the prudent user a good deal of
information.
Of the myriad of ratios that could be generated, some will be more
meaningful than others. Generally ratios are divided into four areas of
classification that provide different kinds of
information: liquidity, turnover, profitability, and debt.
Liquidity ratios indicate a firm's ability to meet its maturing
short-term obligations.

Turnover indicates how effectively a firm manages resources at

its disposal to generate sales.

Profitability indicates the efficiency with which a firm manages

resources.

Debt indicates the extent to which a firm is financed by debt.

Evaluations
Remember, ratios are just one number divided by another and as such
really don't mean much. The trick is in the way ratios are analyzed and
used by the decision maker. A good strategy is to compare ratios to
some sort of benchmark, such as industry averages, or to what a
company has done in the past, or both.

Comparisons
Once ratios are calculated, an analyst needs some benchmarks to find
out where the company stands at that particular point. Useful
benchmarks are industry comparisons and company trends.
It may be useful to compare a company to certain industry averages
to get a feel for how the company is performing. In this case it is
necessary to obtain industry performance measures. There are a
number of sources for industry figures.
Commercial Sources A number of companies publish
information on industry comparisons. Among these sources are
private credit reporting agencies such as Dun & Bradstreet and
RMA - The Risk Management Association. Rating agencies such

as Moody's and Standard & Poor's also provide industry

information.

Government Sources There are a number of government

sources of helpful industry information, such as the U.S.
Industrial Outlook and Quarterly Financial Reports.
Trade Associations Many industries have trade associations or
industry groups that regularly publish information for and about
members.