Accounting and Its Use in Business Decisions
In this chapter, you will learn why accounting is important to the business community. You will learn the different types of businesses and how daily transactions are posted and how they affect the financial statements. This chapter also demonstrates how to prepare the income statement, balance sheet, and statement of stockholders' equity. Pay close attention to the steps involved in the accounting cycle from beginning to end. This chapter will introduce you to the framework of the entire accounting process, which may also be called the accounting equation. The fundamental accounting equation is the basic equation that accountants use to record business transactions. The equation states "assets = liabilities + owners' equity". This section gives the direct and alternative identifications of these elements to help you speak the language of accounting. Assets are things that expect to have future value to the company. For example, if the company buys a new car, this car has future value to the company. Liabilities are promises to pay. Some companies may not have all of the money to pay cash for the car, so they will typically finance, or obtain credit for, and borrow the difference between the down payment and the final price of the car. If approved, the company now promises to pay back the bank or business entity who gave the company money. Owners' equity is the owners' claims on assets. This basically means that, as an owner of the company, you have a claim on the asset that is now identified as the new car the company owns.
The financial accounting process
In this section, we explain the accounting equation - the framework for the entire accounting
process. Then, we show you how to recognize a business transaction and describe underlying
assumptions that accountants use to record business transactions. Next you learn how to analyze and
record business transactions.
In the balance sheet presented in Exhibit 2 (Part C), the total assets of Metro Courier, Inc., were
equal to its total liabilities and stockholders' equity. This equality shows that the assets of a business
are equal to its equities; that is,
Assets = Equities
Assets were defined earlier as the things of value owned by the business, or the economic resources
of the business. Equities are all claims to, or interests in, assets. For example, assume that you
purchased a new company automobile for USD 15,000 by investing USD 10,000 in your own
corporation and borrowing USD 5,000 in the name of the corporation from a bank. Your equity in the
automobile is USD 10,000, and the bank's equity is USD 5,000. You can further describe the USD
5,000 as a liability because you owe the bank USD 5,000. If you are a corporation, you can describe
your USD 10,000 equity as stockholders' equity or interest in the asset. Since the owners in a
corporation are stockholders, the basic accounting equation becomes:
Assets A = Liabilities L + Stockholders' Equity SE
From Metro's balance sheet in Exhibit 2 (Part C), we can enter in the amount of its assets, liabilities,
and stockholders' equity:
A = L + SE
USD 38,700 = USD 6,600 + USD 32,100
Remember that someone must provide assets or resources - either a creditor or a stockholder.
Therefore, this equation must always be in balance.
You can also look at the right side of this equation in another manner. The liabilities and
stockholders' equity show the sources of an existing group of assets. Thus, liabilities are not only claims
against assets but also sources of assets.
Together, creditors and owners provide all the assets in a corporation. The higher the proportion of
assets provided by owners, the more solvent the company. However, companies can sometimes
improve their profitability by borrowing from creditors and using the funds effectively. As a business
engages in economic activity, the dollar amounts and composition of its assets, liabilities, and
stockholders' equity change. However, the equality of the basic accounting equation always holds.
An accounting transaction is a business activity or event that causes a measurable change in the
accounting equation, Assets = Liabilities + Stockholders' equity. An exchange of cash for merchandise
is a transaction. The exchange takes place at an agreed price that provides an objective measure of
economic activity. For example, the objective measure of the exchange may be USD 5,000. These two
factors - evidence and measurement - make possible the recording of a transaction. Merely placing an
order for goods is not a recordable transaction because no exchange has taken place.
A source document usually supports the evidence of the transaction. A source document is any
written or printed evidence of a business transaction that describes the essential facts of that
transaction. Examples of source documents are receipts for cash paid or received, checks written or
received, bills sent to customers for services performed or bills received from suppliers for items
purchased, cash register tapes, sales tickets, and notes given or received. We handle source documents
constantly in our everyday life. Each source document initiates the process of recording a transaction.