Learn Accounting in 80 Sec – Assets, Liabilities and Owners’ Equity | What Is Asset, Liability and Owners’ Equity

Accounting

What is accounting? As defined in http://www.investopedia.com, accounting is the systematic and comprehensive recording of financial transactions pertaining to a business.

Accounting provides information on the:
– Resources available to a firm;
– The means employed to finance those resources, and
– The results achieved through their use.
(http://www.businessdictionary.com/definition/accounting.html)

We have discussed about the basic concept of accounting, which is Debit equals Credit and by following this concept, your accounting records / books will always balance. This is also referred as the double-entry book keeping system. To expand further on this concept, this post will discuss on the accounting equation of Assets equals Liabilities and Owners’ Equity.

Assets = Liabilities + Owners’ Equity

In a nutshell, what you fund your business (Assets) came from your own funds (Owners’ Equity) and borrowings or credit from other sources (Liabilities). The borrowings or credit from other sources could be in the form of loans from friends, parents, financial institutions and credit from suppliers and other stakeholders.

What is an asset?

An asset is something valuable that a business owns, benefits from or has use of, in the generation of income. So, if you are running a bakery business, then your oven is an asset as it is used to produce bread which will then be sold to generate sales / income. If you are a consultancy business, other than your human capital, your computer equipment, furniture and fittings will be your assets. For all businesses, cash and bank balances are critical assets as they are required to fund your business (i.e. paying bills, buying resources).

What is a liability then?

A liability is a claim against the assets, or legal obligations of a person (if your business form is a Sole Proprietorship or Partnership) or the organization, arising out of past or current transactions or actions. It requires the mandatory transfer of assets, or provision of services, at specified dates or in determinable future. Going back to the bakery example, if you purchase flour, sugar, eggs, etc. on credit from Supplier ABC, then you will need to pay Supplier ABC based on the agreed payment terms. So, if Supplier ABC gives you a 30 days credit and your purchase was on 1st Apr, then the payment due date will be 30 days after 1st Apr. For the consulting business, if your practice is to pay 50% of salaries in current month and the balance in the next month, then you nned to have a salaries payable account because if an employee leaves on the 1st day of the following month, he / she is still entitled to get his / her fair share of the service already provided.

Owners’ Equity

Owners’ equity is also a form of liability as it is an obligation of the business to its owners.

An Illustration

Lisa invested $100,000 with her own money into her bakery business. She also borrowed $80,000 from her friend, Peter. This loan is given by Peter, without any repayment term and interest-free. With the investment and loan, Lisa brought an oven for $120,000 and display cabinets for $25,000. She managed to obtain supplies of $15,000 from Acme Company on credit.
The accounting entries to reflect the above transactions are:

Lisa investment in the business:

Cash / Bank (Asset) $100,000 [DR]
Owners’ Equity (Owners’ Equity) $100,000 [CR]

Borrowing from Peter:

Cash / Bank (Asset) $80,000 [DR]
Loan From Peter (Liability) $80,000 [CR]

Purchase of assets:

Purchase of oven (Asset) $120,000 [DR]
Purchase of display cabinets (Asset) $25,000 [DR]
Cash / Bank (Asset) $145,000 [CR]

Supplies on credit from Acme Company:

Inventory (Asset) $15,000 [DR]
Acme Company (Liability) $15,000 [CR]

Summary:

Cash / Bank (Asset) $35,000 [DR]
Purchase of oven (Asset) $120,000 [DR]
Purchase of display cabinets (Asset) $25,000 [DR]
Inventory (Asset) $15,000 [DR]
Loan from Peter (Liability) $80,000 [CR]
Acme Company (Liability) $15,000 [CR]
Owners’ Equity (Owners’ Equity) $100,000 [CR]

Assets balance of $195,000
Liability balance of $95,000
Owners’ Equity balance of $100,000

Thus, Assets = Liabilities + Owners’ Equity and the breakdown is $195,000 = $95,000 + $100,000

 

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