The Beauty of Accounting Equations

A company’s financial situation reflects the amount of resources it has as well as the claims made against those valuable resources at any one time. Claims are sometimes known as equities. As a result, a firm can be defined as a mix of economic resources and equity. Equities are a type of economic resource. Every sort of firm has two different forms of stocks, regardless of industry. They are called creditor’s equity and owner’s equity, respectively.

Economic Resources = Creditor’s Equity + Owner’s Equity

The economic resources a company has at any given time are referred to as assets in accounting terminology. The amount of creditor’s equity a company has, on the other hand, is known as its liabilities. So, here is the conventional accounting equation, sometimes known as the accounting equation:

Assets = Liabilities + Owner’s Equity

The equation, like an algebraic equation, must have equal sides. This equation is useful for examining the financial consequences of your daily company actions.

Let’s talk about a crucial topic in any business. Assets are the economic resources that a company has that are expected to create revenue in the future. Examples include real estate and any other property that a company owns and rents out to customers. If a company is owed money, it enters what is known as accounts receivable, which are monetary objects. However, there are some non-physical assets. Copyright, trademarks, and patents are a few examples, but they are all incredibly valuable to a firm.

Following that, liabilities are a company’s duties, such as paying cash, providing future services to persons, or transferring assets to another corporation. These are known as a company’s debts, or the money that they will owe in the near future. All of these transactions are recorded in accounts payable.
As you are probably aware, having a lot of debt is not fun, and liabilities/debt are legal claims. If a firm fails to pay its debts on time, the law allows creditors (those to whom money is due) to force the sale of its assets. Creditors have extensive rights over owners and must be paid in full even before the owners receive anything. Debt has the potential to deplete all of a company’s resources.

Next, owner’s equity refers to the claim that a company’s owners make in relation to its assets. It is a company’s residual interest or remaining assets after deducting the amount of corporate liabilities. Here is the owner’s equity equation.

Owner’s Equity = Assets – Liabilities

Stockholders’ equity refers to the owner’s equity within a certain corporation, hence the equation looks like this.

Assets = Liabilities + Stockholders’ Equity

Stockholders’ equity is divided into two parts: contributed capital and retained earnings.

Stockholders’ equity = Contributed Capital + Retained Earnings

Contributed capital is the amount that an individual stockholder invests in a business. Contributed capital is typically separated into two portions known as “par value” and “additional paid-in capital.” The retained earnings are the amount of equity gained by stockholders from the business’s income-generating activities that are held for future use by the business. The three sorts of transactions that affect retained earnings are revenues, expenses, and dividends.

The increase and fall in a stock’s value are known as revenues and expenses, and they result from the operation of a firm, whether online or offline. If you’re online, your domain name and hosting provider will be an operating expense if you have your own website. Another example is if a consumer promises to pay you soon for a service that the company will provide. The funds are recorded in the accounts receivable (asset account), increasing the asset value while decreasing the stockholder’s equity amount, which is an example of revenue. However, if a business promises to offer a service in the future, this is referred to as an expense. When this occurs, the assets (accounts receivable) decrease but the liabilities (accounts payable) increase, which makes sense, right?

When revenues exceed expenses, this is known as net income, which is positive. When expenses surpass revenues, this is known as net loss, which means you’re losing business or your business costs more to operate than what you make. Dividends are distributions of assets to owners based on historical profitability. Do not mix up expenses and dividends, as both reduce the amount of retained earnings. The collected net income or revenues less expenses are referred to as retained earnings.

Financial Statements

Financial statements are the primary means of transmitting information about a company to those who are interested in it. What helps me is to think of these statements as a form of business model because they demonstrate how a company is doing financially. Financial statements, like many other methodologies and models, are not flawless and have shortcomings. The income statement, the statement of retained earnings, the balance sheet, and the cash flow statement are the four primary financial statements.

The income statement summarizes the revenues earned or the money made, as well as the expenses or the money deducted from a business. Many accountants regard it as the most essential financial report since it shows whether a company has accomplished its profitability target.

The next one is the statement of retained earnings, which shows the retained earnings over time. When a corporation first began in its accounting period, the retained earnings will be zero. Many businesses substitute the statement of stockholders’ equity for the statement of retained earnings. This is a more complete statement because it reveals not only the features of retained earnings but also the changes in shareholders’ equity accounts.

The balance sheet is the financial status of a business on a specific date, usually at the end of the month or year. The balance sheet shows the value of a company based on its assets and the claims made against those assets, which are the liabilities and stockholders’ equity.

Finally, the cash flow statement is aimed at a company’s liquidity measures. They are essentially the inflow and outflow of cash in a business. The net cash flow is calculated by subtracting the inflow and outflow of money. The statement of cash flows also shows the money earned by merely running a business, as well as the investing and financing transactions that take place during a specific accounting period.

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