Basic Accounting Concepts and the Balance Sheet
If you had been asked to report on the financial status of an individual, instead of a business, you might have begun by asking “What does he own that is of value?” Would this be a reasonable question to ask of a business entity? Yes.
Cash of course has value, so one thing you might wish to determine about the business is how much cash it has. Suppose the business in question is Quilts &Shams Enterprises and it has a cash totaling $5,000 in its bank account. You might begin your report by recording:
Quilts & Shams Enterprises
Things of value
Cash… $5,000.00
In the language of accounting, the term, things of value is not used. The term assets takes its place. The business also owns real estate, office equipment, securities, luxury bedding sets, sheet set and bed in a bag set inventory. Clearly, the $5,000 cash is not its only asset. Quilts & Shams Enterprises possesses cash totaling $5,000 and noncash assets valued at $35,000. Using the phrase other assets to refer to the noncash assets, the balance sheet will appear as follows:
Quilts & Shams Enterprises
Assets
Cash… $ 5,000
Other Assets… 35,000
Total Assets $40,000
If A loans money or extends credit to B, A is called the creditor. Similarly, if C borrows money from D, D is the creditor. When a creditor loans money or extends credit to a business he acquires a claim in that business in that amount against the business.
For example, a creditor who loans $10,000.00 to a business has a claim of $10,000.00 against the business. Because a business will use its assets to pay off its claims, the claims are sometimes called claims against assets.
Of course the owners of a business also have a claim against the assets of a business. They claim everything that is left over after the creditors’ claims have been taken into account. Thus, if the assets total $10,000.00, and if creditors have claims totaling $4,000.00, the owners will claim $6,000.00.
Thus, there are two categories of persons who have claims against the assets of a business: the owners and the creditors. This fact may help you to remember that in the language of accounting, claims against assets that are held by owners or by creditors are called equities.
As part of your financial report on Quilts & Shams Enterprises, you have already made a list of its assets. Would it also be useful to include a list of equities? It would be.
If a creditor sues a business for failure to meet its obligation to him and wins his suit, the court may hold the business liable for the amount of his claim. This may explain the origin of the special technical term that is used to denote equity of a creditor, liability. Thus the word liability refers to the equity of a creditor only.
Assuming Quilts & Shams Enterprises has liabilities amounting to $20,000.00 and total assets of $40,000.00. Evidently only $20,000.00 of assets remains to be claimed after the liabilities has been taken into account. Thus, your report will show the following:
Quilt & Shams Enterprises
Equities
Liabilities… $20,000
Owner’s equity… 20,000
Total $40,000
Whatever remains after the liabilities are taken into account will be claimed by the owners of the business. It follows that the total amount of assets will always be equal to equities. The fact that the total assets of a company always equal the total equities underlies what is called the dual aspect concept. Evidently, the two aspects that this concept refers to are assets and equities, and the concept states that these two aspects are always equal to each other.
The dual aspect concept is the first of the seven fundamental accounting concepts. The equation which states the dual aspect concept: assets = equities
We also know that: equities = liabilities + owner’s equities
Therefore, another form of the dual aspect principle is:
assets = liabilities + owner’s equities
This equation is also called the fundamental accounting equation. Here is the report that you have compiled so far.
Quilts & Shams Enterprises
Balance Sheet as of December 31, 2009
Assets Equities
Cash… $ 5,000 Liabilities… $20,000
Other Assets… 35,000 Owner’s equity… 20,000
Total Assets..$40,000 Total Liabilities. $40,000
As is required by the dual aspect concept, we see that the total of the assets does balance the total of the equities. Because the total of the assets should always balance the total of the equities of a company, a financial document which reports the assets and equities is termed a balance sheet.
The amount of cash possessed by a business is likely to fluctuate from day to day. Do you imagine that it is also possible for the amounts of the other assets and liabilities to change from day to day? You may surmise therefore, that any given balance sheet holds true for a given point in time, it must of course be dated.
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