Understanding assets, liabilites & owner’s equity

1. Assets, liabilities and owner’s equity

The accounting equation, upon which financial accounting is based is:

Capital = Assets – Liabilities

In case of limited liability companies, the capital is commonly known as owner’s equity.  This consists of the residual interest of the owners in the business assets after all liabilities are paid.  In instances of bankruptcy the owner’s equity is the last item distributed from the proceeds of the net assets held by the firm.

Assets comprise the resources held by the business, which derive economic benefits to the firm from the employment of such possessions in the organization’s operations.  There are two categories of assets recognized in the balance sheet, fixed assets and current assets.  Fixed assets are resources that are used for a number of years, while current assets are resources held in the normal course of the firm’s operating cycle and are thus considered as short term assets.

Liabilities are financial obligations that the company has for assets received.  In the balance sheet we also classify between two types of liabilities, long term and current liabilities.  Long term liabilities exceed twelve months for payment, while current liabilities are settled in the normal operating cycle of the organization.

2. Balance sheet components

The items that qualify as assets in the balance sheet are:

Property, plant and equipment – these comprise the fixed assets held by the company, like for example buildings, plant and machinery and motor vehicles. Inventories – the stock held for-resale by the organization. Account receivables – money receivable from clients who purchased goods on credit from our firm. Deferred income taxes – income tax recoverable in future periods due to deductible temporary differences.

Prepaid expenses – expenditure already paid that does not cover the year shown in the financial statements. Cash and cash equivalents – cash and bank balances held at a particular date. The factors that are classified as liabilities in the balance sheet are:

Accounts payable – money due to suppliers of stock for re-sale. Accrued expenses – costs incurred in the year revealed in the final accounts but not yet paid. Proposed dividends – dividends declared and proposed by the directors, but not yet paid to the shareholders. Corporation tax liability – tax due to the government for the taxable profits incurred during the year. Debentures – loans payable after more than one year. The variables showed under the equity heading in the balance sheet are:

Common stock – ordinary shares held by the company valued at nominal price. Share premium – money paid by shareholders for shares issued at a price above the nominal value. Revaluation reserve – the profit arising from the revaluation of fixed assets. Retained earnings – the accumulated profits made by the business, not yet distributed to shareholders.

3. Users of financial statements

The individuals/entities interested in the financial statements are:

Investors – they are interested in the financial performance of the company to see the rate of return due to them and the financial position of the firm to analyze the risk of investing in such company. Lenders – are keen on the profitability and liquidity of the firm to note its ability to pay interests and payments when due.  They also examine the financial position to determine the risk in lending.

Suppliers and other trade creditors – they will analyze the liquidity of the firm and financial position to determine its credit rating.   Indeed credit duration will be given according to such examination. Government and their agencies – they demand the profitability to determine the tax due.  Governmental agencies concentrate on the allocation of resources and activities of the firm, denoted in both income statement and balance sheet. Employees – they are interested in the profitability and financial position of the corporation to assess their job security.

Clients – customers, especially those that require frequent after sales service are interested on the going concern of the firm to ensure that such services will proceed in the future.  They also seek both final accounts. Public – large corporations that provide a significant contribution are also interested that the firm continues operating like the customers.  Therefore the income statement and balance sheet are sought.

References:

International Accounting Standards Committee (2000).  International Accounting Standards Explained.  New York:  John Wiley & Sons Ltd.

Randall H. (1999).  A Level Accounting.  Third Edition.  Great Britain:  Ashford Colour Press Ltd.

Wood F.; Sangster A. (2002).  Business Accounting 1.  Ninth Edition.  Essex:  Pearson Education Limited.