Two Types of Accounts: The financial condition or position of a business enterprise is represented by the relationship of assets to liabilities and capital.
First: Accounts belong to the Balance Sheet and represent the basic accounting equation.
These accounts are:
1. Assets 2. Liabilities 3.Owners Equity
These three basic elements are connected by a fundamental relationship called the accounting equation. This equation expresses the equality of the assets on one side with the claims of the creditors and owners on the other side:
This relationship - which is called the accounting identity or basic accounting equation, is expressed in equation form as:
A = L E
Assets = Liabilities Owners Equity
where A = Total assets, L = Total liabilities, and E = Equity. Because creditor claims are paid before equity claims if a healthcare organization is liquidated - liabilities are shown before equity both on the balance sheet and in the basic accounting equation.
Note that the accounting identity can be rearranged as follows:
E = A − L
This format reinforces the concept that equity represents a residual claim against the total assets of the business and the fact that equity can be negative.
If a business writes down (decreases) the value of its assets, its liabilities are unaffected because these amounts are still owed to creditors and others. If total assets are written down so much that their value drops below that of total liabilities - then the equity reported on the balance sheet becomes a negative
amount.
The basic accounting equation is simply an algebraic form of the balance sheet.
1. Assets
Assets are the cash and non cash resources owned by a business and have economic value, and used in carrying out future services or benefits to the entity using them.
Classification of assets:
- Current assets
Current assets are cash and other types of assets that are reasonably expected to be converted into cash, sold, or used up during the normal operating year. Examples: Cash, Bank, Goods, Accounts Receivable, Prepaid expenses, Inventory and Marketable securities etc.
- Fixed assets
Fixed assets are those assets that are used in the normal operations of the entity to produce and sell goods or perform services for customers. Fixed assets are expected to service for a number of years are not for re-sell. Examples: Lands, cars, buildings, equipments, and furniture etc.
- Intangible assets
Intangible assets are those assets that have no physical substance but they are expected to provide benefits to the entity for several years. Examples: Patents, trade marks, copyrights, goodwill, franchise fees, and trade name.
2. Liabilities
Liabilities are claims against assets, Amounts owed to outsiders, such as notes payable, accounts payable, bonds payable.
Classification of Liabilities:
- Short-term Liabilities
Short-term liabilities are obligations of the entity that are reasonably expected to be paid or settled in the next year or the normal operating cycle.
Examples: Short-term notes payable, accounts payable, salaries and wages payable and other types of accrued liabilities for services received but not yet paid for.
- Long-term Liabilities
Long-term liabilities are those obligations that do not require payment within the next year or the normal operating cycle. In other words, liabilities not classified as short-term are reported in the Long-term liabilities section of the balance sheet. Examples: Loan, bonds, and any other obligation that mature in a period more than one year beyond the balance sheet date is reported as long-term.
3. Owner’s Equity
Owner’s equity represents the owner’s interest in the assets of the entity. It is equal to total assets minus total liabilities, also known as Capital.
There are two main sources of owner’s equity:
i. Amounts contributed by the owner (Capital)
ii. Amount earned by the entity but not yet taken by the owner.
Second: Accounts belong to the Income Statement and involve in the determination of
net income or net loss of a business entity for a specific period of time. These accounts
are:
1. Expenses 2. Revenues
1. Expenses
Expenses are the cost of assets consumed or services used in the process of earning revenue in other words; expenses are outflows or other uses of assets resulting from the sale or delivery of goods or the provision of services by the entity during specific time period. Examples: Utility expenses (electric and water), telephone bill expense, rent expense, wages and salaries expense and depreciation expense etc.
2. Revenues
Revenues are cash in-flow result from the sale of goods or the rendered of services. To illustrate the affect (increase & decrease) of a financial transaction on the above classified accounts, study the following chart:
Basic Accounting Equation
