Financial Accounting: In an Economic Context

THE FUNDAMENTAL ACCOUNTING EQUATION

The four financial statements are all based on a mathematical equation, which states that the dollar value of a company's assets equals the dollar value of its liabilities plus the dollar value of its shareholders' equity. In fact, the balance sheet is a statement of this equation.

Assets = Liabilities ₊ Shareholders' Equity

The mechanics of accounting are structured so that this equality is always maintained. If the two sides of this equation are unequal, the books do not balance, and an error has been made. However, maintaining this equality does not ensure that the financial statements are correct; errors can exist even if the accounting equation balances.

Assets

Assets are items and rights that a company acquires through objectively measurable transactions that can be used in the future to generate economic benefits (i.e., more assets). Such acquisitions are usually made by purchase: An asset is received in exchange for another asset (often cash) or a payable. Assets include cash, securities, receivables from customers, land, buildings, machinery, equipment, and rights such as patents, copyrights, and trademarks. Simply, the left side of the accounting equation represents the dollar values of the items and rights that have been acquired by a company and are expected to benefit the company in the future.

Assets come from three sources: (1) They are borrowed; (2) they are contributed by shareholders (owners); and (3) they are generated by a ...