The Accounting Equation

The resources owned by a business are its assets. Examples of assets include cash, land, buildings, and equipment. The rights or claims to the assets are divided into two types: (1) the rights of creditors and (2) the rights of owners. The rights of creditors are the debts of the business and are called liabilities. The rights of the owners are called stockholders’ equity for a corporation and owner’s equity for a proprietorship, partnership, or limited liability company. Throughout this text, we use the corporate form of business. However, most of the concepts and principles described and il­lustrated also apply to proprietorships, partnerships, and limited liability companies.

The following equation shows the relationship among assets, liabilities, and stockholders’ equity:

Assets = Liabilities + Stockholders’ Equity

This equation is called the accounting equation. Liabilities usually are shown before stockholders’ equity in the accounting equation because creditors have first rights to the assets.

Given any two amounts, the accounting equation may be solved for the third unknown amount. To illustrate, if the assets owned by a business amount to $100,000 and the li­abilities amount to $30,000, the stockholders’ equity is equal to $70,000, as shown below.

Example Exercise 1-2 Accounting Equation

You’re A Star is a motivational consulting business. At the end of its accounting period, December 31,2013, You’re A Star has assets of $800,000 and liabilities of $350,000. Using the accounting equation, determine the following amounts:

  1. Stockholders’ equity as of December 31, 2013.
  2. Stockholders’ equity as of December 31,2014, assuming that assets increased by $130,000 and liabilities decreased by $25,000 during 2014.

Follow My Example 1-2

  • Assets = Liabilities + Stockholders’ Equity

$800,000 = $350,000 + Stockholders’ Equity

Stockholders’ Equity = $450,000

  • First, determine the change in stockholders’ equity during 2014 as follows:

Assets = Liabilities + Stockholders’ Equity

$130,000 = -$25,000 + Stockholders’ Equity

Stockholders’ Equity = $155,000

Next, add the change in stockholders’ equity during 2014 to the stockholders’ equity on December 31, 2013 to arrive at stockholders’ equity on December 31,2014, as shown below.

Stockholders’ Equity on December 31, 2014 = $450,000 + $155,000 = $605,000

Source: Warren Carl S., Reeve James M., Duchac Jonathan (2013), Corporate Financial Accounting, South-Western College Pub; 12th edition.

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