Definition of the Major Components of the Basic Accounting Equation

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The basic accounting equation draws on the rules of double-entry record-keeping, which ensure that total accounting debits are equal to credits. Bookkeepers, also called junior accountants or accounting clerks, make journal entries to record a company’s day-to-day transactions. These entries involve financial accounts, such as assets, liabilities and equity capital.

Definition

The basic accounting equation is: total assets equal total liabilities plus equity capital. This equation means that a company finances its asset purchases with shareholders’ funds and corporate loans. Explained differently, the equation indicates that equity capital equals total assets minus total debts, which means that a company’s net worth is what it owns minus what it owes.

Assets

Assets are economic resources that a company relies on to operate and get a foothold in the marketplace. Accountants use the concept of “useful life” to describe the length of time an asset will serve in corporate operations. A resource with a useful life of 12 months or less is a short-term asset. Examples include inventories, notes receivable, cash, short-term investments and accounts receivable. Long-term assets serve in operating activities for more than one year. Financial managers use “capital assets,” “long-term resources,” “fixed assets” and “tangible resources” identically. Examples include factories, equipment, land and buildings.

Liabilities

Liabilities are debts that a borrower must repay on time. Honoring financial commitments is a mark of economic soundness for companies. It's also an important criterion that credit-rating agencies take into account when appraising default risk. Short-term debts are due within 12 months and include taxes payable, remittances to vendors and salaries. Long-term liabilities have a maturity date exceeding one year. Examples include bonds and notes payable, which are key financial tools that enable a firm to fund significant initiatives (mergers and acquisitions, for example). Government agencies also issue bonds to fund large infrastructure projects, such as the construction of roads and buildings.

Equity Capital

Equity capital represents the shareholders’ ownership stake in a company. Equity buyers, also called stockholders or shareholders, hold voting rights and appoint corporate leadership. They make profits when share prices increase on securities exchanges, such as the New York Stock Exchange. Stockholders also receive periodic dividend payments, an extra incentive that lures investors to financially healthy companies.

Financial Reporting

The fundamental accounting equation relates to the balance sheet, also known as a statement of financial position or statement of financial condition. Other accounting reports include a statement of profit and loss, a cash flow statement and a retained earnings report. A profit and loss statement, or P&L, is also known as an income statement or statement of income.

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