I. The basic accounting identity
We start with a simple equation and then bifurcate each term to add more information.
1. Assets = Liabilities
All resources are owed to someone: they belong to someone.
2. Assets = Owner’s equity (Outsiders’) Liabilities
We separate the liabilities because outsiders’ claims have to be
settled first. Owner’s get the residual value.
If assets increase (owing to operations), owners’ equity increases. If
assets fall in value, owners’ equity falls.
3. Assets = Owner’s Equity LT Liability ST Liability
We separate the liabilities to
know what we have to pay for immediately, as opposed to that for which we are
not pressed. We can keep on breaking it up till the cost of maintaining and presenting
further bifurcations is more than the benefit.
4. Current Assets Fixed Assets = Owners’ Equity LT Liability
This shows that we can bifurcate both sides.
The detail of the assets shows which assets can be liquidated fairly fast (useful
in order to pay off liabilities).
The detail of the assets shows which assets can be liquidated fairly fast (useful in order to pay off liabilities).
No matter which side of the equation we take, it reflects the position
(stock) at a point in time. This statement is called a Balance Sheet (because it
balances) or a Statement of Financial Position.
To see if and how assets and liabilities have grown, we have to see the
changes that took place.
A Cash Flow Statement indicates the changes in assets and the changes in
An Income Statement indicates how the Owner’s equity has increased if
there has been no other additional financing by issuing shares.
|Copyright 2002 Arvind Ashta, Professor Groupe ESC Dijon-Bourgogne, Visiting Faculty at American Business School, Paris and at the University of Paris 6 (Pierre et Marie Curie)|