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 Current 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).

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 resources.

An Income Statement indicates how the Owner’s equity has increased if there has been no other additional financing by issuing shares.  

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