chapter 1-3

CREATING AN ACCOUNTING EQUATION

Learning Objective 1-3

Identifying the Elements of the Accounting Equation
  • The accounting equation consists of three main elements:
    • Assets
    • Liabilities
    • Stockholders' Equity
Sub-divisions of Stockholders' Equity
  • Stockholders' Equity can be further subdivided into:
    • Common Stock
    • Retained Earnings

Understanding Assets

  • Definition of Assets:
    • Resources utilized by businesses to conduct their operations and earn revenue.
    • Example: Carmike Cinemas, Inc. employs various resources, such as:
    • Buildings
    • Seating
    • Screens
    • Projection equipment
    • Vending machines
    • Cash registers
Sources of Assets

  1. Borrowing from Creditors:

    • A business can obtain assets by borrowing from creditors.
    • Typically involves acquiring cash to purchase necessary assets.
    • Liabilities:
      • Represents the obligation to return borrowed cash in the future.

  2. Acquiring from Investors:

    • Businesses can obtain assets by raising funds from investors.
    • Investors are given ownership interests, represented by Common Stock.
    • The commitment to investors is known as Stockholders' Equity.

  3. Generating through Operations:

    • Businesses use assets to produce additional assets.
    • Example: Best Buy sells a TV for a higher price than its cost:
      • Cost of TV: $500
      • Sale Price: $600
      • Increase in Assets = Sale Price - Cost = $600 - $500 = $100
    • Conversely, operations may decrease assets:
      • If the selling price is discounted to $450, the total assets decrease by $50.
Earnings and Losses
  • Earnings/Income:
    • Refers to net increases in assets from operations.
  • Losses:
    • Refers to net decreases in assets from operations.
  • Dividends:
    • Distribution of earnings to stockholders.
    • Payment of dividends is optional, not a legal requirement.
Retained Earnings
  • Businesses may retain assets generated through operations for future use.
  • Retained Earnings:
    • Represents the commitment to use retained earnings for stockholder benefit.
    • Past retained earnings can be used to pay dividends in the future.
    • A company must have current or prior retained earnings to pay dividends.

Claims on Assets

  • Creditors and investors are entitled to claims on the assets of a business.
  • The relationship between a business's assets and claims on those assets is expressed in the Accounting Equation:
Accounting Equation Development
  • Expressed as:
    • Assets = Claims
    • More specifically:
    • Assets = Liabilities + Stockholders' Equity
    • Assets = Liabilities + Common Stock + Retained Earnings

Practical Application Example

Check Your Understanding: Example Problem
  • Given:
    • Total Assets: $250,000
    • Total Liabilities: $60,000
    • Common Stock: $90,000
Steps to Determine Retained Earnings

  1. Calculate Retained Earnings:

    • Retained Earnings=Assets−Liabilities−Common Stock\text{Retained Earnings} = \text{Assets} - \text{Liabilities} - \text{Common Stock}
    • Retained Earnings=250,000−60,000−90,000=100,000\text{Retained Earnings} = 250{,}000 - 60{,}000 - 90{,}000 = 100{,}000

  2. Calculate Percentage of Assets Provided by Retained Earnings:

    • Percentage of Assets=Retained EarningsTotal Assets\text{Percentage of Assets} = \frac{\text{Retained Earnings}}{\text{Total Assets}}
    • Percentage of Assets Provided by Retained Earnings=100,000250,000=0.4=40%\text{Percentage of Assets Provided by Retained Earnings} = \frac{100{,}000}{250{,}000} = 0.4 = 40\%