Balance sheets and income statements

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The balance sheet reveals the financial condition of a business entity by showing the status of its assets, liabilities, and ownership equities on the specific ending date of an operating period. The income statement reports the economic results of the business entity by matching sales revenue inflows, and expense outflows to show the results of operations—net income or net loss. The income statement is generally considered the more important of the two major financial reports. Since it reports the results of operations, it clearly identifies sales revenue inflows and the cost outflows to produce sales revenue. We will discuss the income statement later in this chapter.

The balance sheet provides an easier basis for understanding double entry accounting, so it will be discussed first. The accounting equation, as it is known, consists of three key elements and defines the basic format of the balance sheet. The basic configurations of a balance sheet and an income statement discussed in this chapter are expanded in Chapter 2.

The balance sheet equation is A =L + OE.

Assets (A)

Resources of value used by a business entity to create revenue, which, in turn, increases assets.

Liabilities (L)

Debt obligations owed to creditors as a result of operations to generate sales revenue; to be paid in the near future with assets. Liabilities represent creditor equity

or claims against the assets of the business entity.

Ownership Equity (OE)

Ownership equity represents claims to assets of a business entity. There are three basic forms of ownership equity:

1. Proprietorship—entity financing provided by a sole owner.

2. Partnership—entity financing provided by two or more owners (partners).

3. Corporation—a legal entity incorporated under the laws of a state, separate from its owners. Capital stock: Financing provided by stock-holders (or shareholders) with ownership rep-resented by shares of corporate stock. Each share of stock represents one ownership claim. Retained earnings: Earnings of the corporation that have been retained.

The equality point indicates an absolute necessity to maintain equality on both sides of the equation. The sum total of the left side of the equation, total assets, A, must equal the total sum of the right side of the equation, liabilities, L, plus ownership equity, OE. When a transaction affects both sides of the equation, equality of the equation must be maintained. One side of the equation can-not increase or decrease without the other side increasing or decreasing by the same amount. If a transaction exists that affects only one side of the equation, total increases must equal total decreases.

The assets consumed produce sales revenue that become cost of sales and operating expenses. The liabilities + ownership equity elements of the equation represent the claims against assets by creditors (liabilities) and claims against the assets by the ownership (OE). The following describes the balance sheet elements:

           ASSETS    =     LIABILITIES       +   OWNERSHIP EQUITY

                   (Resources)    (Creditors’ Equity)         (Ownership Equity)

Because the balance sheet equation is a simple linear equation, knowing dollar values of two of the three basic elements allows the value of the missing element to be identified. The following balance sheet equation has values given for all three elements. Then each of the three examples has the value of one element omitted from the equation to show how to find the value of the missing element:



                      $100,000 = $25,000           +           $75,000

                       [A -L =OE] =$100,000 - $25,000 =$ 75,000

                   [A -OE =L] =$100,000 - $75,000 =$ 25,000

                   [L -OE =A] =$ 25,000 -$75,000 =$100,000


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