1.5: The financial accounting process

In this section, we explain the accounting equation—the framework for the entire accounting process. Then, we show you how to recognize a business transaction and describe underlying assumptions that accountants use to record business transactions. Next you learn how to analyze and record business transactions.

In the balance sheet presented in Exhibit 3 (Part C), the total assets of Metro Courier, Inc., were equal to its total liabilities and stockholders’ equity. This equality shows that the assets of a business are equal to its equities; that is,

Assets = Equities

Assets were defined earlier as the things of value owned by the business, or the economic resources of the business. Equities are all claims to, or interests in, assets. For example, assume that you purchased a new company automobile for USD 15,000 by investing USD 10,000 in your own corporation and borrowing USD 5,000 in the name of the corporation from a bank. Your equity in the automobile is USD 10,000, and the bank’s equity is USD 5,000. You can further describe the USD 5,000 as a liability because you owe the bank USD 5,000. If you are a corporation, you can describe your USD 10,000 equity as stockholders’ equity or interest in the asset. Since the owners in a corporation are stockholders, the basic accounting equation becomes:

Assets \((A)=\) Liabilities \((L)+\) Stockholders'equity \((\mathrm{SE})\)

From Metro’s balance sheet in Exhibit 3 (Part C), we can enter in the amount of its assets, liabilities, and stockholders’ equity:

A = L + SE

USD 38,700 = USD 6,600 + USD 32,100

Remember that someone must provide assets or resources—either a creditor or a stockholder. Therefore, this equation must always be in balance.

You can also look at the right side of this equation in another manner. The liabilities and stockholders’ equity show the sources of an existing group of assets. Thus, liabilities are not only claims against assets but also sources of assets.

Together, creditors and owners provide all the assets in a corporation. The higher the proportion of assets provided by owners, the more solvent the company. However, companies can sometimes improve their profitability by borrowing from creditors and using the funds effectively. As a business engages in economic activity, the dollar amounts and composition of its assets, liabilities, and stockholders’ equity change. However, the equality of the basic accounting equation always holds.

An accounting transaction is a business activity or event that causes a measurable change in the accounting equation, Assets = Liabilities + Stockholders’ equity. An exchange of cash for merchandise is a transaction. The exchange takes place at an agreed price that provides an objective measure of economic activity. For example, the objective measure of the exchange may be USD 5,000. These two factors—evidence and measurement—make possible the recording of a transaction. Merely placing an order for goods is not a recordable transaction because no exchange has taken place.

A source document usually supports the evidence of the transaction. A source document is any written or printed evidence of a business transaction that describes the essential facts of that transaction. Examples of source documents are receipts for cash paid or received, checks written or received, bills sent to customers for services performed or bills received from suppliers for items purchased, cash register tapes, sales tickets, and notes given or received. We handle source documents constantly in our everyday life. Each source document initiates the process of recording a transaction.