Elements Fundamentals

Introduction

While in operation, as far as accounting is concerned, a business is financially dealing with two categories of elements: its assets and its liabilities.

An asset is something (a resource) that the company currently owns and uses to get the business functioning.

An asset can be an item without which the company would not operate. For example, for a car rental company, an asset can be the piece of paper used to register information about the customers who come to rent a car. For the same company, an asset can the car that a customer comes to rent.

An asset can also be something that is not a necessity for business conduct but can be particularly useful. For example, for a car rental company, the assets can be the furniture (tables, chairs, book shelves, etc), luxurious cars for demanding customers.

An asset can also be a convenient item for every day use. Examples are water fountain in the hallway, a microwave oven in the kitchen, or garbage cans under the employees desks, etc.

A liability is an obligation that a business has towards an external entity, based on a previous transaction. That is, a liability is a debt or an obligation that a company has towards a person or another business. (In some cases or scenarios, the work liability seems to (always) have a pejorative meaning, not in accounting. Therefore, do not consider the concept or idea of liability as negative or as having negative effects. In fact, without liabilities, which are largely based on promises (that must be kept), it is hard to think of how businesses could function). There are various scenarios in which liabilities apply.

A liability could be money that a business owes to an entity such as a bank. For example, suppose a person starts a doughnut shop. The business starts operating and becomes successful, so much that the company becomes unable to meet the new urgent demands. The business owner finds out that he needs a new doughnut machine but that costs more money than the business owner has. He would borrow money from a bank to purchase the necessary and valuable machine to meet his expectations. The money owed becomes a liability (but notice that this is necessary and useful).

For a car rental company, a business usually cannot or should not purchase dozens of cars to rent to customers. Instead, the business can make some arrangements with a car dealer to put the cars to rent. After the car dealer has delivered a car, each month, the car rental company would pay a certain amount to the car dealer. Therefore, the car is a liability to the car rental company. In the same way, because computers can be expensive, instead of purchasing all the desired computers used by the employees, a car rental company would finance them and pay a certain amount each month.

The entities to whom a business owes something are called creditors. Because a business has the responsibility of paying its debts, the creditors usually have the ability to collect their dues (through legal means).

The owner's equity is the difference between what the business owns and what it owes. Put it another way, the assets are the total of the liabilities and the owner's equity. This can be mathematically expressed as follows:

Assets = Liabilities + Owner's Equity

or

A = L + OE

As you can imagine, the owner's equity can be a measure by which a company has or does not have the needed resources for an effective conduct of its business. To express the relativity of this measure, we say that the owner's equity increases or decreases.

The owner's equity is said to increase when money is put into the business. There are two main ways this happens.

Investments: Usually to starts a business, a person uses his or her own money as the starting capital. During the lifetime of the business, the owner may add more money, however he or she gets it. This way of putting money into the business is called an investment.

Revenues: A revenue is money that gets into the business as a result of a sale of good (such as selling a doughnut or receiving money from renting a car) or a sale of service (such as teaching a night class and getting paid for it).

The owner's equity is said to decrease when money is taken from the business. There are various examples:

Drawings/Withdrawals: The owner may take money from the business for personal use. This is referred to as drawing and results in a decrease of owner's equity.

Expenses: An expense is an action resulting from taking money for normal business use. Examples are purchasing a computer for the company, buying a box of hair product for a hair salon business, or acquiring hard hats for contractors of a construction company.