Equity as Residual Claims

Task 3: Read the article by Michael Sack Elmaleh and write down the keay phrases for retelling it; retell the article.

The Fundamental Accounting Equation:

Assets = Liabilities + Equity

Businesses usually own assets. Assets are things that can be used to generate revenue through the sale of goods and services. Assets include cash, inventory, furniture and equipment, and accounts receivable. A business may also own intangible assets such as patents, trademarks and goodwill.

Generally Accepted Accounting Principles (GAAP) assumes that all assets of a business are either owned outright by the business owners or are subject to the claims of creditors. Creditors include anyone who has loaned money or extended credit to the business. Loans and other forms of extended credit are called liabilities. The portion of assets not subject to claims by creditors is called equity.

There must be a continuous equilibrium between assets on the one side and the total of liabilities and equity on the other side. This is represented by the fundamental equation of accounting:

Assets = Liabilities + Equity

This equation is also the basis for the most basic of accounting reports, the aptly named Balance Sheet. A balance sheet reports what a business owns (assets), what it owes (liabilities) and what remains for the owners (equity) as of a certain date. This equation must always be in balance. Always keep in mind the teeter totter illustration shown below.

Example. If a business has $1,000 of assets at a particular time those assets must be matched by the total of the claims of creditors and owners. Here is one example of an infinite number of acceptable balance sheets:

Equity as Residual Claims

Equity is simply the difference between assets and liabilities. The owner has positive equity only to the extent that assets exceed liabilities. If a business has $1,000 of assets and $600 of liabilities the $600 of liabilities are, in effect, a claim on the assets. Equity is the difference between the assets and liabilities, or $400.

Equity = Assets - Liabilities

Equity is simply the difference between assets and liabilities. The owner has positive equity only to the extent that assets exceed liabilities. If a business has $1,000 of assets and $500 of liabilities the $500 of liabilities are, in effect, a claim on the assets. Equity is the difference between the assets and liabilities, or $500.

If a business ceases operations remaining assets first go to outside creditors. The claims of owners can be realized only after outside creditors’ claims are satisfied. So equity represents the owners’ residual claim on business assets.

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