Core Accounting Concepts: Assets, Liabilities, and Equity
Understanding Business Accounting and Financial Statements
The Role of Accounting in Business
Accounting is a scientific discipline that studies and presents a company’s financial position, based on established norms and principles for recording economic information. The primary objective of accounting is to provide crucial financial and economic information to various stakeholders:
- Owners or Shareholders: To monitor the evolution of their investment.
- Managers: To support informed decision-making.
- Public Administration: For tax purposes and regulatory compliance.
- Workers: To understand the financial status of the organization where they are employed.
- Creditors and Suppliers: To assess the guarantees offered by the company.
Components of Business Assets and Liabilities
Patrimony (or Net Worth) represents the collective property, rights, and obligations (debts) of a firm with third parties. It is the difference between what the company owns (assets and rights) and what it owes (obligations).
Defining Key Elements:
- Assets: Tangible or intangible items that serve to satisfy a need or develop a particular activity, and are therefore valued.
- Rights (Receivables): A set of credits in favor of the company. These are debts that customers and other debtors owe to the company.
- Obligations (Liabilities): A set of debts the company has contracted with third parties.
The difference between the assets and rights that the company possesses and the obligations it has contracted constitutes its Equity (or Net Worth).
Accounting Representation of Financial Structure
The left side of an accounting balance (typically the asset side) reflects the economic structure of the company, representing its total investment or the destination of its funds.
The right side is called the financial structure. It identifies the net assets and liabilities, reflecting the company’s financing structure—that is, the sources of financing, which include equity (net worth) and debts with third parties.
Elements of Equity and Accounts
Patrimonial elements are each of the component parts of a company’s assets, liabilities, and equity. This includes assets, rights, obligations, and owner’s contributions. Each of these elements is represented, measured, and valued by an accounting account.
An account is an accounting tool used to measure and represent each patrimonial element and its variations, as well as transactions related to business results (profit and loss). An account reflects both the initial situation and subsequent variations.
Accounting standardization promotes the unification of criteria and provides general accounting rules applicable to all companies. The standardization of assets and liabilities is reflected in a Chart of Accounts (e.g., the PGC plan in Spain). For each asset element, an account is established, typically with a Debit (left) and Credit (right) side.
Types of Accounting Accounts
Accounting accounts are classified based on their nature and where they appear in financial statements:
- Balance Sheet Accounts: These accounts reflect the financial situation of the company at a specific point in time.
- Asset Accounts: Represent economic and financial elements owned by the company.
- Equity Accounts: Record contributions from partners, distributed profits, and other non-refundable variations in owner’s equity.
- Liability Accounts: Collect outstanding financial obligations and debts the company has with third parties.
- Income Statement Accounts (or Management Accounts): These accounts are used for determining the financial outcome (profit or loss) of the company over a period. They appear in the Profit and Loss Account (Income Statement) and never directly in the Balance Sheet.
- Revenue Accounts: Record increases in the company’s equity during a fiscal period, either through inflows or increases in the value of assets.
- Expense Accounts: Record decreases in the company’s equity due to expenditures incurred during a fiscal period.
Classification of Assets
Non-current assets (or Fixed Assets) are formed by those capital elements held by the firm on a permanent basis, and their primary function is to ensure the long-term operation and life of the company.
- Intangible Assets: This category includes non-physical assets that have economic value, such as patents, software, trademarks, and transferable rights.
- Tangible Assets: These are physical elements of sustainable use that are not intended for sale or processing into other products, but are used to develop the company’s activities (e.g., machinery, buildings).
- Financial Investments and Other Assets: This also includes long-term financial investments like shares and participations in other companies.
Asset Valuation and Depreciation
Depreciation is the systematic, annual accounting expression for the loss of value that fixed assets actually suffer due to their utilization in the production process, the passage of time, and obsolescence.
The net book value of assets is the difference between the purchase price or production cost and the accumulated depreciation recorded up to the same date.
Asset values are typically classified as:
- Historical Value: This is the original cost of acquisition or production of an asset.