Sunday, December 18, 2011
Saturday, December 17, 2011
Transactions change the accounting identity
Transactions allow the firm to interact with outsiders. Transactions are how business happens. They are economic events. The firm produces or consumes resources. Or the firm changes the nature of its economic relationship with its creditors and investors.
The accounting identity needs to hold before and after the transaction. A transaction has a dual effect on the accounting identity because the new resources need to be claimed by creditors or investors. If the firm pays its obligations, fewer resources are available to creditors. If the firm is profitable, the owners benefit.
Transactions affect the firm through accounts. Accounts are classified as assets, liabilities, and equity. Account balances are aggregates of the firm's transactions. They summarize the economic activity of the firm.
The accounting identity needs to hold before and after the transaction. A transaction has a dual effect on the accounting identity because the new resources need to be claimed by creditors or investors. If the firm pays its obligations, fewer resources are available to creditors. If the firm is profitable, the owners benefit.
Transactions affect the firm through accounts. Accounts are classified as assets, liabilities, and equity. Account balances are aggregates of the firm's transactions. They summarize the economic activity of the firm.
Assets = Liabilities + Equity
This equation is the identity of financial accounting. At any given instant, it's true. It's just a snapshot.
Financial accounting requires the economic entity assumption. Our assets are our resources. This stuff makes up the firm - it's not mine; it's not yours; it's not even ours.
It's theirs'. We meet the cast of characters to the right of the equals sign. They are outsiders of the firm, but they claim all the firm's resources.
The liabilities belong to the creditors. Creditors are conservative. Their obligations are determined with certainty. It's in the contract. They don't like the firm taking chances when that may hurt the firm's chances of paying them. Creditors can also be mean. They can force the firm to liquidate if the liabilities exceed the assets and the firm can't pay their obligations when they come due. Their claims come first.
The equity is what's left over for the owners. The owners see opportunity. They share in the growth of the firm and have an indefinite claim to resources as long as they continue to be owners. Why own? The firm pays its owners lease payments called dividends for providing them capital. Investors can be flighty, though. Investors expect the equity of the firm to grow. A rational investor who does not expect growth will sell his shares.
Financial accounting requires the economic entity assumption. Our assets are our resources. This stuff makes up the firm - it's not mine; it's not yours; it's not even ours.
It's theirs'. We meet the cast of characters to the right of the equals sign. They are outsiders of the firm, but they claim all the firm's resources.
The liabilities belong to the creditors. Creditors are conservative. Their obligations are determined with certainty. It's in the contract. They don't like the firm taking chances when that may hurt the firm's chances of paying them. Creditors can also be mean. They can force the firm to liquidate if the liabilities exceed the assets and the firm can't pay their obligations when they come due. Their claims come first.
The equity is what's left over for the owners. The owners see opportunity. They share in the growth of the firm and have an indefinite claim to resources as long as they continue to be owners. Why own? The firm pays its owners lease payments called dividends for providing them capital. Investors can be flighty, though. Investors expect the equity of the firm to grow. A rational investor who does not expect growth will sell his shares.
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