PAETE SCIENCE and BUSINESS

COLLEGE
Paete, Laguna

ACCOUNTING

Submitted by:
GIDEON V. MAMENTA

INTRODUCTION TO ACCOUNTING
Accountancy is the process of communicating financial information
about a business entity to users such as shareholders and managers
(Elliot, Barry & Elliot, Jamie: Financial accounting and reporting).
Accounting has been defined as:
the art of recording, classifying, and summarizing in a significant
manner and in terms of money, transactions and events which
are, in part at least, of financial character, and interpreting the
results thereof.(AICPA)
Users of Accounting Information - Internal & External
Accounting information helps users to make better financial decisions.
Users of financial information may be both internal and external to the
organization.
Internal users (Primary Unsers) of accounting information include
the following:

Management: for analyzing the organization's performance and

position and taking appropriate measures to improve the
company results.

Employees: for assessing company's profitability and

consequence on their future remuneration and job security.

Owners: for analyzing the viability and profitability of their

investment and determining any future course of action.

its

Accounting information is presented to internal users usually in the

form of management accounts, budgets, forecasts and financial
statements.

External users (Secondary

include the following:

Users) of accounting information

Creditors: for determining the credit worthiness of the

organization. Terms of credit are set by creditors according to the

assessment of their customers' financial health. Creditors include

suppliers as well as lenders of finance such as banks.

Tax Authourities: for determining the credibility of the tax returns

filed on behalf of the company.

Investors: for analyzing the feasibility of investing in the

company. Investors want to make sure they can earn a
reasonable return on their investment before they commit any
financial resources to the company.

Customers: for assessing the financial position of its suppliers

which is necessary for them to maintain a stable source of supply
in the long term.

Regulatory Authorities: for ensuring that the company's

disclosure of accounting information is in accordance with the
rules and regulations set in order to protect the interests of the
stakeholders who rely on such information in forming their
decisions.

Introduction to Accounting
Accountancy is the process of communicating financial information
about a business entity to users such as shareholders and managers
(Elliot, Barry & Elliot, Jamie: Financial accounting and reporting).
Accounting has been defined as:
the art of recording, classifying, and summarizing in a significant
manner and in terms of money, transactions and events which
are, in part at least, of financial character, and interpreting the
results thereof.(AICPA)
Users of Accounting Information - Internal & External
Accounting information helps users to make better financial decisions.
Users of financial information may be both internal and external to the
organization.

Internal users (Primary Users) of accounting information include

the following:

Management: for analyzing the organization's performance and

position and taking appropriate measures to improve the
company results.

Employees: for assessing company's profitability and

consequence on their future remuneration and job security.

Owners: for analyzing the viability and profitability of their

investment and determining any future course of action.

its

Accounting information is presented to internal users usually in the

form of management accounts, budgets, forecasts and financial
statements.
External users (Secondary
include the following:

Users) of accounting information

Creditors: for determining the credit worthiness of the

organization. Terms of credit are set by creditors according to the
assessment of their customers' financial health. Creditors include
suppliers as well as lenders of finance such as banks.

Tax Authourities: for determining the credibility of the tax returns

filed on behalf of the company.

Investors: for analyzing the feasibility of investing in the

company. Investors want to make sure they can earn a
reasonable return on their investment before they commit any
financial resources to the company.

Customers: for assessing the financial position of its suppliers

which is necessary for them to maintain a stable source of supply
in the long term.

Regulatory Authorities: for ensuring that the company's disclosure of

accounting information is in accordance with the rules and regulations
set in order to protect the interests of the stakeholders who rely on
such information in forming their decisions. Types of Accounting
Accounting is a vast and dynamic profession and is constantly adapting
itself to the specific and varying needs of its users. Over the past few
decades, accountancy has branched out into different types of
accounting to cater for the diversity of needs of its users.

Main types of accountingare as follows:

1. Financial
2. Management
3. Governmental
4. Tax
5. Forensic
6. Project
7. Social
Financial Accounting, or financial reporting, is the process of producing
information for external use usually in the form of financial statements.
Financial Statements reflect an entity's past performance and current
position based on a set of standards and guidelines known as GAAP
(Generally Accepted Accounting Principles). GAAP refers to the
standard framework of guideline for financial accounting used in any
given jurisdiction. This generally includes accounting standards (e.g.
International Financial Reporting Standards), accounting conventions,
and rules and regulations that accountants must follow in the
preparation of the financial statements.
Management Accounting produces information primarily for internal
use by the company's management. The information produced is
generally more detailed than that produced for external use to enable
effective organization control and the fulfillment of the strategic aims
and objectives of the entity. Information may be in the form budgets
and forecasts, enabling an enterprise to plan effectively for its future or
may include an assessment based on its past performance and results.
The form and content of any report produced in the process is purely
upon management's discretion.
Cost accounting is a branch of management accounting and involves
the application of various techniques to monitor and control costs. Its
application is more suited to manufacturing concerns.
Governmental Accounting, also known as public accounting or federal
accounting, refers to the type of accounting information system used
in the public sector. This is a slight deviation from the financial
accounting system used in the private sector. The need to have a

separate accounting system for the public sector arises because of the
different aims and objectives of the state owned and privately owned
institutions. Governmental accounting ensures the financial position
and performance of the public sector institutions are set in budgetary
context since financial constraints are often a major concern of many
governments. Separate rules are followed in many jurisdictions to
account for the transactions and events of public entities.
Tax Accounting refers to accounting for the tax related matters. It is
governed by the tax rules prescribed by the tax laws of a jurisdiction.
Often these rules are different from the rules that govern the
preparation of financial statements for public use (i.e. GAAP). Tax
accountants therefore adjust the financial statements prepared under
financial accounting principles to account for the differences with rules
prescribed by the tax laws. Information is then used by tax
professionals to estimate tax liability of a company and for tax
planning purposes.
Forensic Accounting is the use of accounting, auditing and
investigative techniques in cases of litigation or disputes. Forensic
accountants act as expert witnesses in courts of law in civil and
criminal disputes that require an assessment of the financial effects of
a loss or the detection of a financial fraud. Common litigations where
forensic accountants are hired include insurance claims, personal injury
claims, suspected fraud and claims of professional negligence in a
financial matter (e.g. business valuation).
Project Accounting refers to the use of accounting system to track the
financial progress of a project through frequent financial reports.
Project accounting is a vital component of project management. It is a
specialized branch of management accounting with a prime focus on
ensuring the financial success of company projects such as the launch
of a new product. Project accounting can be a source of competitive
advantage for project-oriented businesses such as construction firms.
Social Accounting, also known as Corporate Social Responsibility
Reporting and Sustainability Accounting, refers to the process of
reporting implications of an organization's activities on its ecological
and social environment. Social Accounting is primarily reported in the
form of Environmental Reports accompanying the annual reports of
companies. Social Accounting is still in the early stages of development
and is considered to be a response to the growing environmental
consciousness amongst the public at large.
What are Financial Statements?

Financial Statements represent a formal record of the financial

activities of an entity. These are written reports that quantify the
financial strength, performance and liquidity of a company. Financial
Statements reflect the financial effects of business transactions and
events on the entity.
Four Types of Financial Statements
The four main types of financial statements are:
1. Statement of Financial Position
Statement of Financial Position, also known as the Balance Sheet,
presents the financial position of an entity at a given date. It is
comprised of the following three elements:
o Assets: Something a business owns or controls (e.g. cash,
inventory, plant and machinery, etc)
o Liabilities: Something a business owes to someone (e.g.
creditors, bank loans, etc)
o Equity: What the business owes to its owners. This
represents the amount of capital that remains in the
business after its assets are used to pay off its outstanding
liabilities. Equity therefore represents the difference
between the assets and liabilities.

2. Income Statement
Income Statement, also known as the Profit and Loss Statement,
reports the company's financial performance in terms of net
profit or loss over a specified period. Income Statement is
composed of the following two elements:
o Income: What the business has earned over a period (e.g.
sales revenue, dividend income, etc)
o Expense: The cost incurred by the business over a period
(e.g. salaries and wages, depreciation, rental charges, etc)

Net profit or loss is arrived by deducting expenses from income.

View detailed explanation and Example of Income Statement
3. Cash Flow Statement
Cash Flow Statement, presents the movement in cash and bank
balances over a period. The movement in cash flows is classified
into the following segments:
o Operating Activities: Represents the cash flow from primary
activities of a business.
o Investing Activities: Represents cash flow from the
purchase and sale of assets other than inventories (e.g.
purchase of a factory plant)
o Financing Activities: Represents cash flow generated or
spent on raising and repaying share capital and debt
together with the payments of interest and dividends.
View detailed explanation and Example of Cash Flow Statement
4. Statement of Changes in Equity
Statement of Changes in Equity, also known as the Statement of
Retained Earnings, details the movement in owners' equity over
a period. The movement in owners' equity is derived from the
following components:
o Net Profit or loss during the period as reported in the
income statement
o Share capital issued or repaid during the period
o Dividend payments
o Gains or losses recognized
revaluation surpluses)

directly

in

equity

(e.g.

o Effects of a change in accounting policy or correction of

accounting error

Link between Financial Statements

Statement of Financial Position [Balance Sheet]

Definition
Statement of Financial Position, also known as the Balance Sheet,
presents the financial position of an entity at a given date. It is
comprised of three main components: Assets, liabilities and equity.

Statement of Financial Position helps users of financial statements to

assess the financial soundness of an entity in terms of liquidity risk,
financial risk, credit risk and business risk.
Example
Following is an illustrative example of a Statement of Financial Position
prepared under the format prescribed by IAS 1 Presentation of Financial
Statements.

Statement of Financial Position as at 31st December 2013

2013
2012
Notes
ASSETS
Non-current assets
Property, plant & equipment
Goodwill
Intangible assets

9
10
11

130,000
30,000
60,000
220,000

Current assets
Inventories
Trade receivables
Cash and cash equivalents

12
13
14

12,000 10,000
25,000 30,000
8,000
10,000
45,000 50,000
265,000 250,000

100,000
50,000
15,000
165,000

TOTAL ASSETS

120,000
30,000
50,000
200,000

EQUITY AND LIABILITIES

Equity
Share capital
Retained earnings
Revaluation reserve
Total equity

100,000
40,000
10,000
150,000

Non-current liabilities
Long term borrowings

Current liabilities
Trade and other payables
7
Short-term borrowings
8
Current
portion
of
long-term
6
borrowings
Current tax payable
9
Total current liabilities
Total liabilities
TATAL EQUITY AND LIABILITIES

35,000

50,000

35,000
10,000

25,000
8,000

15,000

15,000

5,000

2,000

65,000 50,000
100,000 100,000
265,000 250,000

Classification of Components
Statement of financial position consists of the following key elements:
Assets
An asset is something that an entity owns or controls in order to derive
economic benefits from its use. Assets must be classified in the
balance sheet as current or non-current depending on the duration
over which the reporting entity expects to derive economic benefit
from its use. An asset which will deliver economic benefits to the entity
over the long term is classified as non-current whereas those assets
that are expected to be realized within one year from the reporting
date are classified as current assets.
Assets are also classified in the statement of financial position on the
basis of their nature:

Tangible & intangible: Non-current assets with physical substance

are classified as property, plant and equipment whereas assets
without any physical substance are classified as intangible
assets. Goodwill is a type of an intangible asset.

Inventories balance includes goods that are held for sale in the
ordinary course of the business. Inventories may include raw
materials, finished goods and works in progress.

Trade receivables include the amounts that are recoverable from

customers upon credit sales. Trade receivables are presented in
the statement of financial position after the deduction of
allowance for bad debts.

Cash and cash equivalents include cash in hand along with any
short term investments that are readily convertible into known
amounts of cash.

Liabilities
A liability is an obligation that a business owes to someone and its
settlement involves the transfer of cash or other resources. Liabilities
must be classified in the statement of financial position as current or
non-current depending on the duration over which the entity intends to
settle the liability. A liability which will be settled over the long term is
classified as non-current whereas those liabilities that are expected to
be settled within one year from the reporting date are classified as
current liabilities.
Liabilities are also classified in the statement of financial position on
the basis of their nature:

Trade and other payables primarily include liabilities due to

suppliers and contractors for credit purchases. Sundry payables
which are too insignificant to be presented separately on the
face of the balance sheet are also classified in this category.

Short term borrowings typically include bank overdrafts and short

term bank loans with a repayment schedule of less than 12
months.

Long-term borrowings comprise of loans which are to be repaid

over a period that exceeds one year. Current portion of long-term
borrowings include the installments of long term borrowings that
are due within one year of the reporting date.

Current Tax Payable is usually presented as a separate line item

in the statement of financial position due to the materiality of the
amount.

Equity

Equity is what the business owes to its owners. Equity is derived by

deducting total liabilities from the total assets. It therefore represents
the residual interest in the business that belongs to the owners.
Equity is usually presented in the statement of financial position under
the following categories:

Share capital represents the amount invested by the owners in

the entity

Retained Earnings comprises the total net profit or loss retained

in the business after distribution to the owners in the form of
dividends.

Revaluation Reserve contains the net surplus of any upward

revaluation of property, plant and equipment recognized directly
in equity.

Assets, Liabilities & Equity

Accounting is fundamentally about Assets, Liabilities and Equity. Once
you understand what these are, you will be well on your way to
understanding Accounting.
Beginners will be happy to know that the general day to day meaning
of the word 'asset' relates perfectly to the accounting meaning. So
when you listen to phrases such as "Mr. X or Miss Y is an asset to the
organization" you know that the speaker is implying that these
individuals are of value to the company.
In the accounting sense, an asset is an item of value owned by a
company. Assets may be tangible physical items or intangible items
with no physical form. Assets add value to a company, and are
important to a company's continued success.
As with assets, you may look at the wider world to gain an
understanding of what's a liability. No one is particularly pleased when
he or she is described as a "liability". This is so because the liability
description is a negative one.
In accounting, liabilities are obligations of the company to transfer
something of value (an asset - see above) to another party. On a
companys balance sheet, a liability may be a legal debt or an accrual,
which is an estimate of an obligation.

You're now two thirds of the way to understanding the basics of

accounting, and what you'll see on the typical balance sheet. The final
third is equity. In day-to-day parlance, you may be familiar with the
word "equity" if you're a homeowner. Homeowners who make regular
mortgage payments will accumulate equity value in their property, and
will be able to borrow against that equity.
Equity is the owner's value in an asset or group of assets.
In accounting, equity is usually defined as the value of the assets
contributed by the owners. This is added to the total income earned
and retained by the company to give the company's total equity value.
This description of equity is correct but very simplistic. A more
profound description is really that used by the homeowner, that is,
equity is the owner's value in an asset or group of assets.
As an example, a company with total assets valued at 1,000, may have
debt (liabilities) valued at 900, in which case the owner's value in the
assets is 100, representing the company's equity.
The following is the Equity equation:
Total Assets minus Total Liabilities (T - A = E). T - A (or Equity) is also
referred to as Net Worth, Capital & Shareholders Equity.
GROUPING ASSETS
Assets are grouped in order of liquidity, not only because it makes
sense but also because liquidity is the lifeblood of a company. Liquidity
refers to the ease in which an asset can be converted to cash. Cash is
therefore the most liquid of all assets.
Assets that are very liquid are shown on the balance sheet as current
assets. Current assets are assets that are expected to be converted to
cash in 12 months or less. Those assets with convertibility exceeding
twelve months are considered to be illiquid and are categorized as
fixed or long-term assets.
CURRENT ASSETS
1.
2.
3.
4.
5.

Cash
Short-term investments
Accounts Receivable
Inventory
Prepayments (Prepaid expenses)

The assets above represent the current assets that are usually found
on the typical balance sheet. As shown, the assets are arranged in
descending order in order of liquidity, from cash, which is the most
liquid asset, to prepayment, which is the least liquid of the five items
above.
The management of current assets is fundamental to the operating
success of a business. This is where the vital operating assets are
found, driving the day-to-day activity of the company. Companies are
forced to spend significant sum of money to ensure proper
management of current assets.
For instance, cash is usually monitored by the company's Treasury
department, which focuses on the management of bank accounts,
investments, lockboxes etc. Accounts receivable is managed with
collections and credit staff, while inventory is managed with an array of
staff for purchasing, disbursement and valuation.
Assets, Liabilities & Equity - An Intro (Part II)
It's the current assets that provide the fuel for the engine of growth in
a company. Inventory is a good example of the importance of current
assets. Inventory represents assets being held by the company for
sale, and the speed of the movement of the inventory through the
company is of significant importance to the operating success of the
company.
Fixed Assets
Fixed assets are those assets owned by a company that contributes to
the company's income but are not consumed in the income generating
process and are not held for cash conversion purposes. Fixed assets
are tangible items usually requiring significant cash outlay and lasting
for an extended period of time.
When an asset is purchased, the value of the asset is not recorded
against the company's revenue, but is entered by opening a separate
account for the account. This accounting process is known as
capitalizing.
For accounting purposes, a portion of the value of the fixed asset is
charged against profit during each accounting period. This process is
called depreciation.

Unlike its more parochial meaning, depreciation is not simply a

reduction in value. It is a fundamental aspect of accounting as dictated
by the Matching principle that ensures that expense is matched
against the revenue it helps to generate.
Many methods of depreciation calculation exist today, however major
corporations usually use one of the following methods:

Straight line

Declining/Reducing balance

a. Sum of years' digits

b. Double declining balance
While it is not possible to list all fixed assets here, the following are a
few that will show up on the typical balance sheet:

Machinery

Property, Plant and Equipment

Motor Vehicles

Leasehold Improvements

Because of the cash outlay involved, the purchase of most fixed assets
is usually preceded by an extended period of cost/benefit analysis by
the company's accounting staff. The aim of this analysis is to
determine, as best as possible that the asset purchased will add value
to the company during its useful life, by generating greater positive
cash flow than it cost when it was purchased. '
Fixed assets are usually booked at the acquisition cost. However, in
some cases additional costs may be incurred to make the asset
useable. This cost should also be included in the cost of the fixed asset.
Consider the purchase of a refrigerator by a grocery store. The
refrigerator cost 10,000, however it needed a special thermostat to
allow it to operate in the store. Because the thermostat cost the
company a 1,000, the value of the refrigerator will be recorded as
11,000 (10,000 + 1,000).

As the asset is used in the business it may have to be repaired from

time to time. The cost of the repair can either be capitalized or
expensed, depending on whether the repair resulted in an extension of
the asset's life or not. Repairs extending the life of the asset will add to
the value of the asset (that is, capitalized), while repairs that merely
serve to maintain the life of the asset will be expensed.
Generally speaking, the following initial cost of an asset will be
capitalized to represent the value of the asset:

The price of the asset

The charge for delivery

Charges for installation and other setups.

During the life of the asset, the following costs will be capitalized:

Any replacement extending the life of the asset

Any significant addition to the asset

Any extensive service that will extend the life of the asset

Understanding fixed assets is very important to a clear understanding

of accounting and should be an area exploited by anyone anxious to
learn about the accounting process.
Liabilities
Companies will borrow from financial institutions, from suppliers or
from the any individual, group of individuals or corporation willing to
lend. Debt is therefore an ever-present part of a company's financial
consideration.
At any point in time, the average company will find itself in the
following position: It will own assets; it's owners will maintain some
value in the company; it will be indebted to creditors/non-owners.
Liabilities reflect the level of indebtedness to creditors.

Liability is a source of funds for a company, and the company will use
the fund (purchasing power) to enhance the business (purchase fixed
assets, inventory, pay creditors etc.)
Liabilities are contractual obligations and companies are required to
honor their liability contracts or face legal suits. The content of a
liability contract may be extremely simple or very complex. Some
creditors may request that the borrowing company pay interest on its
debt, as well as maintain certain accounting ratios, a specific cash
balance or a certain level of net worth, while another credit may simple
require repayment of the principal at a particular time.
Current Liabilities
Current liabilities may be viewed as the flip side of current assets, and
requires similar managerial attention as current assets. Current
liabilities represent the amount owed to creditors due for payment
within 12 months.
Current liabilities are usually amount owed for operating expenses,
dominated by accounts payable. However in many cases, current
liabilities also include Current Portion of Long Term Debt, which is the
amount of long-term debt due for payment in less than 12 months.
Managing current liabilities is very important to a company's cash flow
process and extended viability. Failure to appropriately manage current
liabilities will result in working capital issues, which could lead to
operating failures.
Current liabilities are ideally settled using current assets, necessitating
the combined management of the two. Current assets less current
liabilities are called working capital.
The following are a few of the current liabilities you may see on the
typical balance sheet:

Accounts Payable

Notes Payable

Short-term portion of long-term debts

Income Tax Payable

Wages Payable

Accruals/accrued expenses

Accounts payable represents trade debts and is usually due within 30

days. Many companies are able to negotiate trade debt terms longer
than 30 days, improving their cash position for as long as payment is
delayed.
Notes payable represents intermediate debt borrowed for a period
greater than 2 but less than 10 years. The amount included among
current liabilities is the amount due in less than twelve months. The
amount due after 12 months is reflected on the balance sheet as longterm debt.
A significant amount of a company's long-term debt is repaid over
many years. Amount will fall due on a yearly basis and that portion is
shown on the balance sheet as current liabilities in the form of "Current
Portion of Long-term Debt". Failure to pay this amount when due may
result in a loan default, which could have serious negative repercussion
for the company.
Income tax payable is the amount of tax owed to the government
based on the accounting profit earned.
Wages payable represents amounts owed to employees.
Accrued expenses represent operating expenses incurred but not paid
for. Accrued expenses may be analyzed as the flip side of prepaid
expenses.
While
prepaid
expenses
represent
amount
for
services/goods not yet received, accrued expenditure represents
services used/goods received but not yet paid for.
Long-Term Liabilities
Long-term liabilities are debt obligations of the company that is not
due for repayment within the next 12 months. Most companies will
hold both short and long-term debt, with no limit on how "long-term"
the debt may be. So while there are a minimum number of months for

a liability to be considered long-term, there is no maximum time

period.
Long-term liabilities are usually much larger in value than short-term
liabilities and are usually non-trade debt. There are many differences
between the two groups of debt (current and long-term), however most
of the differences are not unique to any one group, but are instead
more often used in one group and not the other. Collateral is a good
example of a debt requirement often associated with long-term debt.
This is not to say that a creditor offering short-term loans is prevented
from requesting collateral, however this is usually more popular for
debt with a life of more than one year. The same is true of covenants
and convertibility.
Unlike short-term liabilities, long-term liabilities are often an important
part of the capital structure of a company. It provides fund for the
purchase of long-lived assets used to generate revenue over many
years, and from which cash flow is not immediate. This source of fund
can provide significant benefits to a company, but can also lead to
significant problems. Many companies are forced into bankruptcy
because of the difficulties in financing long-term debt and the heavy
burden the interest charges bring to bear on the companys operating
cash flow and bottom line.
There are numerous types of long-term liabilities, with companies and
creditors having the flexibility to negotiate hundreds of different
variations of loans/debentures/bonds. A new type of long-term debt is
maybe created everyday, however, the following are the ones you will
probably find under the Long-Term Liabilities section of the next
balance sheet you peruse:

Debt to Financial institutions

Bonds

Debentures

Mortgages

Each loan will have some kind of agreement for repayment, including
the due dates and the specific amount. The loan contract may also
include the following: Any applicable interest rate, a default clause, a
listing of the collaterals being held by the creditor, any covenants
associated with the loan and a convertibility clause. Prudent

management will seek to understand the content of the loan contract

before accepting the loan, and will continue to adhere to the contract
throughout the life of the loan. Failure to do so may activate the default
clause, which could result in a demand for immediate repayment for
the entire debt by the creditors.
Equity
Businesses need to be financed, and although this financing is not
necessarily required to come from the owners, most companies will
have a portion of its financing fund coming from those owning the
business. This funding that is supplied to the company by the owners is
called "equity".
Equity is also provided when the company generates profit and retains
that profit in the business. This is reflected on the balance sheet as
Retained Earnings. By the same token, a company generating losses
will reduce its equity by the value of the loss.
Equity by definition indicates the value of the company to its owners. It
is therefore possible for the owners to contribute equity to the business
but lose that equity during the life of the business. You will from time to
time observe balance sheets with negative equity balances. Of course,
business owners commit their funding to companies mainly to increase
their wealth with the operating success of the company; it is therefore
possible for owners to increase their equity significantly without
actually contributing new funding to the business.
Just so you know, some writers do describe liability as the equity of
creditors, a description that doesn't sit well with many, as it seems to
transform the true meaning of the word "equity". The description is
correct if equity is taken to mean, "rights to property", which is what
the creditors have. Generally speaking, equity speaks to the property
rights held by the owners of a business in the business they own.
Equity (also referred to as Capital, Shareholder's equity, Net Worth) can
be mathematically stated as the difference between Total Assets and
Total Liabilities. This difference is also known as Net Assets. Positive
equity therefore implies that the sum of the company's assets is
greater than the sum of its liabilities, while negative equity implies that
the sum of its assets is less than the sum of its liabilities, in which case
the business is completely "owned" by the creditors. Not a pleasant
situation for any company to be in!

The Shareholders' Equity section of the balance sheet can be very

crowded and it can also be sparse. A balance sheet with a sparse
shareholders' equity section will probably only show the following:

Preferred Stock

Common Stock

Retained Earnings

A more complex balance sheet will show a more crowded section on

shareholders' equity. It may look something like this:

Preferred Stock

Common stock, par value 1:

a. Authorized shares
b. Issued shares

Additional Paid-In Capital

Retained earnings

Treasury stock

Foreign currency translation adjustment

Preferred stock Preferred stock is usually defined as a hybrid

between debt and equity. It's a hybrid because it maintains the
dividend-paying characteristic of common stock, as well as the fixed
interest payment of debt. Unlike common stockholders, preferred
stockholders are usually not given voting rights. Common stock
Common Stock has no predetermined dividend payout rate or time, but
the holders maintain the rights to vote and the right to share in the
residual value of the company upon liquidation. Additional Paid-In
Capital Additional Paid-In Capital represents the excess paid for the
company's stock above the par value. Treasury stock Treasury stock,
which is always a negative value, represents the company's purchase
of its own stock.
Rationale - Why the balance sheet always balances?

The balance sheet is structured in a manner that the total assets of an

entity equal to the sum of liabilities and equity. This may lead you to
wonder as to why the balance sheet must always be in equilibrium.
Assets of an entity may be financed from internal sources (i.e. share
capital and profits) or from external credit (e.g. bank loan, trade
creditors, etc.). Since the total assets of a business must be equal to
the amount of capital invested by the owners (i.e. in the form of share
capital and profits not withdrawn) and any borrowings, the total assets
of a business must equal to the sum of equity and liabilities.
This leads us to the Accounting Equation: Assets = Liabilities + Equity
Purpose & Importance
Statement of financial position helps users of financial statements to
assess the financial health of an entity. When analyzed over several
accounting periods, balance sheets may assist in identifying underlying
trends in the financial position of the entity. It is particularly helpful in
determining the state of the entity's liquidity risk, financial risk, credit
risk and business risk. When used in conjunction with other financial
statements of the entity and the financial statements of its
competitors, balance sheet may help to identify relationships and
trends which are indicative of potential problems or areas for further
improvement. Analysis of the statement of financial position could
therefore assist the users of financial statements to predict the
amount, timing and volatility of entity's future earnings.