2. The basis for the accounting process

The basis for the accounting process is the accounting equation. It shows the relationship among the firm’s assets, liabilities and owner’s equity.

Assets are the items of value that a firm owns – cash, inventories, land, equipment, buildings, patents, and the like.

Liabilities are the firm’s debts and obligations – what it owes to others.

Owner’s equity is the difference between a firm’s assets and its liabilities – what would be left over for the firm’s owners if its assets were used to pay off its liabilities.

The relationship among these three terms is the following:

Owner’s equity = assets – liabilities

(The owner’s equity is equal to the assets minus the liabilities)

For a sole proprietorship or partnership, the owner’s equity is shown as the difference between assets and liabilities. In a partnership, each partner’s share of the ownership is reported separately by each owner’s name. For a corporation, the owner’s equity is usually referred to as stockholders’ equity or shareholders’ equity. It is shown as the total value of its stock, plus retained earnings that have accumulated to date.

By moving the above three terms algebraically, we obtain the standard form of the accounting equation.

Assets = liabilities + owners’ equity

(The assets are equal to the liabilities plus the owners’ equity)