The three major elements of accounting are: Assets, Liabilities, and Capital. These terms are used widely in accounting so we'll take a close look at each element. But before we go into them, we need to understand what an "account" is first.
The term "account" is used often in this tutorial so let's understand what it is before we proceed. In accounting, an account is a descriptive storage unit used to collect and store information of similar nature.
For example, "Cash".
Cash is an account that stores all transactions that involve cash receipts and cash payments. All cash receipts are recorded as increases in "Cash" and all payments are recorded as deductions in the same account.
Through this, we will be able to determine the cash balance as all related additions and deductions are collated in the account.
Another example, "Office Supplies". Suppose a company acquires boxes of pens and pays in cash. That transaction would be recorded in the "Office Equipment" account for the pens bought and also a reduction in the "Cash" account for the payment made.
Now, let's take a look at the accounting elements.
Assets refer to resources owned and controlled by the entity as a result of past transactions and events, from which future economic benefits are expected to flow to the entity. In simple terms, assets are properties or rights owned by the business. They may be classified as current or non-current.
A. Current assets – Assets are considered current if they are held for the purpose of being traded, expected to be realized or consumed within twelve months after the end of the period or its normal operating cycle (whichever is longer), or if it is cash. Examples of current asset accounts are:
B. Non-current assets – Assets that do not meet the criteria to be classified as current. Hence, they are long-term in nature – useful for a period longer that 12 months or the company's normal operating cycle. Examples of non-current asset accounts include:
Liabilities are economic obligations or payables of the business.
Company assets come from 2 major sources – borrowings from lenders or creditors, and contributions by the owners. The first refers to liabilities; the second to capital.
Liabilities represent claims by other parties aside from the owners against the assets of a company.
Like assets, liabilities may be classified as either current or non-current.
A. Current liabilities – A liability is considered current if it is due within 12 months after the end of the balance sheet date. In other words, they are expected to be paid in the next year.
If the company's normal operating cycle is longer than 12 months, a liability is considered current if it is due within the operating cycle.
Current liabilities include:
B. Non-current liabilities – Liabilities are considered non-current if they are not currently payable, i.e. they are not due within the next 12 months after the end of the accounting period or the company's normal operating cycle, whichever is shorter.
In other words, non-current liabilities are those that do not meet the criteria to be considered current. Hah! Make sense? Non-current liabilities include:
Also known as net assets or equity, capital refers to what is left to the owners after all liabilities are settled. Simply stated, capital is equal to total assets minus total liabilities. Capital is affected by the following:
Owner contributions and income increase capital. Withdrawals and expenses decrease it.
The terms used to refer to a company's capital portion varies according to the form of ownership. In a sole proprietorship business, the capital is called Owner's Equity or Owner's Capital; in partnerships, it is called Partners' Equity or Partners' Capital; and in corporations, Stockholders' Equity.
In addition to the three elements mentioned above, there are two items that are also considered as key elements in accounting. They are income and expense. Nonetheless, these items are ultimately included as part of capital.
Income refers to an increase in economic benefit during the accounting period in the form of an increase in asset or a decrease in liability that results in increase in equity, other than contribution from owners.
Income encompasses revenues and gains.
Revenues refer to the amounts earned from the company’s ordinary course of business such as professional fees or service revenue for service companies and sales for merchandising and manufacturing concerns.
Gains come from other activities, such as gain on sale of equipment, gain on sale of short-term investments, and other gains.
Income is measured every period and is ultimately included in the capital account. Examples of income accounts are: Service Revenue, Professional Fees, Rent Income, Commission Income, Interest Income, Royalty Income, and Sales.
Expenses are decreases in economic benefit during the accounting period in the form of a decrease in asset or an increase in liability that result in decrease in equity, other than distribution to owners.
Expenses include ordinary expenses such as Cost of Sales, Advertising Expense, Rent Expense, Salaries Expense, Income Tax, Repairs Expense, etc.; and losses such as Loss from Fire, Typhoon Loss, and Loss from Theft. Like income, expenses are also measured every period and then closed as part of capital.
Net income refers to all income minus all expenses.
And we've come to the end of this lesson. We have covered all the elements of accounting. For a recap: assets are properties owned by a business; liabilities are obligations to other parties; and, capital refers to the portion of the assets available to the owners of the business after all liabilities are settled.
On the next page, you will find some exercises to test and solidify your knowledge of the accounting elements. Be sure to check it out!
Assets are properties owned and controlled by a business. Current assets are short-term in nature, such as cash and inventories. Non-current assets are long-term; for example, land, building, and equipment.
Liabilities are obligations to other parties, such as payable to suppliers, loans from banks, bonds issued, etc. They are also classified into current (short-term) and non-current (long-term) liabilities.
Capital refers to the net interest in the company and is equal to total assets minus total liabilities.