Assets, Liabilities and Equity

What is an asset?

An asset is a resource controlled by the owners of the business entity. An asset is used to produce future revenue or support business operations. For instance, a business might own a machine which is used to make products it sells. A business could also own building used to support its daily operations. Other examples of assets are cash, equipment, inventory, accounts receivable, etc.

In order to start a business, a business owner needs assets. By assets I do not mean only cash, assets could be a computer, intangible assets like patent, copyright, etc. To simply put it in another way, the resources businesses use to make money are called assets.

Sources of assets

Asset financing could come from equity or liabilities. If equity financing is used it could come from retained earnings or investment by the owner also known as contributed capital. I explain these terms further below.

Equity

Let’s assume you decide to start an ice cream business over the summer. Read http://www.dairyscience.info/index.php/ice-cream/218-ice-cream-startup.html#questions to see what assets are needed.

Contributed capital

Once you have your list of assets (gathered through the research process above), you realize you do not have all you need to start your ice cream business on hand. You will need to get some new equipment, inventory, supplies, etc. You either know someone who has the assets you need or you need or a way to acquire the cash to buy the assets. The first place you will probably look for resources are your personal assets. You can use contributed capital from your personal funds. Contributed capital is money you or another investor puts into the business to get it going. In other words, if you did not have all the money, you could get cash from your mom and she will be considered an investor in your business. In exchange your mom will expect to share profits with you. The profits you mom gets paid from your business is called dividends.

Retained Earnings

Once you have the cash to start your ice cream business, you opened your ice cream shop. After one year you made $20,000 in profits. This $20,000 if left in the business becomes retained earnings. Retained earnings is earnings from past operations not withdrawn/ distributed to the owners. Retained earnings is normally used to help the business owner reinvest and grow their business. Therefore if you decide to use your profit from a previous year, you will be using retained earnings to start your business.

To summarize, equity financing could come from contributed capital or retained earnings. In the first year, you do not have any retained earnings so would need to use contributed capital to finance.

Liabilities

On the other hand, rather than investing in your business, your mom could decide to be a lender. In other words, she just wants her money back. Your mom will also want to be paid interests as compensation for the business risk she has taken. If your mom acts as a lender, then you will be funding the business with liabilities. Liabilities are obligations you incur in your business that give others rights to your assets.

The Accounting Equation

As you can see assets can be funded with either equity (your mom as an investor) or liability (your mom as a lender). This fact is the fundamental on which accounting is based. The accounting equation is based on the fact that assets are derived by either equity or liability transactions and is stated as follows:

Assets = Liabilities + Equity

Assignment

Read the article below and list the assets needed to start the ice cream business. http://www.dairyscience.info/index.php/ice-cream/218-ice-cream-startup.html#questions

List all the assets and total costs needed to start the ice cream business (replace the pound sign with the dollar sign)
List possible sources of cash to fund your asset need
Clearly state if your source of cash is from equity or debt financing
Use the accounting equation to balance out your needs. By this I mean your liability + equity must equal your total assets.

This means that if your total asset needs adds up to $200,000 and you get $100,000 from debt and $100,000 from equity. Then your accounting equation is: