A limitation of measuring assets at historical cost is that the value of the ‘monetary unit or dollar is not always stable. Inflation is a term used to describe the situation where the value of the monetary unit decreases, meaning that it will purchase less than it did previously. Deflation, on the other hand, is the oppositesituation in which the value of the monetary unit increases, meaning that it will purchase more than it did previously. Typically, countrieslike the United States have experienced inflation rather than deflation. When inflation becomes severe, historical cost ‘ , amounts for assets lose their relevance as a basis for making business decisions. Much consideration has been given to the use of balance sheets that would show assets at current appraised values or at replacement costs rather than at historical cost.
Accountants in the United States. by adhering to the cost basis of accounting, are implying that the dollar is a stable unit of measurement, as is the gallon, the acre, or the mile. The cost principle and the stable-dollar assumption work very well in periods of stable prices but are less satisfactory under conditions 01″ rapid inflation. For example, if a company bought land 20 years ago for $100,000 and purchased a second similar tract of land today for $500.000. the total cost of land shown by the accounting records would be $600,600. This treatment ignores the fact that dollars spent 20 years ago had greater purchasing power than today’s dollar. Thus the $600,000 total for the cost of land is a mixture of two “sizes” 01″ dollars with different purchasing power.
After much research into this problem, the FASB required on a trial basis that large corporations annually disclose financial data adjusted for the effects of inflation. But after several years or experimentation, the FASB concluded that the costs of developing this information exceeded its usefulness. At the present time. this disclosure is optional. as judged uppropriatc by the accountant who prepares the financial statements.
Owner’s equity represents the owner’s claim to the assets of the business. Because creditors’ claims have legal priority over those of the owner. owner’s equity is a residual amount. Jf you are the owner of a husiness. you are entitled to assets that are left after the claims of creditors have been satisfied in full. Therefore, owner’s equity is always
equal to total assets minus total liabilities. Fot example, using the data from the illustrated balance sheet of Vagabond Travel Agency
Owner’s equity does not represent a specific claim to cash or any other particular asset. Rather, it is the owner’s overall financial interest in the entire company
Increases in Owner’s ,Equity
The owner’s equity in a business comes from.two sources:
1. Investments of cash or other assets b.y the owner
2. Earnings from profitable operation of the business
Accounting for withdrawals and net losses will be addressed in
The Accounting Equation
A fundamental characteristic of every statement of financial position is that the total for assets always equals’ the total of liabi tides plus owner’s equity. This agreement or balance of total assets with the total of liabilities and owner’s equity is the reason for calling this financial statement a balance sheet. But why do total assets equal the total of liabilities and owner’s equity?
The dollar totals on the two sides of the balance sheet are always equal because these two sides are two views of the same business. The listing of assets shows us what things the business owns; the listing of liabilities and owner’s equity tells us who supplied these resources to the business and how much each group supplied. Everything that a business owns has been supplied to it either by creditors. or by the owner. Therefore, the total claims of the creditors plus the claim of the owner equal the total assets or the business.
The Effects of Business Transactions An Illustration
How does a statement of financial position come about? What has occurred in the past for it to exist at any point in time? The statement of financial position is a picture of the results of past business transactions that has been captured by the company’s financial information system and organized into a concise financial description of where the company stands at a point in time. The specific items and dollar amounts.are the direct results of the transactions in which the company has engaged. Two different companies’ balance sheets almost certainly would be different because of differences in the nature, timing, and dollar amounts of their-business ransactions.
The- Business Entity
Assume that Michael McBryan, an experienced auto mechanic, opens his own automotive repair business, Overnight Auto Service. A distinctive feature of Overnight’s operations is that all repair work is done at night. This strategy offers customers the convenience of dropping off their cars in the evening and picking them up the, following morning .
Operating at night also enables Overnight to minimize its labor costs. Instead of hiring full-time employees, Overnight offers part-time work to mechanics who already have .day jobs at major automobile dealerships. This eliminates the need for costly employee ‘training programs and for such payroll fringe benefits, as group health insurance and employees’ pension plans, benefits usually associated with full-time employment.
The Company’s First Transaction
McBryan officially, started Overnight on November ,I, 200 I. On that date. he opened a bank account in the name of the business. into which he deposited $80,000 of his personal savings. This transaction provided Overnight with its first asset-Cash-and also created the initial owner’s equity in the business entity. A balance sheet showing the company’s financial position after this initial transaction follows:
Purchase of an Asset for Cash
Representing the business, McBryan negotiated with both the City of Santa Teresa and the Metropolitan Transit Authority (MTA) to purchase an abandoned bus garage. (The MTA owned the garage. butthe city owned the land.) On November 3, Overnight purchased the land from the city for $52.000 cash, This transaction had two immediate effects on the company’s financial position: first. Overnight’s cash was reduced by $52,000; and second, the company acquired a new asset- e-Land, The company’s financial position after this transaction was as follows
Purchase of an Asset and Financing Part of the Cost
On November 5, Overnight purchased the old garage building froin Metropolitan Transit Authority for $36.000. Overnight made a cash down payment of $6,000 and issued a 90-day non-interest- bearing note payable for the $30,000 balance owed.
As a result of this transaction, Overnight had (I) $6,000 less cash; (2) a new asset. . Building, which cost $36,000; and (3) a new liability, Notes Payable, in the amount of . $30,000. This transaction is reflected in the following balance sheet
Payment of a Liability
On November’ 26, Overnight made a partial payment of $6.800 on its account payable to Snap-On Tools. This transaction reduced Overnight’s cash and accounts payable by the same amount, leaving total assets and’ the total of liabilities plus owner’s equity in balance. Overnight’s balance sheet at November 26 appears below:
By the middle of the month, McBryan had acquired the assets Overnight needed to start operating, and he began to provide repair services for’ customers. Rather than recording each individual sale of repair services, he decided to accumulate them and record them twice a month-the 15th and the last day of each month. Sales of repair services for the lust half of November were $2,200. all of which was received in cash
Payment of Expenses
In order to earn the $2,2CO of revenue that we have just recorded, Mcbryan had to.pay some operating expenses, r.amely utilities and wages. He decided to puy operating expenses twice a month-the 15th and the last day of the month. For November, he owed $200 for utilities and $1,~OOfor wages to his employees, which he paid on. November 30. Paying expenses has an opposite effect from revenues on Mcllryan’s value in the company-his investment is reduced. Of course, paying expenses also results in a decrease of cash. The November 30 balance sheet, after the payment of utilities and wages, is as follows: