accounting equation

accounting equation 

accounting equation (or basic accounting equation) offers us a simple way to  

understand how these three amounts relate to each other. The accounting equation for a sole proprietorship is:

Assets = Liabilities + Owner’s Equity

The accounting equation for a corporation is:

Assets = Liabilities + Stockholders’ Equity

Assets are a company’s resources—things the company owns. Examples of assets include cash, accounts receivable, inventory, prepaid insurance, investments, land, buildings, equipment, and goodwill. From the accounting equation, we see that the amount of assets must equal the combined amount of liabilities plus owner’s (or stockholders’) equity.

Liabilities are a company’s obligations—amounts the company owes. Examples of liabilities include notes or loans payable, accounts payable, salaries and wages payable, interest payable, and income taxes payable (if the company is a regular corporation). Liabilities can be viewed in two ways:

(1) as claims by creditors against the company’s assets, and
(2) a source—along with owner or stockholder equity—of the company’s assets.

Owner’s equity or stockholders’ equity is the amount left over after liabilities are deducted from assets:

Assets – Liabilities = Owner’s (or Stockholders’) Equity.

Owner’s or stockholders’ equity also reports the amounts invested into the company by the owners plus the cumulative net income of the company that has not been withdrawn or distributed to the owners.

If a company keeps accurate records, the accounting equation will always be “in balance,” meaning the left side should always equal the right side. The balance is maintained because every business transaction affects at least two of a company’s accounts. For example, when a company borrows money from a bank, the company’s assets will increase and its liabilities will increase by the same amount. When a company purchases inventory for cash, one asset will increase and one asset will decrease. Because there are two or more accounts affected by every transaction, the accounting system is referred to as double entry accounting.

A company keeps track of all of its transactions by recording them in accounts in the company’s general ledger. Each account in the general ledger is designated as to its  

type: asset, liability, owner’s equity, revenue, expense, gain, or loss account. 

Balance Sheet and Income Statement

The balance sheet is also known as the statement of financial position and it reflects the accounting equation. The balance sheet reports a company’s assets, liabilities, and owner’s (or stockholders’) equity at a specific point in time. Like the accounting equation, it shows that a company’s total amount of assets equals the total amount of liabilities plus owner’s (or stockholders’) equity.

The income statement is the financial statement that reports a company’s revenues and expenses and the resulting net income. While the balance sheet is concerned with one point in time, the income statement covers a time interval or period of time. The income statement will explain part of the change in the owner’s or stockholders’ equity during the time interval between two balance sheets. 

Sole Proprietorship Transaction #1.

Let’s assume that J. Ott forms a sole proprietorship called Accounting Software Co. (ASC). On December 1, 2009, J. Ott invests personal funds of $10,000 to start ASC. The effect of this transaction on ASC’s accounting equation is:

	Assets	=	Liabilities	+	Owner’s Equity
	+$10,000	=	No Effect	+	+$10,000

As you can see, ASC’s assets increase by $10,000 and so does ASC’s owner's equity. As a result, the accounting equation will be in balance.

You can interpret the amounts in the accounting equation to mean that ASC has assets of $10,000 and the source of those assets was the owner, J. Ott. Alternatively, you can view the accounting equation to mean that ASC has assets of $10,000 and there are no claims by creditors (liabilities) against the assets. As a result, the owner has a claim for the remainder or residual of $10,000.

This transaction is recorded in the asset account Cash and the owner’s equity account J. Ott, Capital. The general journal entry to record the transactions in these accounts is:

Date	Account Titles	Debit	Credit
Dec. 1, 2009	Cash	10,000
	J. Ott, Capital		10,000

After the journal entry is recorded in the accounts, a balance sheet can be prepared to show ASC’s financial position at the end of December 1, 2009:

Accounting Software Co.
Balance Sheet
December 1, 2009
ASSETS			LIABILITIES
Cash	$	10,000	OWNER’S EQUITY
		.	J. Ott, Capital	$	10,000
Total Assets	$	10,000	Total Liab & Owner's Equity	$	10,000
.

The purpose of an income statement is to report revenues and expenses. Since ASC has not yet earned any revenues nor incurred any expenses, there are no transactions to be reported on an income statement.

Sole Proprietorship Transaction #2.

On December 2, 2009 J. Ott withdraws $100 of cash from the business for his personal use. The effect of this transaction on ASC’s accounting equation is:

	Assets	=	Liabilities	+	Owner’s Equity
	–$100	=	No Effect	+	–$100

The accounting equation remains in balance since ASC’s assets have been reduced by $100 and so has the owner’s equity.

This transaction is recorded in the asset account Cash and the owner’s equity account J. Ott, Drawing. The general journal entry to record the transactions in these accounts is:

Date	Account Titles	Debit	Credit
Dec. 2, 2009	J. Ott, Drawing	100
	Cash		100

Since the transactions of December 1 and 2 were each in balance, the sum of both transactions should also be in balance:

Transaction	Assets	=	Liabilities	+	Owner’s Equity
1	+$10,000	=	No Effect	+	+$10,000
2	–$100	=	No Effect	+	–$100
Totals	$9,900	=	$0	+	$9,900

The totals indicate that ASC has assets of $9,900 and the source of those assets is the owner of the company. You can also conclude that the company has assets or resources of $9,900 and the only claim against those resources is the owner’s claim.

The December 2 balance sheet will communicate the company’s financial position as of midnight on December 2:

Accounting Software Co.
Balance Sheet
December 2, 2009
ASSETS			LIABILITIES
Cash	$	9,900	OWNER’S EQUITY
		.	J. Ott, Capital	$	9,900*
Total Assets	$	9,900	Total Liab & Owner's Equity	$	9,900
.

.
			Beginning Owner's Equity	$	0
			+ Owner's Investment	+	10,000
			+ Net Income	+	0
			Subtotal	$	10,000
			– Owner's Draws	–	100
			Ending Owner's Equity at Dec. 2	$	9,900*
.

Withdrawals of company assets by the owner for the owner’s personal use are known as “draws.” Since draws are not expenses, the transaction is not reported on the company’s income statement.

Receive 80 essential business forms—professionally designed to
increase your understanding of business and financial accounting.

Created with the amazing clarity of AccountingCoach.com. Read 1,200+ user testimonials.

All business forms come in two formats (you get both):

 

Financial Statements Forms	PDF Form	PDF Form (Filled in)
Balance Sheet: Manufacturer - Corporation
Balance Sheet: Retail/Wholesale - Corporation
Balance Sheet: Retail/Wholesale - Sole Proprietor
Balance Sheet: Services - Corporation
Balance Sheet: Services - Sole Proprietor
Cost of Goods Manufactured
Income Statement: Manufacturer - Corporation, Multiple-Step
Income Statement: Manufacturer - Corporation, Single-Step
Income Statement: Retail/Whsle - Corporation, Multiple-Step
Income Statement: Retail/Whsle - Corporation, Single-Step
Income Statement: Retail/Whsle - Sole Proprietor, Multiple-Step
Income Statement: Retail/Whsle - Sole Proprietor, Single-Step
Income Statement: Services - Corporation
Income Statement: Services - Sole Proprietor
Personal Financial Information
Selling, General and Administrative (SG&A) Expenses
Statement of Cash Flows: Corporation, Indirect Method
Statement of Cash Flows: Sole Proprietor, Indirect Method
Statement of Owner's Equity: Sole Proprietor

Financial Ratios and Analysis Forms	PDF Form	PDF Form (Filled in)
Working Capital
Working Capital to Total Assets
Working Capital Turnover Ratio
Current Ratio
Quick Ratio or Acid Test Ratio
Accounts Receivable Turnover
Days Sales in Accounts Receivable
Inventory Turnover Ratio
Days Sales in Inventory
Fixed Asset Turnover Ratio
Total Assets Turnover Ratio
Debt to Total Assets Ratio
Debt to Equity Ratio
Equity Ratio
Equity Turnover Ratio
Times Interest Earned
Profit Margin after Tax
Gross Profit Margin
Return on Total Assets
Return on Stockholders' Equity
EBITDA
Book Value per Share of Common Stock
Free Cash Flow
Cash Flow to Debt Ratio

Break-even Point, Contribution Margin, Cost-Volume-Profit Forms	PDF Form	PDF Form (Filled in)
Break-even Point in Units (one product or one service)
Break-even Point in Dollars (one product or one service)
Break-even Point in Dollars (multiple products or services)
Contribution Margin Calculations
Contribution Margin Income Statement: Retail/Wholesale
Contribution Margin Income Statement: Service Business
High-low Method
Sales Needed for Desired Net Income (single or multiple products/services)

Depreciation and Amortization Forms	PDF Form	PDF Form (Filled in)
Depreciation: Straight-line Method
Depreciation: Double Declining Balance (DDB) Method
Depreciation: Sum of the Years' Digits Method
Depreciation: Units of Activity Method
Amortization of Bond Discount: Effective Interest Method
Amortization of Bond Discount: Straight-line Method
Amortization of Bond Premium: Effective Interest Method
Amortization of Bond Premium: Straight-line Method

General Forms	PDF Form	PDF Form (Filled in)
Aging of Accounts Payable
Aging of Accounts Receivable
Average: 13 month
Bank Reconciliation
Bank Reconciliation Outstanding Checks
Check Request Form
Current Portion of Long-term Debt
Economic Order Quantity (EOQ)
Inventory: Estimating Using the Gross Profit Method
Inventory: Estimating Lost or Missing Amounts
Items Requiring Attention
Money Counter's Tally
Present Value Calculation
Standard Costing: Direct Labor Rate & Efficiency Variances
Standard Costing: Direct Materials Price Variance
Standard Costing: Direct Materials Usage Variance
Standard Costing: Fixed Manufacturing Overhead Variances
Standard Costing: Variable Manufacturing Overhead Variances
To Do List
Trial Balance
Worksheet: Trial Balance and Adjustments

Scroll down to view all the forms included in The Master Set of 80 Business Forms.

 

Sole Proprietorship Transaction #3.

On December 3, 2009 Accounting Software Co. spends $5,000 of cash to purchase computer equipment for use in the business. The effect of this transaction on the accounting equation is:

	Assets	=	Liabilities	+	Owner’s Equity
	+$5,000	=	No Effect	+	No Effect
	–$5,000

The accounting equation reflects that one asset increases and another asset decreases. Since the amount of the increase is the same as the amount of the decrease, the accounting equation remains in balance.

This transaction is recorded in the asset accounts Equipment and Cash. Equipment increases by $5,000, and Cash decreases by $5,000. The general journal entry to record the transactions in these accounts is:

Date	Account Titles	Debit	Credit
Dec. 3, 2009	Equipment	5,000
	Cash		5,000

The combined effect of the first three transactions is shown here:

Transaction	Assets	=	Liabilities	+	Owner’s Equity
1	+$10,000	=	No Effect	+	+$10,000
2	–$100	=	No Effect	+	–$100
3	+$5,000	=	No Effect	+	No Effect
	–$5,000
Totals	$9,900	=	$0	+	$9,900

The totals tell us that the company has assets of $9,900 and the source of those assets is the owner of the company. It also tells us that the company has assets of $9,900 and the only claim against those assets is the owner’s claim.

The balance sheet dated December 3, 2009 will reflect the financial position as of midnight on December 3:

Accounting Software Co.
Balance Sheet
December 3, 2009
ASSETS			LIABILITIES	$	0
Cash	$	4,900	OWNER’S EQUITY
Equipment		5,000	J. Ott, Capital	$	9,900*
Total Assets	$	9,900	Total Liab & Owner's Equity	$	9,900
.

.
			Beginning Owner's Equity	$	0
			+ Owner's Investment	+	10,000
			+ Net Income	+	0
			Sub Total	$	10,000
			– J. Ott, Drawing	–	100
			Ending Owner's Equity at Dec. 3	$	9,900*
.

The purchase of equipment is not an immediate expense. It will become part of depreciation expense only after it is placed into service. We will assume that as of December 3 the equipment has not been placed into service, therefore, no expense will appear on an income statement for the period of December 1 through December 3.

Sole Proprietorship Transaction #4.

On December 4, 2009 ASC obtains $7,000 by borrowing money from its bank. The effect of this transaction on the accounting equation is:

	Assets	=	Liabilities	+	Owner’s Equity
	+$7,000	=	+$7,000	+	No Effect

As you can see, ASC’s assets increase and ASC’s liabilities increase by $7,000.

This transaction is recorded in the asset accountCash and the liability account Notes Payable as shown in this accounting entry:

Date	Account Titles	Debit	Credit
Dec. 4, 2009	Cash	7,000
	Notes Payable		7,000

The combined effect on the accounting equation from the first four transactions is available here:

Transaction	Assets	=	Liabilities	+	Owner’s Equity
1	+$10,000	=	No Effect	+	+$10,000
2	–$100	=	No Effect	+	–$100
3	+$5,000	=	No Effect	+	No Effect
	–$5,000
4	+$7,000	=	+$7,000	+	No Effect
Totals	$16,900	=	$7,000	+	$9,900

The totals indicate that the transactions through December 4 result in assets of $16,900. There are two sources for those assets–the creditors provided $7,000 of assets, and the owner of the company provided $9,900. You can also interpret the accounting equation to say that the company has assets of $16,900 and the lenders have a claim of $7,000 and the owner has a claim for the remainder.

The balance sheet dated December 4 will report ASC’s financial position as of that date:

Accounting Software Co.
Balance Sheet
December 4, 2009
ASSETS			LIABILITIES
Cash	$	11,900	Notes Payable	$	7,000
Equipment		5,000	OWNER’S EQUITY
		.	J. Ott, Capital	$	9,900*
Total Assets	$	16,900	Total Liab & Owner's Equity	$	16,900
.

.
			Beginning Owner's Equity	$	0
			+ Owner's Investment	+	10,000
			+ Net Income	+	0
			Subtotal	$	10,000
			– J. Ott, Drawing	–	100
			Ending Owner's Equity at Dec. 4	$	9,900*
.