A
VI
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, AccountingCoach.com
Accounting Equation
All underlined words are defined in the attached Glossary (Pages 41 – 43).
Introduction to the Accounting Equation
From the large, multi-national corporation down to the corner beauty salon, every
business transaction will have an effect on a company’s financial position. The financial
position of a company is measured by the following items:
1. Assets (what it owns)
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2. Liabilities (what it owes to others)
3. Owner’s Equity (the difference between assets and liabilities)
The 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
U
a sole proprietorship is:
Assets = Liabilities + Owner’s Equity
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The accounting equation for a corporation is:
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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.
For personal use by the original purchaser only. Copyright © 2009 AccountingCoach.com. 1
,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owners plus the cumulative net income of the company that has not been withdrawn or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.
ST
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
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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.
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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
A
statement will explain part of the change in the owner’s or stockholders’ equity during
the time interval between two balance sheets.
Examples
In our examples below, we show how a given transaction affects the accounting
equation. We also show how the same transaction affects specific accounts by
providing the journal entry that is used to record the transaction in the company’s
general ledger.
As is the case throughout AccountingCoach.com, each account title appears in a bold
red font and is linked to the respective account description appearing in the site’s
1,000+ word glossary.
For personal use by the original purchaser only. Copyright © 2009 AccountingCoach.com. 2
, Our examples will show the effect of each transaction on the balance sheet and income
statement. Our examples also assume that the accrual basis of accounting is being
followed.
Accounting Equation for a Sole Proprietorship
Transactions 1 - 2
We present nine transactions to illustrate how a company’s accounting equation stays in
balance.
When a company records a business transaction, it is not entered into an accounting
equation, per se. Rather, transactions are recorded into specific accounts contained in
the company’s general ledger. Each account is designated as an asset, liability, owner's
equity, revenue, expense, gain, or loss account. The general ledger accounts are then
used to prepare the balance sheets and income statements throughout the accounting
ST
periods.
In the examples that follow, we will use the following accounts: Cash; Accounts
Receivable; Equipment; Notes Payable; Accounts Payable; J. Ott, Capital; J. Ott,
Drawing; Service Revenues; Advertising Expense; Temp Service Expense. (To view a
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more complete listing of accounts for recording transactions, you can visit Chart of
Accounts.)
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Sole Proprietorship Transaction #1.
Let’s assume that J. Ott forms a sole proprietorship called Accounting Software Co.
A
(ASC). On December 1, 2007, J. Ott invests personal funds of $10,000 to start ASC.
The effect of this transaction on ASC’s accounting equation is:
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.
For personal use by the original purchaser only. Copyright © 2009 AccountingCoach.com. 3
VI
U
ST
, AccountingCoach.com
Accounting Equation
All underlined words are defined in the attached Glossary (Pages 41 – 43).
Introduction to the Accounting Equation
From the large, multi-national corporation down to the corner beauty salon, every
business transaction will have an effect on a company’s financial position. The financial
position of a company is measured by the following items:
1. Assets (what it owns)
ST
2. Liabilities (what it owes to others)
3. Owner’s Equity (the difference between assets and liabilities)
The 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
U
a sole proprietorship is:
Assets = Liabilities + Owner’s Equity
VI
The accounting equation for a corporation is:
A
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.
For personal use by the original purchaser only. Copyright © 2009 AccountingCoach.com. 1
,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.
ST
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
U
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.
VI
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
A
statement will explain part of the change in the owner’s or stockholders’ equity during
the time interval between two balance sheets.
Examples
In our examples below, we show how a given transaction affects the accounting
equation. We also show how the same transaction affects specific accounts by
providing the journal entry that is used to record the transaction in the company’s
general ledger.
As is the case throughout AccountingCoach.com, each account title appears in a bold
red font and is linked to the respective account description appearing in the site’s
1,000+ word glossary.
For personal use by the original purchaser only. Copyright © 2009 AccountingCoach.com. 2
, Our examples will show the effect of each transaction on the balance sheet and income
statement. Our examples also assume that the accrual basis of accounting is being
followed.
Accounting Equation for a Sole Proprietorship
Transactions 1 - 2
We present nine transactions to illustrate how a company’s accounting equation stays in
balance.
When a company records a business transaction, it is not entered into an accounting
equation, per se. Rather, transactions are recorded into specific accounts contained in
the company’s general ledger. Each account is designated as an asset, liability, owner's
equity, revenue, expense, gain, or loss account. The general ledger accounts are then
used to prepare the balance sheets and income statements throughout the accounting
ST
periods.
In the examples that follow, we will use the following accounts: Cash; Accounts
Receivable; Equipment; Notes Payable; Accounts Payable; J. Ott, Capital; J. Ott,
Drawing; Service Revenues; Advertising Expense; Temp Service Expense. (To view a
U
more complete listing of accounts for recording transactions, you can visit Chart of
Accounts.)
VI
Sole Proprietorship Transaction #1.
Let’s assume that J. Ott forms a sole proprietorship called Accounting Software Co.
A
(ASC). On December 1, 2007, J. Ott invests personal funds of $10,000 to start ASC.
The effect of this transaction on ASC’s accounting equation is:
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.
For personal use by the original purchaser only. Copyright © 2009 AccountingCoach.com. 3
