Accounting Equation (Explanation Part 1)

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:

• Assets (what it owns)
• Liabilities (what it owes to others)
• 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 a sole proprietorship is:

The accounting equation for a corporation is:

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:

• as claims by creditors against the company’s assets, and
• as sources (along with owner’s or stockholders’ equity) of the company’s assets.

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

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the amounts invested into the company by the owners plus the cumulative net income of the company that has not been withdrawn or distributed to the owners.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 using the double-entry system, the accounting equation will always be “in balance,” meaning the left side of the equation will be equal to 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 the double-entry accounting or bookkeeping system.

A company keeps track of all of its transactions by recording them in accounts contained 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.

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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.

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.

In addition, we show the effect of each transaction on the balance sheet and income statement. (Our examples assume that the accrual basis of accounting is being followed.)

Parts 2 – 6 illustrate transactions involving a sole proprietorship.
Parts 7 – 10 illustrate almost identical transactions as they would take place in a corporation.
Click here to skip to Part 7.