For the past 52 years, Harold Averkamp (CPA, MBA) has worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. He is the sole author of all the materials on AccountingCoach.com.
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Introduction
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:
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the amounts invested into the company by the owners plus the cumulative net income of the company that has not been withdrawn or distributed to the owners.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.
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.)
Sections 2 – 6 illustrate transactions involving a sole proprietorship.
Sections 7 – 10 illustrate almost identical transactions as they would take place in a corporation. Click here to skip to Section 7.
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Accounting Equation for a Sole Proprietorship: Transactions 1-2
We present eight 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 amounts in the general ledger accounts are then used to prepare the balance sheets and income statements.
In our transactions, we will use the following accounts:
Let’s assume that J. Ott forms a sole proprietorship called Accounting Software Co. (ASC). On December 1, 2023, 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.
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 transaction in these accounts is:
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, 2023:
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 amounts to be reported on an income statement.
Sole Proprietorship Transaction #2.
On December 2, 2023, J. Ott withdraws $100 of cash from the business for his personal use. The effect of this transaction on ASC’s accounting equation is:
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:
Since the transactions of December 1 and December 2 were in balance, the sum of both transactions should also be in balance:
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:
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.
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Accounting Equation for a Sole Proprietorship: Transactions 3-4
Sole Proprietorship Transaction #3.
On December 3, 2023, 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:
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. The Equipment account increases by $5,000, and the Cash account decreases by $5,000. The journal entry for this transactions is:
The combined effect of the first three transactions is shown here:
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, 2023, will reflect the financial position as of midnight on December 3:
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, 2023, ASC obtains $7,000 by borrowing money from its bank. The effect of this transaction on the accounting equation is:
As you can see, ASC’s assets increase and ASC’s liabilities increase by $7,000.
This transaction is recorded in the asset account Cash and the liability account Notes Payable as shown in this accounting entry:
The combined effect on the accounting equation from the first four transactions is available here:
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:
The proceeds of the bank loan are not considered to be revenue since ASC did not earn the money by providing services, investing, etc. As a result, there is no income statement effect from this transaction.
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Accounting Equation for a Sole Proprietorship: Transactions 5-6
Sole Proprietorship Transaction #5.
On December 5, 2023, Accounting Software Co. pays $600 for ads that were run in recent days. The effect of this advertising transaction on the accounting equation is:
Since ASC is paying $600, its assets decrease. The second effect is a $600 decrease in owner’s equity, because the transaction involves an expense. (An expense is a cost that is used up or its future economic value cannot be measured.)
Although owner’s equity is decreased by an expense, the transaction is not recorded directly into the owner’s capital account at this time. Instead, the amount is initially recorded in the expense account Advertising Expense and in the asset account Cash.
The general journal entry to record the transaction is:
The combined effect of the first five transactions is available here:
The totals now indicate that Accounting Software Co. has assets of $16,300. The creditors provided $7,000 and the owner of the company provided $9,300. Viewed another way, the company has assets of $16,300 with the creditors having a claim of $7,000 and the owner having a residual claim of $9,300.
The balance sheet as of midnight on December 5 is:
**The income statement (which reports the company’s revenues, expenses, gains, and losses during a specified time interval) is a link between balance sheets. It provides the results of operations—an important part of the change in owner’s equity.
Since this transaction involves an expense, it will involve ASC’s income statement. The company’s income statement for the first five days of December is:
Sole Proprietorship Transaction #6.
On December 6, 2023, ASC performed consulting services for its clients. The clients were billed for the agreed upon amount of $900. The amounts are to be paid within 30 days. The effect on ASC’s accounting equation is:
Since ASC has performed the services, it has earned revenues and it has the right to receive $900 from the clients. This right (known as an account receivable) causes assets to increase. The earning of revenues causes owner’s equity to increase.
Although revenues cause owner’s equity to increase, the revenue transaction is not recorded into the owner’s capital account at this time. Rather, the amount earned is recorded in the revenue account Service Revenues. This will allow the company to report the revenues on its income statement at any time. (After the year ends, the amount in the revenue accounts will be transferred to the owner’s capital account.)
The general journal entry to record the transaction is:
The combined effect of the first six transactions can be viewed here:
The totals tell us that as of midnight on December 6, the company had assets of $17,200. It also shows the sources of the assets: creditors provided $7,000 and the owner of the company provided $10,200. The totals also reveal that the company had assets of $17,200 and the creditors had a claim of $7,000 and the owner had a claim for the remaining $10,200.
Below is the balance sheet as of midnight on December 6:
**The income statement (which reports the company’s revenues, expenses, gains, and losses during a specified time interval) is a link between balance sheets. It provides the results of operations—an important part of the change in owner’s equity.
The Income Statement for Accounting Software Co. for the period of December 1 through December 6 is:
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Accounting Equation for a Sole Proprietorship: Transactions 7–8
Sole Proprietorship Transaction #7.
On December 7, 2023, ASC uses a temporary help service for 6 hours at a cost of $20 per hour. ASC will pay the invoice when it is due in 10 days. The effect on its accounting equation is:
ASC’s liabilities increase by $120 and the expense causes owner’s equity to decrease by $120.
The liability will be recorded in Accounts Payable and the expense will be reported in Temp Service Expense. The journal entry for recording the use of the temp service is:
The effect of the first seven transactions on the accounting equation can be viewed here:
The totals indicate that as of midnight on December 7, the company had assets of $17,200 and the sources were $7,120 from the creditors and $10,080 from the owner of the company. The accounting equation totals also tell us that the company had assets of $17,200 with the creditors having a claim of $7,120. This means that the owner’s residual claim was $10,080.
The statement of financial position for ASC as of midnight on December 7, 2023 is:
**The income statement (which reports the company’s revenues, expenses, gains, and losses for a specified time interval) is a link between balance sheets. It provides the results of operations—an important part of the change in owner’s equity.
Accounting Software Co.’s income statement for the first seven days of December is:
Sole Proprietorship Transaction #8.
On December 8, 2023, ASC received $500 from the clients it had billed on December 6, 2023. The collection of accounts receivables has this effect on the accounting equation:
The company’s asset (cash) increases and another asset (accounts receivable) decreases. Liabilities and owner’s equity are unaffected. (There are no revenues on this date. The revenues were recorded when they were earned on December 6.)
The general journal entry to record the increase in Cash, and the decrease in Accounts Receivable is:
The combined effect of the first eight transactions is shown here:
The totals for the first eight transactions indicate that the company had assets of $17,200. The creditors provided $7,120 and the owner provided $10,080. The accounting equation also indicates that the company’s creditors had a claim of $7,120 and the owner had a residual claim of $10,080.
ASC’s balance sheet as of midnight December 8, 2023 is:
**The income statement (which reports the company’s revenues, expenses, gains, and losses during a specified period of time) is a link between balance sheets. It provides the results of operations—an important part of the change in owner’s equity.
The income statement for ASC for the eight days ending on December 8 is shown here:
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Calculating a Missing Amount within Owner’s Equity
The income statement for the calendar year 2023 will explain a portion of the change in the owner’s equity between the balance sheets of December 31, 2022 and December 31, 2023. The other items that account for the change in owner’s equity are the owner’s investments into the sole proprietorship and the owner’s draws (or withdrawals). A recap of these changes is the statement of changes in owner’s equity. Here is a statement of changes in owner’s equity for the year 2023 assuming that the Accounting Software Co. had only the eight transactions that we covered earlier.
Example of Calculating a Missing Amount
The format of the statement of changes in owner’s equity can be used to determine an unknown component. For example, if the net income for the year 2023 is unknown, but you know the amount of the draws and the beginning and ending balances of owner’s equity, you can calculate the net income. (This might be necessary if a company does not have complete records of its revenues and expenses.) Let’s demonstrate this by using some new hypothetical amounts:
Step 1.
The owner’s equity at December 31, 2022 can be computed using the accounting equation:
Step 2.
The owner’s equity at December 31, 2023 can be computed as well:
Step 3.
Insert into the statement of changes in owner’s equity the information that was given and the amounts calculated in Step 1 and Step 2:
Step 4.
The “Subtotal” can be calculated by adding the last two numbers on the statement: $94,000 + $40,000 = $134,000. After this calculation we have:
Step 5.
Starting at the top of the statement we know that the owner’s equity before the start of 2023 was $60,000 and in 2023 the owner invested an additional $10,000. As a result we have $70,000 before considering the amount of Net Income. We also know that after the amount of Net Income is added, the Subtotal has to be $134,000 (the Subtotal calculated in Step 4). The Net Income is the difference between $70,000 and $134,000. Net income must have been $64,000.
Step 6.
Insert the previously missing amount (in this case it is the $64,000 of net income) into the statement of changes in owner’s equity and recheck the math:
Since the statement is mathematically correct, we are confident that the net income was $64,000.
The remaining parts of this Explanation will illustrate similar transactions and their effect on the accounting equation when the company is a corporation instead of a sole proprietorship.
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Accounting Equation for a Corporation: Transactions C1–C2
The accounting equation (or basic accounting equation) for a corporation is:
Examples
In our examples below, we show how a given transaction affects the accounting equation for a corporation. We also show how the same transaction will be recorded in the company’s general ledger accounts.
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.)
In the examples that follow, we will use the following accounts:
We also assume that the corporation is a Subchapter S corporation in order to avoid the income tax accounting that would occur with a “C” corporation. (In a Subchapter S corporation the owners are responsible for the income taxes instead of the corporation.)
Corporation Transaction C1
Let’s assume that members of the Ott family form a corporation called Accounting Software, Inc. (ASI). On December 1, 2023, several members of the Ott family invest a total of $10,000 to start ASI. In exchange, the corporation issues a total of 1,000 shares of common stock. (The stock has no par value and no stated value.) The effect on the corporation’s accounting equation is:
Since ASI’s assets increase by $10,000 and stockholders’ equity increases by the same amount the accounting equation is in balance.
The accounting equation tells us that ASI has assets of $10,000 and the source of those assets was the stockholders. Alternatively, the accounting equation tells us that the corporation has assets of $10,000 and the only claim to the assets is from the stockholders (owners).
This transaction is recorded in the asset account Cash and in the stockholders’ equity account Common Stock. The general journal entry to record the transaction is:
After the journal entry is recorded in the accounts, a balance sheet can be prepared to show ASI’s financial position at the end of December 1, 2023:
The purpose of an income statement is to report revenues and expenses. Since ASI has not yet earned any revenues nor incurred any expenses, there are no amounts to be reported on an income statement.
Corporation Transaction C2.
On December 2, 2023, ASI purchases $100 of its stock from one of its stockholders. The stock will be held by the corporation as Treasury Stock. The effect of the accounting equation is:
The purchase of its own stock for cash causes ASI’s assets to decrease by $100 and its stockholders’ equity to decrease by $100.
This transaction is recorded in the asset account Cash and in the stockholders’ equity account Treasury Stock. The accounting entry in general journal form is:
Since the transactions of December 1 and December 2 were in balance, the sum of both transactions should also be in balance:
The totals indicate that ASI has assets of $9,900 and the source of those assets is the stockholders. The accounting equation also shows that the corporation has assets of $9,900 and the only claim against the assets is the stockholders’ claim.
The December 2 balance sheet will communicate the corporation’s financial position as of midnight on December 2:
The purchase of a corporation’s own stock will never result in an amount to be reported on the income statement.
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Accounting Equation for a Corporation: Transactions C3–C4
Corporation Transaction C3.
On December 3, 2023, ASI spends $5,000 of cash to purchase computer equipment for use in the business. The effect of this transaction on ASI’s accounting equation is:
The accounting equation shows that one asset increases and one 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. The Equipment account increases by $5,000 and the Cash account decreases by $5,000. The journal entry for this transaction is:
The effect on the accounting equation from the first three transactions is:
The totals tell us that the corporation has assets of $9,900 and the source of those assets is the stockholders. The totals tell us that the company has assets of $9,900 and that the only claim against those assets is the stockholders’ claim.
The balance sheet dated December 3, 2023, reflects the financial position of the corporation as of midnight on December 3:
The purchase of equipment is not an immediate expense. It will become part of depreciation expense only after the equipment is placed in service. We will assume that as of December 3 the equipment has not been placed into service. Therefore, there is no expense to be reported on the income statement for the period of December 1-3.
Corporation Transaction C4.
On December 4, 2023, ASI obtains $7,000 by borrowing money from its bank. The effect of this transaction on the accounting equation is:
As you see, ACI’s assets increase and its liabilities increase by $7,000.
This transaction is recorded in the asset account Cash and the liability account Notes Payable with the following journal entry:
The following shows the effects on the accounting equation from the first four transactions:
These 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 stockholders provided $9,900. You can also interpret the accounting equation to say that the corporation has assets of $16,900 and the creditors have a claim of $7,000. The residual or remainder of $9,900 is the stockholders’ claim.
The balance sheet dated December 4 reports the corporation’s financial position as of that date:
The receipt of money from the bank loan is not revenue since ASI did not earn the money by providing services, investing, etc. As a result, there is no income statement effect from this or earlier transactions.
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Accounting Equation for a Corporation: Transactions C5–C6
Corporation Transaction C5.
On December 5, 2023, Accounting Software, Inc. pays $600 for ads that were run in recent days. The effect of the advertising transaction on the corporation’s accounting equation is:
Since ASI is paying $600, its assets decrease. The second effect is a $600 decrease in stockholders’ equity, because the transaction involves an expense. (An expense is a cost that is used up or its future economic value cannot be measured.)
Although stockholders’ equity decreases because of an expense, the transaction is not recorded directly into the retained earnings account. Instead, the amount is initially recorded in the expense account Advertising Expense and in the asset account Cash.
The journal entry for this transaction is:
The combined effect of the first five transactions is:
The totals now indicate that Accounting Software, Inc. has assets of $16,300. The creditors provided $7,000 and the stockholders provided $9,300. Viewed another way, the corporation has assets of $16,300 with the creditors having a claim of $7,000 and the stockholders having a residual claim of $9,300.
The balance sheet as of the end of December 5 is:
**The income statement (which reports the company’s revenues, expenses, gains, and losses for a specified time period) is a link between balance sheets. It provides the results of operations—an important part of the change in retained earnings and stockholders’ equity.
Since this transaction involves an expense, it will affect ASI’s income statement. The corporation’s income statement for the first five days of December is presented here:
Because we assumed that Accounting Services, Inc. is a Subchapter S corporation, income tax expense is not reported on the corporation’s income statement.
Corporation Transaction C6.
On December 6, 2023, ASI performed consulting services for its clients. The clients were billed for the agreed upon amount of $900. The amounts are to be paid within 30 days. The effect on ASI’s accounting equation is:
Since ASI has performed the services, it has earned revenues and it has the right to receive $900 from its clients. This right means that assets increased. The earning of revenues also causes stockholders’ equity to increase.
Although revenues cause stockholders’ equity to increase, the revenue transaction is not recorded directly into a stockholders’ equity account at this time. Rather, the amount earned is recorded in the revenue account Service Revenues. This will allow the corporation to report the amount in the revenue account on its income statement at any time. (After the year ends, the amount in the revenue accounts will be transferred to the retained earnings account.) The general journal entry for this transaction is:
The effect on the accounting equation from the first six transactions can be viewed here:
The totals tell us that at the end of December 6, the corporation had assets of $17,200. It also shows that $7,000 of the assets came from creditors and that $10,200 came from stockholders. The totals can also be viewed another way: ASI had assets of $17,200 with its creditors having a claim of $7,000 and the stockholders having a claim for the remainder or residual of $10,200.
The balance sheet as of midnight on December 6 is presented here:
**The income statement (which reports the company’s revenues, expenses, gains, and losses for a specified time period) is a link between balance sheets. It provides the results of operations—an important part of the change in retained earnings and stockholders’ equity.
The income statement for Accounting Software, Inc. for the period of December 1 through December 6 is shown here:
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Accounting Equation for a Corporation: Transactions C7–C8
Corporation Transaction C7.
On December 7, 2023, ASI uses a temporary help service for 6 hours at a cost of $20 per hour. ASI records the invoice immediately, but it will pay the $120 when it is due in 10 days. This transaction has the following effect on the accounting equation:
The accounting equation shows that ASI’s liabilities increase by $120 and the expense causes stockholders’ equity to decrease by $120.
The liability will be recorded in Accounts Payable and the expense will be recorded in Temp Service Expense. The general journal entry for utilizing the temp service is:
The effect of the first seven transactions on the accounting equation can be viewed here:
The totals show us that the corporation had assets of $17,200 and the sources were the creditors with $7,120 and the stockholders with $10,080. The accounting equation totals also reveal that the corporation’s creditors had a claim of $7,120 and the stockholders had a claim for the remaining $10,080.
The financial position of ASI as of midnight of December 7 is presented in the following balance sheet:
**The income statement (which reports the corporations’ revenues, expenses, gains, and losses for a specified time period) is a link between balance sheets. It provides the results of operations—an important part of the change in stockholders’ equity.
The income statement for the first seven days of December is shown here:
Corporation Transaction C8.
On December 8, 2023, ASI received $500 from the clients it had billed on December 6. The effect on the accounting equation is:
The corporation’s cash increases and one of its other assets (accounts receivable) decreases. Liabilities and stockholders’ equity are unaffected. (There are no revenues on this date. The revenues were recorded when they were earned on December 6.)
The general journal entry to record the increase in Cash and the decrease in Accounts Receivable is:
The effect on the accounting equation from the transactions through December 8 is shown here:
The totals after the first eight transactions indicate that the corporation had assets of $17,200. The creditors had provided $7,120 and the company’s stockholders provided $10,080. The accounting equation also indicates that the company’s creditors had a claim of $7,120 and the stockholders had a residual claim of $10,080.
ASI’s balance sheet as of midnight of December 8 is shown here:
**The income statement (which reports the corporation’s revenues, expenses, gains, and losses for a specified time period) is a link between balance sheets. It provides the results of operations—an important part of the change in stockholders’ equity.
The income statement for ASI’s first eight days of operations is shown here:
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Expanded Accounting Equation for a Sole Proprietorship
The owner’s equity in the basic accounting equation is sometimes expanded to show the accounts that make up owner’s equity: Owner’s Capital, Revenues, Expenses, and Owner’s Draws.
Instead of the accounting equation, Assets = Liabilities + Owner’s Equity, the expanded accounting equation is:
The eight transactions that we had listed under the basic accounting equation for a Sole Proprietorship Transaction #8 are shown in the following expanded accounting equation:
With the expanded accounting equation, you can easily see the company’s net income:
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Expanded Accounting Equation for a Corporation
The stockholders’ equity part of the basic accounting equation can also be expanded to show the accounts that make up stockholders’ equity: Paid-in Capital, Revenues, Expenses, Dividends, and Treasury Stock.
Instead of the accounting equation, Assets = Liabilities + Stockholders’ Equity, the expanded accounting equation is:
The eight transactions that we had listed under the basic accounting equation for a Corporation Transaction C8 are shown in the following expanded accounting equation:
With the expanded accounting equation, you can easily see the corporation’s net income:
Where to Go From Here
We recommend taking our Practice Quiz next, and then continuing with the rest of our Accounting Equation materials (see the full outline below).
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You should consider our materials to be an introduction to selected accounting and bookkeeping topics, and realize that some complexities (including differences between financial statement reporting and income tax reporting) are not presented. Therefore, always consult with accounting and tax professionals for assistance with your specific circumstances.
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Things that are resources owned by a company and which have future economic value that can be measured and can be expressed in dollars. Examples include cash, investments, accounts receivable, inventory, supplies, land, buildings, equipment, and vehicles.
Assets are reported on the balance sheet usually at cost or lower. Assets are also part of the accounting equation: Assets = Liabilities + Owner’s (Stockholders’) Equity.
Some valuable items that cannot be measured and expressed in dollars include the company’s outstanding reputation, its customer base, the value of successful consumer brands, and its management team. As a result these items are not reported among the assets appearing on the balance sheet.
Obligations of a company or organization. Amounts owed to lenders and suppliers. Liabilities often have the word “payable” in the account title. Liabilities also include amounts received in advance for a future sale or for a future service to be performed.
Assets = Liabilities + Owner’s Equity. For a corporation the equation is Assets = Liabilities + Stockholders’ Equity. For a nonprofit organization the accounting equation is Assets = Liabilities + Net Assets. Because of double-entry accounting this equation should be in balance at all times. The accounting equation is expressed in the financial statement known as the balance sheet.
A simple form of business where there is one owner. Legally the owner and the sole proprietorship are the same. However, for accounting purposes the economic entity assumption results in the sole proprietorship’s business transactions being accounted for separately from the owner’s personal transactions.
A balance sheet heading or grouping that includes both cash and those marketable assets that are very close to their maturity dates.
A current asset resulting from selling goods or services on credit (on account). Invoice terms such as (a) net 30 days or (b) 2/10, n/30 signify that a sale was made on account and was not a cash sale.
A current asset whose ending balance should report the cost of a merchandiser’s products awaiting to be sold. The inventory of a manufacturer should report the cost of its raw materials, work-in-process, and finished goods. The cost of inventory should include all costs necessary to acquire the items and to get them ready for sale.
When inventory items are acquired or produced at varying costs, the company will need to make an assumption on how to flow the changing costs. See cost flow assumption.
If the net realizable value of the inventory is less than the actual cost of the inventory, it is often necessary to reduce the inventory amount.
A current asset which indicates the cost of the insurance contract (premiums) that have been paid in advance. It represents the amount that has been paid but has not yet expired as of the balance sheet date.
A related account is Insurance Expense, which appears on the income statement. The amount in the Insurance Expense account should report the amount of insurance expense expiring during the period indicated in the heading of the income statement.
A major classification on the balance sheet. It is the second long term asset section after current assets. Included are land, buildings, leasehold improvements, equipment, furniture, fixtures, delivery trucks, automobiles, etc. that are owned by the company.
Goodwill is a long-term (or noncurrent) asset categorized as an intangible asset. Goodwill arises when a company acquires another entire business. The amount of goodwill is the cost to purchase the business minus the fair market value of the tangible assets, the intangible assets that can be identified, and the liabilities obtained in the purchase.
The amount in the Goodwill account will be adjusted to a smaller amount if there is an impairment in the value of the acquired company as of a balance sheet date. (Private companies may opt to amortize goodwill generally over a 10-year period and thereby minimize the cost and complexity involved with testing for impairment.)
This current liability account will show the amount a company owes for items or services purchased on credit and for which there was not a promissory note. This account is often referred to as trade payables (as opposed to notes payable, interest payable, etc.)
A current liability account that reports the amounts owed to employees for hours worked but not yet paid as of the date of the balance sheet.
This current liability account reports the amount of interest the company owes as of the date of the balance sheet. (Future interest is not recorded as a liability.)
Also referred to as shareholders’ equity. At a corporation it is the residual or difference of assets minus liabilities.
This is the bottom line of the income statement. It is the mathematical result of revenues and gains minus the cost of goods sold and all expenses and losses (including income tax expense if the company is a regular corporation) provided the result is a positive amount. If the net amount is a negative amount, it is referred to as a net loss.
The 500 year-old accounting system where every transaction is recorded into at least two accounts. To learn more, see Explanation of Debits and Credits.
The recording of a company’s transactions into the accounts contained in the general ledger. It is usually associated with the accounting tasks prior to the preparation of the trial balance.
That part of the accounting system which contains the balance sheet and income statement accounts used for recording transactions.
One of the main financial statements. The balance sheet reports the assets, liabilities, and owner’s (stockholders’) equity at a specific point in time, such as December 31. The balance sheet is also referred to as the Statement of Financial Position.
One of the main financial statements of a nonprofit organization. This financial statement reports the amounts of assets, liabilities, and net assets as of a specified date. This financial statement is similar to the balance sheet issued by a company.
One of the main financial statements (along with the balance sheet, the statement of cash flows, and the statement of stockholders’ equity). The income statement is also referred to as the profit and loss statement, P&L, statement of income, and the statement of operations. The income statement reports the revenues, gains, expenses, losses, net income and other totals for the period of time shown in the heading of the statement. If a company’s stock is publicly traded, earnings per share must appear on the face of the income statement.
Usually financial statements refer to the balance sheet, income statement, statement of cash flows, statement of retained earnings, and statement of stockholders’ equity.
The balance sheet reports information as of a date (a point in time). The income statement, statement of cash flows, statement of retained earnings, and the statement of stockholders’ equity report information for a period of time (or time interval) such as a year, quarter, or month.
Fees earned from providing services and the amounts of merchandise sold. Under the accrual basis of accounting, revenues are recorded at the time of delivering the service or the merchandise, even if cash is not received at the time of delivery. Often the term income is used instead of revenues.
Examples of revenue accounts include: Sales, Service Revenues, Fees Earned, Interest Revenue, Interest Income. Revenue accounts are credited when services are performed/billed and therefore will usually have credit balances. At the time that a revenue account is credited, the account debited might be Cash, Accounts Receivable, or Unearned Revenue depending if cash was received at the time of the service, if the customer was billed at the time of the service and will pay later, or if the customer had paid in advance of the service being performed.
If the revenues earned are a main activity of the business, they are considered to be operating revenues. If the revenues come from a secondary activity, they are considered to be nonoperating revenues. For example, interest earned by a manufacturer on its investments is a nonoperating revenue. Interest earned by a bank is considered to be part of operating revenues.
Costs that are matched with revenues on the income statement. For example, Cost of Goods Sold is an expense caused by Sales. Insurance Expense, Wages Expense, Advertising Expense, Interest Expense are expenses matched with the period of time in the heading of the income statement. Under the accrual basis of accounting, the matching is NOT based on the date that the expenses are paid.
Expenses associated with the main activity of the business are referred to as operating expenses. Expenses associated with a peripheral activity are nonoperating or other expenses. For example, a retailer’s interest expense is a nonoperating expense. A bank’s interest expense is an operating expense.
Generally, expenses are debited to a specific expense account and the normal balance of an expense account is a debit balance. When an expense account is debited, the account credited might be Cash (if cash was paid at the time of the expense), Accounts Payable (if cash will be paid after the expense is recorded), or Prepaid Expense (if cash was paid before the expense was recorded.)
The entry made in a journal. It will contain the date, the account name and amount to be debited, and the account name and amount to be credited. Each journal entry must have the dollars of debits equal to the dollars of credits.
The accounting method under which revenues are recognized on the income statement when they are earned (rather than when the cash is received). The balance sheet is also affected at the time of the revenues by either an increase in Cash (if the service or sale was for cash), an increase in Accounts Receivable (if the service was performed on credit), or a decrease in Unearned Revenues (if the service was performed after the customer had paid in advance for the service).
Under the accrual basis of accounting, expenses are matched with revenues on the income statement when the expenses expire or title has transferred to the buyer, rather than at the time when expenses are paid. The balance sheet is also affected at the time of the expense by a decrease in Cash (if the expense was paid at the time the expense was incurred), an increase in Accounts Payable (if the expense will be paid in the future), or a decrease in Prepaid Expenses (if the expense was paid in advance).
The amount of principal due on a formal written promise to pay. Loans from banks are included in this account.
This is an owner’s equity account. The balance in this account reflects the owner’s investment in this sole proprietorship plus the net income and minus the owner’s draws since the company began. (The current year net income and draws may not yet be recorded in this account. The net income may still be in the temporary revenue and expense accounts and the draws may still be in J. Ott, Drawing, also a temporary account. The temporary accounts will be closed to J. Ott, Capital after the year’s financial statements are prepared.)
This is a contra owner’s equity account, because it has a debit balance if draws were made. Even though it is a balance sheet account, it is a temporary account. At the end of each year the account’s debit balance is closed to J. Ott, Capital.
Under the accrual basis of accounting, the Service Revenues account reports the fees earned by a company during the time period indicated in the heading of the income statement. Service Revenues include work completed whether or not it was billed. Service Revenues is an operating revenue account and will appear at the beginning of the company’s income statement.
Advertising Expense is the income statement account which reports the dollar amount of ads run during the period shown in the income statement. Advertising Expense will be reported under selling expenses on the income statement.
Under the accrual basis of accounting, this account reports the cost of the temporary help services that a company used during the period indicated on its income statement.
The systematic allocation of the cost of an asset from the balance sheet to Depreciation Expense on the income statement over the useful life of the asset. (The depreciation journal entry includes a debit to Depreciation Expense and a credit to Accumulated Depreciation, a contra asset account). The purpose is to allocate the cost to expense in order to comply with the matching principle. It is not intended to be a valuation process. In other words, the amount allocated to expense is not indicative of the economic value being consumed. Similarly, the amount not yet allocated is not an indication of its current market value.
Gains result from the sale of an asset (other than inventory). A gain is measured by the proceeds from the sale minus the amount shown on the company’s books. Since the gain is outside of the main activity of a business, it is reported as a nonoperating or other revenue on the company’s income statement.
A bill issued by a seller of merchandise or by the provider of services. The seller refers to the invoice as a sales invoice and the buyer refers to the same invoice as a vendor invoice.
This current liability account will show the amount a company owes for items or services purchased on credit and for which there was not a promissory note. This account is often referred to as trade payables (as opposed to notes payable, interest payable, etc.)
The type of stock that is present at every corporation. (Some corporations have preferred stock in addition to their common stock.) Shares of common stock provide evidence of ownership in a corporation. Holders of common stock elect the corporation’s directors and share in the distribution of profits of the company via dividends. If the corporation were to liquidate, the secured lenders would be paid first, followed by unsecured lenders, preferred stockholders (if any), and lastly the common stockholders.
A stockholders’ equity account that generally reports the net income of a corporation from its inception until the balance sheet date less the dividends declared from its inception to the date of the balance sheet.
A corporation’s own stock that has been repurchased from stockholders. Also a stockholders’ equity account that usually reports the cost of the stock that has been repurchased.
A tax status allowed by the U.S. Internal Revenue Service.
The income statement account which contains a portion of the cost of plant and equipment that is being matched to the time interval shown in the heading of the income statement. (There is no depreciation expense for land.)
For the past 52 years, Harold Averkamp (CPA, MBA) has
worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. He is the sole author of all the materials on AccountingCoach.com.
