Explanation of the Topic...Accounting Equation
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Accounting Equation for a Sole Proprietorship — Transactions 3–4
Sole Proprietorship Transaction #3.
On December 3, 2006 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:
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, 2006 will reflect the financial position as of midnight on December 3:
| Accounting Software Co. | ||||||
| Balance Sheet | ||||||
| December 3, 2006 | ||||||
| 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, 2006 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 account Cash and the liability account Notes Payable as shown in this accounting entry:
| Date | Account Titles | Debit | Credit |
| Dec. 4, 2006 | 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, 2006 | |||||
| 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* | |||
| . | |||||
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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