Accounting Equation(Quick Test #2 with Coaching)

The owners of corporations are referred to as stockholders (or shareholders). Hence, a corporation's accounting equation is either of the following:

Assets = Liabilities + Stockholders' Equity

Assets = Liabilities + Shareholders' Equity

J. Smith, Drawing is a temporary account that is connected to the permanent account J. Smith, Capital. At the end of the accounting year, the balance in the account J. Smith, Drawing is transferred to the account J. Smith, Capital.

During the accounting year, the debit balance in J. Smith, Drawing is reported in the balance sheet section owner’s equity.

You might think of J. Smith, Drawing as a subaccount account (or contra account) of J. Smith, Capital.

The normal balance in the owner’s capital account is a credit balance.

Here’s a Tip:
The owner’s capital account is part of the owner’s equity which appears on the right side of the accounting equation. In accounting, debit means left or left side. Credit means right or right side.

The combined asset account balances are debit balances and appear on the left side of the accounting equation. The combined liability account balances and the combined owner’s equity account balances are credit balances and appear on the right side of the accounting equation.

For instance, when an owner starts a sole proprietorship business, the company’s asset account Cash is debited and the owner’s capital account is credited. If the company earns $400 in revenues and is paid immediately, the Cash account is debited and the Revenues account (a temporary income statement account and a subaccount of the owner’s capital account) is credited.

The owner’s capital account could have a debit balance if the owner had cumulative draws and company losses that were greater than the owner’s investments in the company.

You can learn more from our Explanation of Accounting Equation and our Explanation of Debits and Credits.

The income statement accounts with credit balances (generally revenue and gain accounts) cause the owner’s capital account to increase.

(Expenses and losses are income statement accounts with debit balances that will cause the normal credit balance in the owner’s capital account to decrease.)

You can think of the income statement accounts as subaccounts of the owner's capital account.

You can learn more from our Explanation of Accounting Equation and our Explanation of Debits and Credits.

If a company has a positive amount of net income (credit balances in its income statement accounts are greater than the debit balances) the net credit amount will be a credit to the account J. Smith, Capital.

In a manual system, the credit to J. Smith, Capital occurs when the income statement accounts (revenues, gains, expenses, losses) are closed at the end of the accounting year.

Basically, the net credit amount of the income statement account balances increases the normal credit balance in J. Smith, Capital.

If a corporation has a positive amount of net income (the balances in the temporary income statement accounts such as expenses, revenues, gains, and losses result in a net credit amount), the net income should be credited to the account Retained Earnings.

In a manual system, the credit to Retained Earnings occurs when the income statement accounts are closed at the end of the accounting year.

Basically, the net credit amount of the income statement account balances increases the normal credit balance Retained Earnings, an account that is part of stockholders' equity.

For example, if the owner invests $10,000 in her sole proprietorship, the business asset Cash is increased with a debit of $10,000 and the owner’s capital account is increased with a credit of $10,000.

If her business earns $1,000 by delivering a consulting service for a client, a business asset (Cash or Accounts Receivable) is increased with a debit entry and the Revenues account will be credited. Revenues increase owner’s equity even though the $1,000 is temporarily recorded in an income statement account such as Revenues, Service Revenues, or Fees Earned.

An expense is recorded in a temporary income statement account as a debit amount. The debit in an expense account reduces a corporation’s net income. The reduction in net income is basically a reduction in the normal credit balance of the corporation’s retained earnings, which is a main component of the corporation’s stockholders’ equity.

Paid-in capital is another main component of stockholders’ equity. Paid-in capital reports the amounts the corporation received at the time it issued shares of stock.

See the following image of Smith Company’s accounting equation at the end of the day on December 31 and the solution:

The image that follows shows the change in the accounting equation from the end of the day on June 30 to the end of the day on December 31. (The balance at the end of the day on June 30 becomes the beginning balance on July 1.)

The change in the balance of the owner’s equity could be due to the combination of several factors such as the company’s net income or net loss, the owner’s investments, and the owner’s draws.

Since the owner did not invest additional money in the business and did not withdraw any money from the business, the change in the amount of owner’s equity is the result of the company’s net income as shown in the following image:

A company’s net income is calculated by subtracting its expenses and losses from its revenues and gains.

In Question 11, we calculated Smith Company’s net income to be $37,000. In this question, we were told that the company’s expenses were $80,000. Therefore, the revenues and gains must have been $117,000. The amount is verified on the image that follows.

The following image lists the items which will cause the owner’s equity to change.

We then fill in the amounts that were given and the amounts that were $0. Next, we show that the Net income or (Net loss) is the amount that must be determined.

We conclude with a "proof" that Helpful Company had negative net income, or net loss, of $15,000.

The accounting equation for Lee Company at the end of the year and the solution are:

The following image arranges the known amounts to determine the unknown amount of Lee Company’s net loss:

A company’s net income or net loss is calculated by subtracting its expenses and losses from its revenues and gains. Answer #15 showed that Lee Company’s net loss was $37,000.

Since the expenses and losses were stated to be $300,000, the revenues and gains had to be $37,000 less than $300,000. In other words, the revenues and gains must have been $263,000. This is shown in the following image:

The accounting equation for Tiger Corporation at the end of the recent year and the solution are shown in the following image:

The following image shows which items will change the amount of stockholders’ equity during the year. We then show the amounts that are known (were given in the introduction to Question 17). This allows us to determine the unknown amount. In this case, the missing amount needed is the net income of $35,000.

You can learn more from our Explanation of Stockholders’ Equity.

One component of stockholders’ equity is the paid-in capital accounts such as Common Stock. The balance in the Common Stock account(s) can change from:

• The amount received from issuing new shares of common stock
• The retirement of some shares of the corporation’s common stock

Since the question stated there were no shares issued or retired, there was no change in the balance in the Common Stock account during the year.

This is confirmed in the following image:

You can learn more from our Explanation of Stockholders’ Equity.

Another major component of stockholders’ equity is retained earnings. The balance in a corporation’s Retained Earnings account can change from:

• The amount of net income or net loss
• The stockholders’ dividends declared by the corporation

The following image shows that the net of these two items caused the Retained Earnings balance to increase by $10,000 during the year.

You can learn more from our Explanation of Stockholders’ Equity.