At the base of all accounting lies the accounting equation (Money Instructor, 2005). Fundamentally, “the accounting system reflects two basic aspects of a company: what it owns and what it owes” (Wild, Larson & Chiapetta, 2007, p. 12). In accounting, these two aspects must always equal each other (QuickMBA, 2007). The relationship between these two aspects can be expressed using the accounting equation: Assets = Liabilities + Owners’ Equity. Liabilities come first before equity in the accounting equation to emphasize the importance that outside obligations (liabilities) have to be met before inside obligations (equity) (Wild et al, 2007, p. 12). However, this equation can be rearranged into two other forms to help analyze each of the three components. First, to solve for liabilities, this equation can be expressed as Liabilities = Assets – Owners’ Equity. Next, to calculate owner’s equity, the accounting equation can be stated as Owners’ Equity = Assets – Liabilities. In the end, if you have at least two of these elements, you will be able to measure the third (Money Instructor, 2005; Wild et al, 2007, p. 12).
Please note that the accounting equation is especially crucial when creating balance sheets since the information revealed through the equation acts as the basis for these financial documents (QuickMBA, 2007). To maintain an up-to-date and accurate picture of a business’s assets, liabilities, and equity, though, the accounting equation needs to properly account for the various business transactions that can occur from day to day. For that reason, each time a transaction occurs two or more of these elements are increased and/or decreased in an equal fashion so the accounting equation remains in balance (Goldberg, n.d.; QuickMBA, 2007). For example, say a company has an increase of $1,000 to its assets since the owner decided to invest more money into his business. This increase to assets represents an equal increase to the amount of money the company owes to the owner (equity). Thus, the accounting equation will not remain in balance unless $1,000 is added to the company’s equity as well (QuickMBA, 2007). It is important to realize, though, that a transaction can affect only one side of the accounting equation. For instance, if a company chooses to purchase office supplies for $350 using cash, this will not affect the business’s liabilities or equity. Instead, it only represents the exchange of one asset for another (cash is decreased by $350, while office supplies increase by $350). Finally, a transaction can cause more than two affects on the accounting equation. For example, say a retailer decides to buy a shipment of a new product for $15,000. This causes an automatic increase of $15,000 to inventory (an asset). However, instead of paying for this shipment with only cash, the company decides to pay $5,000 up front and purchase the rest on credit. As a result, cash is only decreased by $5,000 and liabilities are increased by $10,000, thus causing three changes to the accounting equation (Money Instructor, 2005).
Before we can thoroughly appreciate, however, how transactions affect the accounting equation, we must first be familiar with all three of this equation’s components: (1) assets, (2) liabilities, and (3) equity. First, let us examine the first component, assets. As I mentioned in my introduction to the accounting equation, assets are essentially anything an organization owns (or controls) (Money Instructor, 2005; Wild et al, 2007, p. 12). Assets are also referred to as a company’s resources and “are expected to yield future benefits (Wild et al, 2007, p. 12). When a company tracks its assets, it normally creates various separate asset accounts. This organization makes using the accounting equation much simpler. Typical asset accounts include buildings, land, cash, equipment, and supplies. Finally, a business also usually sets up the following asset accounts: (1) accounts receivable (any customer obligations owed to the company), (2) notes receivable (any debt owed to the business through promissory notes), and prepaid accounts (prepaid expenses: i.e., rent paid beyond current month) (Goldberg, n.d.).
Next, we will explore liabilities. Basically, “liabilities are creditors’ claims on assets” (Wild et al, 2007, p. 12). These claims can be in the form of a company’s assets and/or even the products and services it provides (Wild et al, 2007, p. 12). Like assets, there are several common liability accounts that categorize a business’s liabilities. The first typical liability account is accounts payable. This account summarizes all obligations the company owes to individuals and entities outside the business. Related to this account is notes payable, which include any outside debt the company owes that has a promissory note. Businesses also have an accrued liabilities account, which tracks any obligations they owe but have not paid yet. Finally, companies often establish a liability account for unearned revenue (revenue for future services and goods) (Goldberg, n.d.). Some examples of everyday liabilities include taxes owed to the IRS or payments owed for supplies purchased on credit (Wild et al, 2007, p. 12).
Finally, let us take a closer look at owner’s equity. Like liabilities, equity represents claims on a business’s assets. But unlike, liabilities, these claims come from within the company itself since equity represents all company obligations to its owner(s). The owners of a company are entitled to all investments that they have made into the company, as well as any profits the business generates (QuickMBA, 2007; Wild et al, 2007, p. 12-13). Equity is charted throughout the year using four temporary accounts. The first is owner’s capital, which is labeled with the owner’s name and records all investments the owner has made into his or her business. Next, we have owner’s withdrawals (also labeled with the owner’s name), which includes any asset the owner has taken out of the company. Finally, the last two accounts track the business’s revenues and expenses (Goldberg, n.d.; QuickMBA, 2007). Revenues are “what the business earns for providing goods or services,” while expenses represent “the cost of assets the business uses to generate revenues” (Money Instructor, 2005, expanded accounting equation section). Ultimately, the accounting equation can be expanded to show how each of these accounts affect an organization’s equity: Assets = Liabilities + Owner, Capital – Owner, Withdrawals + Revenues – Expenses (Wild et al, 2007, p. 13).
References:
Goldberg, E. (n.d.). 211 FAP18 ch 2 notes-Analyzing & recording transactions. Retrieved June 8, 2008, from Northern Virginia Community College: http://www.nvcc.edu/home/egoldberg/211FAP18ch2notes.htm
Money Instructor. (2005). Introduction to transaction analysis: The basic accounting equation. Retrieved June 9, 2008, from http://www.moneyinstructor.com/lesson/accountingtransaction.asp
QuickMBA. (2007). The accounting equation. Retrieved June 8, 2008, from http://www.quickmba.com/accounting/fin/equation/
Wild, J. J., Larson, K. D., & Chiapetta, B. (2007). Fundamental accounting principles (18th edition). Boston: McGraw-Hill/Irwin.
