2 4: The Basic Accounting Equation Business LibreTexts

Economic entities are any organization or business in the financial world. For the past 52 years, Harold Averkamp (CPA, MBA) hasworked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. 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.

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. An asset is a resource that is owned or controlled by the company to be used for future benefits. Some assets are tangible like cash while others are theoretical or intangible like goodwill or copyrights.

However, each partner generally has unlimited personal liability for any kind of obligation forecasting net working capital for the business (for example, debts and accidents). Some common partnerships include doctor’s offices, boutique investment banks, and small legal firms. We use owner’s equity in a sole proprietorship, a business with only one owner, and they are legally liable for anything on a personal level. While dividends DO reduce retained earnings, dividends are not an expense for the company. To learn more about the income statement, see Income Statement Outline. The 500 year-old accounting system where every transaction is recorded into at least two accounts.

Income and retained earnings

The shareholders’ equity number is a company’s total assets minus its total liabilities. For example, an increase in an asset account can be matched by an equal increase to a related liability or shareholder’s equity account such that the accounting equation stays in balance. Alternatively, an increase in an asset account can be matched by an equal decrease in another asset account. It is important to keep the accounting equation in mind when performing journal entries. To further illustrate the analysis of transactions and their effects on the basic accounting equation, we will analyze the activities of Metro Courier, Inc., a fictitious corporation. Refer to the chart of accounts illustrated in the previous section.

1. It’s important to note that although dividends reduce retained earnings, they are not expenses.
2. The claims to the assets owned by a business entity are primarily divided into two types – the claims of creditors and the claims of owner of the business.
3. Since the balance sheet is founded on the principles of the accounting equation, this equation can also be said to be responsible for estimating the net worth of an entire company.

In above example, we have observed the impact of twelve different transactions on accounting equation. All assets owned by a business are acquired with the funds supplied either by creditors or by owner(s). In other words, we can say that the value of assets in a business is always equal to the sum of the value of liabilities and owner’s equity. The total dollar amounts of two sides of accounting equation are always equal because they represent two different views of the same thing. The accounting equation states that a company’s total assets are equal to the sum of its liabilities and its shareholders’ equity. The accounting method under which revenues are recognized on the income statement when they are earned (rather than when the cash is received).

This straightforward relationship between assets, liabilities, and equity is considered to be the foundation of the double-entry accounting system. The accounting equation ensures that the balance sheet remains balanced. That is, each entry made on the debit side has a corresponding entry (or coverage) on the credit side. The balance sheet reports the assets, liabilities, and owner’s (stockholders’) equity at a specific point in time, such as December 31.

An accounting transaction is a business activity or event that causes a measurable change in the accounting equation. Merely placing an order spend and receive money transactions in xero for goods is not a recordable transaction because no exchange has taken place. In the coming sections, you will learn more about the different kinds of financial statements accountants generate for businesses. That part of the accounting system which contains the balance sheet and income statement accounts used for recording transactions.

Module 1: The Role of Accounting in Business

The balance sheet is also referred to as the Statement of Financial Position. Since the balance sheet is founded on the principles of the accounting equation, this equation can also be said to be responsible for estimating the net worth of an entire company. The fundamental components of the accounting equation include the calculation of both company holdings and company debts; thus, it allows owners to gauge the total value of a firm’s assets.

In other words, the accounting equation will always be “in balance”. These may include loans, accounts payable, mortgages, deferred revenues, bond issues, warranties, and accrued expenses. Although the balance sheet always balances out, the accounting equation can’t tell investors how well a company is performing.

Equity

It’s important to note that although dividends reduce retained earnings, they are not expenses. Therefore, dividends are excluded when determining net income (revenue – expenses), just like stockholder investments (common and preferred). It’s called the Balance Sheet (BS) because assets must equal liabilities plus shareholders’ equity.

Financial Accounting

The first classification we should introduce is current vs. non-current assets or liabilities. If the net amount is a negative amount, it is referred to as a net loss. 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.

Example Transaction #1: Investment of Cash by Stockholders

A debit refers to an increase in an asset or a decrease in a liability or shareholders’ equity. A credit in contrast refers to a decrease in an asset or an increase in a liability or shareholders’ equity. This equation sets the foundation of double-entry accounting, also known as double-entry bookkeeping, and highlights the structure of the balance sheet. Double-entry accounting is a system where every transaction affects at least two accounts. Obligations owed to other companies and people are considered liabilities and can be categorized as current and long-term liabilities. Metro Courier, Inc., was organized as a corporation on January 1, the company issued shares (10,000 shares at $3 each) of common stock for $30,000 cash to Ron Chaney, his wife, and their son.