Dive into the cornerstone of financial accounting with our comprehensive guide to understanding the fundamentals of the accounting equation. Unravel the core concepts that drive accurate financial analysis and decision-making in this essential exploration of balance, equity, and assets.
Accounting Equation
We’re going to delve into one of the most fundamental concepts in accounting, known as the “Accounting Equation”. The accounting equation is a fundamental concept in accounting that represents the relationship between a company’s assets, liabilities, and equity. The equation is as follows:
Let’s break this down:
- Assets. Assets are the economic resources or benefits that a business owns or controls. They can take the form of cash, inventory, equipment, property, investments, and accounts receivable. Assets are categorized based on their liquidity, with current assets being those that are expected to be converted into cash or used up within one year, and non-current assets representing long-term holdings.
Assets are placed on the left side (debit side) of the accounting equation because they represent the sources or uses of funds owned by the business. By organizing assets on the left side, it indicates where the assets are originating from and provides a clear representation of the financial resources available to the business.
- Liabilities. Liabilities are the obligations or debts that a business owes to external parties. They can include loans, accounts payable, accrued expenses, and outstanding bills. Liabilities are classified into current liabilities (due within one year) and long-term liabilities (due beyond one year).
Liabilities are placed on the right side (credit side) of the accounting equation to indicate the sources of funds or financing provided by external parties. By aligning liabilities on the credit side, it shows that the business has obtained funds from creditors or lenders to finance its operations or acquire assets.
- Capital. Capital, also known as equity, represents the owner’s investment in the business. It includes the initial investment made by the owner(s) and any subsequent contributions or withdrawals. Capital can be further divided into contributed capital and retained earnings, which reflect the accumulated profits or losses over time.
Similar to liabilities, capital is placed on the right side (credit side) of the accounting equation alongside liabilities. This positioning emphasizes that the owner(s) provide funds or contribute capital alongside external financing to support the business’s operations and growth.
The placement of accounts on specific sides of the equation stems from the double-entry accounting system, which ensures that every transaction has equal debits and credits. This system is designed to maintain the equation’s balance: Assets = Liabilities + Capital.
By separating assets, liabilities, and capital into separate sides, the accounting equation provides a clear representation of the financial position of a business. Any transaction that affects the equation must be recorded using both a debit and a credit entry, which ensures that the equation remains in balance. This allows accountants and stakeholders to analyze the financial health and stability of the business accurately.
The accounting equation needs to balance at all times, meaning that the total value of assets must equal the total value of liabilities plus equity. This equation reflects the fundamental concept of double-entry bookkeeping, where every financial transaction has an equal and opposite effect on the balance sheet.
For example, if a company acquires a new asset, let’s say a computer worth $1,000, it would increase the asset side of the equation by $1,000. To balance the equation, the company could either contribute additional equity of $1,000 or take on a liability of $1,000, such as a loan to finance the purchase.
The accounting equation is a foundational principle that helps ensure accuracy and consistency in financial reporting. It is used as the basis for preparing financial statements, such as the balance sheet, which provides a snapshot of a company’s financial position at a specific point in time.
In the context of a corporation, the accounting equation is often written as:
Asset Accounts Will Likely Have Debit Balances
Examples of asset accounts are:
- Cash
- Accounts Receivable
- Inventory
- Prepaid Expenses
- Land
- Buildings
- Equipment
- Machinery
- Furniture and Fixtures
- Vehicles, and more
Generally, asset accounts will have debit balances and their account balances will be increased with a debit entry. Therefore, a credit entry will decrease the asset’s normal debit balance. There are a few asset accounts that are expected to have credit balances. These are known as contra-asset accounts.
Two examples of contra-asset accounts include:
- Allowance for Doubtful Accounts (which relates to the debit balance in Accounts Receivable)
- Accumulated Depreciation (which relates to the debit balances in the accounts Buildings, Equipment, Vehicles, etc.)
These contra-asset accounts will be credited instead of crediting the related asset accounts.
Liability Accounts Will Likely Have Credit Balances
Some examples of liability accounts include:
- Accounts Payable
- Loans Payable
- Notes Payable
- Interest Payable
- Wages Payable
- Rent Payable
- Income Taxes Payable
- Accrued Expenses Payable (or Accrued Liabilities)
- Deferred Revenues (Unearned Revenue), and others
Generally, liability accounts are expected to have credit balances and their account balances will be increased with a credit entry. To decrease a liability account’s balance a debit entry is needed.
Stockholders’ (or Owner’s) Equity Accounts Will Have Credit Balances
Some examples of stockholders’ (or owner’s) equity accounts include:
- Common Stock
- Paid-in Capital in Excess of Par
- Retained Earnings
- Accumulated Other Comprehensive Income
- Ajay Carigma, Capital
Generally, these accounts are expected to have credit balances and their account balances will be increased with a credit entry. To decrease one of these accounts a debit entry is needed.
Note: Treasury Stock and Mary Smith, Drawing are two contra-equity accounts that are expected to have debit balances.
Revenue Accounts Will Have Credit Balances
Examples of revenue accounts include:
- Sales
- Service Fees Earned
- Fee Revenues
- Interest Income
Revenue accounts will have credit balances and their account balances will be increased with a credit entry. Revenue accounts have credit balances because revenues increase stockholders’ (or owner’s) equity.
There are a few revenue accounts that will have debit balances. Two examples are:
- Sales Discounts
- Sales Returns and Allowances
Revenue accounts that are expected to have debit balances are known as contra-revenue accounts.
These accounts are debited because they cause a decrease in the expected credit balances of the stockholders’ (or owner’s) equity accounts.
Expense Accounts Will Have Debit Balances
The following are just a few of the many general ledger accounts for expenses:
- Salaries Expense
- Rent Expense
- Utilities Expense
- Repairs and Maintenance Expense
- Advertising Expense
- Depreciation Expense
- Interest Expense
- Income Tax Expense
The accounts for expenses will have debit balances and will almost always be debited. Expenses have debit balances because they decrease the normal credit balances of stockholders’ (owner’s) equity.
The Accounts for Revenues and Expenses are Temporary Accounts
At the end of each financial year, we closed the accounts related to income, like revenue and expenses (money earned and money spent), as well as gains and losses. We move these balances into an account that represents the owner’s equity, or the owner’s stake in the business. This ‘cleanup’ means that these income-related accounts start the new year with zero balances. Because we ‘reset’ these accounts each year, we call them “temporary accounts.”
On the other hand, accounts on the balance sheet (like assets, liabilities, and equity) don’t get reset. Their balances carry over from one year to the next. For example, if the business owns a building, the value of that building stays in the account from year to year until it’s sold or fully depreciated. Because these accounts hold onto their balances across years, we call them “permanent accounts.”
Understanding how Different Accounts Relate to Each Other
The transactions below contain various types of activities that occur in a business. Let’s study what effects they have on the accounting elements or value.
1. Owner’s Investment
March 1, 2023- Carlito Angeles opened a Motor Repair Shop and invested ₱400,000 cash.
Equation:
2. Purchase in Cash
March 2- Bought supplies amounting to ₱3,000 cash.
Equation:
3. Purchase on Account
March 3- C. Angeles purchased equipment worth ₱50,000 on account.
Equation:
4. Revenue Income in Cash
March 5- Received from A. Robles ₱2,000 for the repair done on her car.
Equation:
5. Revenue Income on Credit
March 9- Billed J. Alejandro ₱1,000 for the maintenance of her automobile.
Equation:
6. Payment of Expenses
March 12- The business paid ₱15,000 in rent for the month.
Equation:
(An increase in expenses reduces the net income of a business, which in turn decreases the owner’s equity).
7. Receipt of Cash in Advance (Unearned Revenue)
March 18- The business receives ₱1,200 in advance for services to be provided in the future.
Equation:
8. Payment of Account
March 22- C. Angeles paid ₱4,500 of its accounts payable balance in cash.
Equation:
9. Receipt of Payment from Customer’s Account
March 25- Received payment from J. Alejandro. (Refer to transaction no. 5)
Equation:
10. Purchase with a down payment and a loan
March 27- The business purchased furniture for ₱20,000, paid ₱16,000 in cash, and has ₱4,000 to be paid after 60 days. This transaction affects the accounting equation in the following way:
Equation:
11. Withdrawal of Investment
March 31- C. Angeles withdrew ₱8,000 cash for personal use.
Equation:
In each of these examples, you can see how changes in one account affect other accounts in the accounting equation. Understanding these relationships is essential for accurate financial reporting and analysis.
The following table summarizes the effects of these transactions on the accounting equation:
| Date | Cash (Asset) | Supplies (Asset) | Equip (Asset) | A/R (Asset) | Furniture (Asset) | A/P (Liability) | Unearned Revenue (Liability) | Capital (Equity) | Withdrawal (Equity) | Rent Expense (Equity) |
|---|---|---|---|---|---|---|---|---|---|---|
| Mar 1 | 400,000 | 400,000 | ||||||||
| 2 | (3,000) | 3,000 | ||||||||
| Bal. | 397,000 | 3,000 | 400,000 | |||||||
| 3 | 50,000 | 50,000 | ||||||||
| Bal. | 397,000 | 3,000 | 50,000 | 50,000 | 400,000 | |||||
| 5 | 2,000 | 2,000 | ||||||||
| Bal. | 399,000 | 3,000 | 50,000 | 50,000 | 402,000 | |||||
| 9 | 1,000 | 1,000 | ||||||||
| Bal. | 399,000 | 3,000 | 50,000 | 1,000 | 50,000 | 403,000 | ||||
| 12 | (15,000) | (15,000) | ||||||||
| Bal. | 384,000 | 3,000 | 50,000 | 1,000 | 50,000 | 403,000 | (15,000) | |||
| 18 | 1,200 | 1,200 | ||||||||
| Bal. | 385,200 | 3,000 | 50,000 | 1,000 | 50,000 | 1,200 | 403,000 | (15,000) | ||
| 22 | (4,500) | (4,500) | ||||||||
| Bal. | 380,700 | 3,000 | 50,000 | 1,000 | 45,500 | 1,200 | 403,000 | (15,000) | ||
| 25 | 1,000 | (1,000) | ||||||||
| Bal. | 381,700 | 3,000 | 50,000 | 45,500 | 1,200 | 403,000 | (15,000) | |||
| 27 | (16,000) | 20,000 | 4,000 | |||||||
| Bal. | 365,700 | 3,000 | 50,000 | 20,000 | 49,500 | 1,200 | 403,000 | (15,000) | ||
| 31 | (8,000) | (8,000) | ||||||||
| Bal. | 357,700 | 3,000 | 50,000 | 20,000 | 49,500 | 1,200 | 403,000 | (8,000) | (15,000) | |
| TOTAL | 430,700 | 430,700 |
The table below contains various business transactions and their effects on the accounting equation.
| TRANSACTION | ASSET | LIABILITY | OWNER’S EQUITY |
|---|---|---|---|
| The initial investment of the owner. | increase | no effect | increase |
| Acquisition of non-cash assets in cash. | increase decrease | no effect | no effect |
| Acquisition of non-cash assets on credit. | increase | increase | no effect |
| Acquisition of non-cash assets with down payment and payable | increase decrease | increase | no effect |
| Sales of non-cash assets in cash. | increase | no effect | increase |
| Sales of non-cash assets on credit. | increase | no effect | increase |
| Rendered service in cash. | increase | no effect | increase |
| Rendered service on credit. | no effect | increase | increase |
| Borrowed money from the creditors | increase | increase | no effect |
| Payment of liability. | decrease | decrease | no effect |
| Payment of expense. | decrease | no effect | decrease |
| Collection of Accounts Receivables | increase decrease | no effect | no effect |
| Personal withdrawal of investment by the owner | decrease | no effect | decrease |
| Issuance of notes to existing liabilities | no effect | decrease increase | no effect |
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