The Accounting Equation

The resource controlled by a business are referred to as its avails. For a new business, those assets originate from ii possible sources:

• Investors who purchase ownership in the business
• Creditors who extend loans to the business

Those who contribute assets to a business have legal claims on those assets. Since the full assets of the business are equal to the sum of the assets contributed by investors and the assets contributed past creditors, the following relationship holds and is referred to as the
accounting equation
:

 Assets = Liabilities   +   Owners’ Equity Resources Claims on the Resource

Initially, possessor equity is affected by capital contributions such as the issuance of stock. One time business operations embark, there will be income (revenues minus expenses, and gains minus losses) and peradventure additional upper-case letter contributions and withdrawals such as dividends. At the end of a reporting period, these items will touch on the owners’ equity as follows:

 Assets = Liabilities + Owners’ Equity + Revenues – Expenses + Gains – Losses + Contributions – Withdrawals

These additional items under owners’ equity are tracked in temporary accounts until the end of the bookkeeping period, at which time they are closed to owners’ equity.

The accounting equation holds at all times over the life of the business. When a transaction occurs, the total avails of the business concern may change, but the equation will remain in residuum. The accounting equation serves as the basis for the balance sheet, as illustrated in the following example.

Read:   All of the Following Are Payroll Liabilities Except:

#### The Accounting Equation  –  A Practical Example

To better empathize the accounting equation, consider the following case. Mike Peddler decides to open a bicycle repair shop. To become started he rents some store space, purchases an initial inventory of bike parts, and opens the shop for business. Here is a listing of the transactions that occurred during the first month:

 Date Transaction Sep 1 Owner contributes \$7500 in cash to capitalize the business concern. Sep 8 Purchased \$2500 in bike parts on business relationship, payable in xxx days. Sep xv Paid beginning calendar month’s shop rent of \$1000. Sep 17 Repaired bikes for \$1100; collected \$400 cash; billed customers for the \$700 balance. Sep 18 \$275 in bike parts were used. Sep 25 Collected \$425 from customer accounts. Sep 28 Paid \$500 to suppliers for parts purchased earlier in the month.

These transactions affect the bookkeeping equation equally shown below.

 Assets = Liabilities  +  Owner’s Equity Cash + WheelParts + AccountsReceivable = AccountsPayable + Peddler,Majuscule + Revenue(Expenses) Sep 1 7500 = 7500 Sep viii 2500 = 2500 Sep 15 (1000) = (thousand) Sep 17 400 700 = 1100 Sep eighteen (275) = (275) Sep 25 425 (425) = Sep 28 (500) = (500) Totals: 6825 + 2225 + 275 = 2000 + 7500 + (175) \$9325 = \$9325

Note that for each date in the in a higher place example, the sum of entries under the “Assets” heading is equal to the sum of entries nether the “Liabilities + Possessor’s Disinterestedness” heading. In well-nigh of these cases, the transaction affected both sides of the accounting equation. Still, note that the Sep 25 transaction affected only the asset side with an increase in greenbacks and an equal simply contrary decrease in accounts receivable.

Read:   Solve for the Missing Amounts for the Following Separate Cases

At the terminate of the month of September, the internet income (revenues minus expenses) is airtight to capital and the balance sail for the business would appear as follows:

 Peddler’s BikesBalance SheetSeptember xxx, 20twenty Assets Liabilities  &Owner’s Equity Greenbacks 6825 Accounts Payable 2000 Accounts Receivable 275 Peddler, Upper-case letter 7325 Bike Parts 2225 Total Assets \$9325 Total Liabilities \$9325

The bike parts are considered to be inventory, which appears every bit an asset on the residuum sheet. The owner’southward equity is modified according to the difference betwixt revenues and expenses. In this instance, the difference is a loss of \$175, then the owner’s equity has decreased from \$7500 at the beginning of the month to \$7325 at the end of the month.

#### Debits and Credits

The above example illustrates how the accounting equation remains in residue for each transaction. Annotation that negative amounts were portrayed as negative numbers. In practice, negative numbers are not used; in a double-entry bookkeeping organization the recording of each transaction is made via debits and credits in the appropriate accounts.

Schaum’s Outline of Bookkeeping and Accounting