# Accounting Equation

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## Accounting Equation for a Sole Proprietorship: Transactions 1–2

We present nine transactions to illustrate how a company’s accounting equation stays in balance.

When a company records a business transaction, it is not entered into an accounting equation, per se. Rather, transactions are recorded into specific accounts contained in the company’s general ledger. Each account is designated as an asset, liability, owner's equity, revenue, expense, gain, or loss account. The general ledger accounts are then used to prepare the balance sheets and income statements throughout the accounting periods.

In the examples that follow, we will use the following accounts:

Cash
Accounts Receivable
Equipment
Notes Payable
Accounts Payable
J. Ott, Capital
J. Ott, Drawing
Service Revenues
Temp Service Expense

(To view a more complete listing of accounts for recording transactions, see the Explanation of Chart of Accounts.)

Sole Proprietorship Transaction #1.

Let’s assume that J. Ott forms a sole proprietorship called Accounting Software Co. (ASC). On December 1, 2011, J. Ott invests personal funds of \$10,000 to start ASC. The effect of this transaction on ASC’s accounting equation is:

 Assets = Liabilities + Owner’s Equity +\$10,000 = No Effect + +\$10,000

As you can see, ASC’s assets increase by \$10,000 and so does ASC’s owner's equity. As a result, the accounting equation will be in balance.

You can interpret the amounts in the accounting equation to mean that ASC has assets of \$10,000 and the source of those assets was the owner, J. Ott. Alternatively, you can view the accounting equation to mean that ASC has assets of \$10,000 and there are no claims by creditors (liabilities) against the assets. As a result, the owner has a claim for the remainder or residual of \$10,000.

This transaction is recorded in the asset account Cash and the owner’s equity account J. Ott, Capital. The general journal entry to record the transactions in these accounts is:

 Date Account Titles Debit Credit Dec. 1, 2011 Cash 10,000 J. Ott, Capital 10,000

After the journal entry is recorded in the accounts, a balance sheet can be prepared to show ASC’s financial position at the end of December 1, 2011:

 Accounting Software Co. Balance Sheet December 1, 2011 ASSETS LIABILITIES Cash \$ 10,000 OWNER’S EQUITY . J. Ott, Capital \$ 10,000 Total Assets \$ 10,000 Total Liab & Owner's Equity \$ 10,000 .

The purpose of an income statement is to report revenues and expenses. Since ASC has not yet earned any revenues nor incurred any expenses, there are no transactions to be reported on an income statement.

Sole Proprietorship Transaction #2.

On December 2, 2011 J. Ott withdraws \$100 of cash from the business for his personal use. The effect of this transaction on ASC’s accounting equation is:

 Assets = Liabilities + Owner’s Equity –\$100 = No Effect + –\$100

The accounting equation remains in balance since ASC’s assets have been reduced by \$100 and so has the owner’s equity.

This transaction is recorded in the asset account Cash and the owner’s equity account J. Ott, Drawing. The general journal entry to record the transactions in these accounts is:

 Date Account Titles Debit Credit Dec. 2, 2011 J. Ott, Drawing 100 Cash 100

Since the transactions of December 1 and 2 were each in balance, the sum of both transactions should also be in balance:

 Transaction Assets = Liabilities + Owner’s Equity 1 +\$10,000 = No Effect + +\$10,000 2 –\$100 = No Effect + –\$100 Totals \$9,900 = \$0 + \$9,900

The totals indicate that ASC has assets of \$9,900 and the source of those assets is the owner of the company. You can also conclude that the company has assets or resources of \$9,900 and the only claim against those resources is the owner’s claim.

The December 2 balance sheet will communicate the company’s financial position as of midnight on December 2:

 Accounting Software Co. Balance Sheet December 2, 2011 ASSETS LIABILITIES Cash \$ 9,900 OWNER’S EQUITY . J. Ott, Capital \$ 9,900* Total Assets \$ 9,900 Total Liab & Owner's Equity \$ 9,900 .
 . Beginning Owner's Equity \$ 0 + Owner's Investment + 10,000 + Net Income + 0 Subtotal \$ 10,000 – Owner's Draws – 100 Ending Owner's Equity, Dec. 2 \$ 9,900* .

Withdrawals of company assets by the owner for the owner’s personal use are known as “draws.” Since draws are not expenses, the transaction is not reported on the company’s income statement.

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