Accounting Equation

Sole Proprietorship Transaction #5.

On December 5, 2011 Accounting Software Co. pays $600 for ads that were run in recent days. The effect of this advertising transaction on the accounting equation is:

Since ASC is paying $600, its assets decrease. The second effect is a $600 decrease in owner’s equity, because the transaction involves an expense. (An expense is a cost that is used up or its future economic value cannot be measured.)

Although owner’s equity is decreased by an expense, the transaction is not recorded directly into the owner’s capital account at this time. Instead, the amount is initially recorded in the expense account Advertising Expense and in the asset account Cash. The general journal entry to record the transaction is:

The combined effect of the first five transactions is available here:

The totals now indicate that Accounting Software Co. has assets of $16,300. The creditors provided $7,000 and the owner of the company provided $9,300. Viewed another way, the company has assets of $16,300 with the creditors having a claim of $7,000 and the owner having a residual claim of $9,300.

The balance sheet as of the end of December 5, 2011 is:

Since this transaction involves an expense, it will involve ASC’s income statement. The company’s income statement for the first five days of December is:

Sole Proprietorship Transaction #6.

On December 6, 2011 ASC performs consulting services for its clients. The clients are billed for the agreed upon amount of $900. The amounts are due in 30 days. The effect on the accounting equation is:

Since ASC has performed the services, it has earned revenues and it has the right to receive $900 from the clients. This right (known as an account receivable) causes assets to increase. The earning of revenues causes owner’s equity to increase.

Although revenues cause owner’s equity to increase, the revenue transaction is not recorded into the owner’s capital account at this time. Rather, the amount earned is recorded in the revenue account Service Revenues. This will allow the company to report the revenues on its income statement at any time. (After the year ends, the amount in the revenue account will be transferred to the owner’s capital account.) The general journal entry to record the transaction is:

The combined effect of the first six transactions can be viewed here:

The totals tell us that at the end of December 6, the company has assets of $17,200. It also shows the sources of the assets: creditors providing $7,000 and the owner of the company providing $10,200. The totals also reveal that the company has assets of $17,200 and the creditors have a claim of $7,000 and the owner has a claim for the remaining $10,200.

Below is the balance sheet as of midnight on December 6:

The Income Statement for Accounting Software Co. for the period of December 1 through December 6 is:

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