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. He is the sole author of all the materials on AccountingCoach.com.
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Introduction
The basic accounting equation is:
The equation remains in balance thanks to the double-entry accounting (or bookkeeping) system.
The double-entry system requires a company’s transactions to be entered/recorded in two (or more) general ledger accounts. One account will have the amount entered on the left-side (a debit entry), while another account will have the amount entered on the right-side (a credit entry). As a result, the total amount of debits in the accounts will be equal to the total amount of credits in the accounts. (This can be verified with a trial balance.) In addition, the total of the asset account balances will be equal to the total of the liability account balances plus the total of the equity account balances. This will be evidenced by the accounting equation and the company’s balance sheet.
The accounting equation amounts are computed using the balances in the following permanent/balance sheet accounts:
Asset accounts. In the general ledger, the asset accounts normally* have their balances on the left side (debit balances). In the accounting equation, the total amount in the asset accounts is shown on the left side. A few examples are Cash, Accounts Receivable, and Inventory.
Liability accounts. In the general ledger, the liability accounts normally* have their balances on the right side (credit balances). In the accounting equation, the total amount in the liability accounts is shown on the right side. Three examples are Notes Payable, Accounts Payable, and Interest Payable.
Owner’s (stockholders’) equity accounts. In the general ledger, the equity accounts normally* have their balances on the right side (credit balances). In the accounting equation, the total amount in the equity accounts is shown on the right side. Examples include a sole proprietor’s Capital account and a corporation’s Common Stock and Retained Earnings accounts.
The accounting equation provides a snapshot of the total amount of a company’s recorded assets (resources owned), its total amount of recorded liabilities (amounts owed), and the owner’s equity (the remainder or residual).
To illustrate, assume that a company’s accounting equation shows the following:
You might think of the liabilities and owner’s equity as claims against the company’s assets in this order: secured liabilities, unsecured liabilities, residual claims of owners. You could also think of the liabilities and the owner’s equity as the source of the company’s assets. Of the $550,000 of assets, the creditors provided $420,000 and the owners provided $130,000.
Using a little algebra, the accounting equation can be restated:
How Revenues and Expenses Fit In
It is easy to see that an additional investment by the owner will directly increase the owner’s equity. Similarly, a withdrawal of money by the owner for personal use will decrease the amount of owner’s equity.
However, owner’s equity also changes when the company earns revenues and/or it incurs expenses:
Revenues (and gains) cause the owner’s equity to increase. (Recall that the owner’s equity accounts normally have credit balances and will increase with a credit entry.) So, while owner’s equity increases when the company earns revenues, the revenue transaction will be recorded in the general ledger with a credit in a revenue account. (The debit is often recorded in the asset account Cash or Accounts Receivable.)
[Later, the credit balances in the revenue accounts will be moved to an owner’s equity account thereby increasing the equity account’s credit balance.]
Expenses (and losses) cause the owner’s equity to decrease. While owner’s equity decreases when the company incurs an expense, the expense transaction will be first recorded in the general ledger with a debit in an expense account. (The credit might be to Cash or Accounts Payable, or another account.)
[Later, the debit balances in the expense accounts will be moved to an owner’s equity account thereby decreasing the equity account’s credit balance.]
To illustrate, assume a company earned $500 in consulting fees and is paid immediately. As a result:
The company’s accounting equation will show a $500 increase in assets, and a $500 increase in owner’s equity.
However, the transaction is recorded in the general ledger with a debit of $500 to the Cash account, and a credit of $500 to the temporary account Consulting Revenue. (Later, the credit balance in Consulting Revenue will be transferred with a credit to an owner’s equity account.)
Some Transactions Will Involve Two Asset Accounts
You should be aware that some transactions will cause one asset to increase and another asset to decrease. In those situations, the total amounts in the accounting equation will not change. Here are two examples:
A company pays $5,000 for new office equipment. Cash decreased; Office Equipment increased.
A company collects a $2,000 account receivable that was recorded when the sale occurred in the previous month. Cash increased; Accounts Receivable decreased.
We will look at 8 transactions at a sole proprietorship and show the following:
The effect on the company’s accounting equation
How they are recorded in the company’s accounts
The resulting balance sheet
When appropriate, an income statement
A schedule of the changes in the owner’s equity
How to compute a company’s net income from incomplete information
That will be followed by looking at similar transactions at a corporation.
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Accounting Equation for a Sole Proprietorship: Transactions 1-2
When a company records a business transaction, it is not recorded in the accounting equation, per se. Rather, transactions are recorded into specific accounts contained in the company’s general ledger. The accounts are designated as an asset, liability, owner’s equity, revenue, expense, gain, or loss account. The amounts in the general ledger accounts will be used to prepare the balance sheets and income statements.
In our transactions, we will use the following accounts:
Our examples assume that the accrual basis of accounting is being used.
Sole Proprietorship Transaction #1.
Assume that J. Ott forms a sole proprietorship called Accounting Software Co. (ASC). On December 1, 2024, J. Ott invests personal funds of $10,000 to start ASC. The effect of this transaction on ASC’s accounting equation is:
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 is 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 residual claim for the remainder 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 transaction is:
After the journal entry is recorded in the accounts, a balance sheet will show ASC’s financial position at the end of December 1, 2024 as follows:
Since ASC has not yet earned any revenues nor incurred any expenses, there are no amounts to be reported on an income statement.
Sole Proprietorship Transaction #2.
On December 2, 2024, J. Ott withdraws $100 of cash from the business for his personal use. The effect of this transaction on ASC’s accounting equation is:
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 transaction in a general journal entry format is:
Since the transactions of December 1 and December 2 were in balance, the sum of both transactions should also be in balance:
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:
Withdrawals of company assets by the owner for the owner’s personal use are known as “draws.” Since draws are not expenses, there is no transaction involving the company’s income statement for the two-day period of December 1 through December 2.
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Accounting Equation for a Sole Proprietorship: Transactions 3-4
Sole Proprietorship Transaction #3.
On December 3, 2024, Accounting Software Co. spends $5,000 of cash to purchase computer equipment for use in the business. The effect of this transaction on the accounting equation is:
The accounting equation reflects that one asset increased and another asset decreased. Since the amount of the increase is the same as the amount of the decrease, the accounting equation remains in balance.
This transaction is recorded in the asset accounts Equipment and Cash. The Equipment account increases by $5,000, and the Cash account decreases by $5,000. The journal entry for this transactions is:
The combined effect of the first three transactions is shown here:
The totals tell us that the company has assets of $9,900 and the source of those assets is the owner of the company. It also tells us that the company has assets of $9,900 and the only claim against those assets is the owner’s claim.
The balance sheet dated December 3, 2024, reflects ASC’s financial position as of midnight on December 3:
The purchase of equipment is not an immediate expense. It will become part of depreciation expense only after it is placed into service. We will assume that as of December 3 the equipment has not been placed into service, therefore, there is no expense or revenue to be reported on an income statement for the period of December 1 through December 3.
Sole Proprietorship Transaction #4.
On December 4, 2024, ASC obtains $7,000 by borrowing money from its bank. The effect of this transaction on the accounting equation is:
As you can see, ASC’s assets increased and ASC’s liabilities increased by $7,000.
This transaction is recorded in the asset account Cash and the liability account Notes Payable as shown in this accounting entry:
The combined effect on the accounting equation from the first four transactions is shown here:
The totals indicate that the transactions through December 4 result in assets of $16,900. There are two sources for those assets—the creditors provided $7,000 of assets, and the owner of the company provided $9,900. You can also interpret the accounting equation to say that the company has assets of $16,900 and the lenders have a claim of $7,000 and the owner has a residual claim for the remainder.
The balance sheet dated December 4 will report ASC’s financial position as of the final moment on December 4:
The proceeds of the bank loan are not considered to be revenue since ASC did not earn the money by providing services, investing, etc. As a result, there is no income statement effect from this transaction. For the accounting period of the four days ended December 4, there is no revenue or expense to be reported on the income statement.
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Accounting Equation for a Sole Proprietorship: Transactions 5-6
Sole Proprietorship Transaction #5.
On December 5, 2024, 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 decreases with a company 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 shown 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 midnight on December 5 is:
**The income statement (which reports the company’s revenues, expenses, gains, and losses during a specified time interval) is a link between balance sheets. It provides the results of operations—an important part of the change in owner’s equity.
Since this transaction involves an expense, it will be reported on ASC’s income statement. The company’s income statement for the first five days of December is:
Sole Proprietorship Transaction #6.
On December 6, 2024, ASC performed consulting services for its clients. The clients were billed for the agreed upon amount of $900. The amounts are to be paid within 30 days. The effect on ASC’s accounting equation is:
Since ASC has completed the services, it has earned revenues and it has the right to receive $900 from the clients. This right increases the asset known as accounts receivable. The earning of revenues causes owner’s equity to increase.
Although revenues cause owner’s equity to increase, the revenue transaction is not recorded directly into the owner’s capital account. Rather, the amount earned is recorded in the revenue account Service Revenues. At some point, the amount in the revenue accounts will be transferred to the owner’s capital account.
The general journal entry to record Transaction #6 is:
The following is a recap of the first six transactions:
The totals tell us that as of midnight on December 6, the company had assets of $17,200. It also indicates the creditors provided $7,000 and the owner of the company provided $10,200. The totals also reveal that the company had assets of $17,200 and the creditors had a claim of $7,000. The owner had a residual claim for the remaining $10,200.
The balance sheet as of midnight on December 6 is presented here:
**The income statement (which reports the company’s revenues, expenses, gains, and losses during a specified time interval) is a link between balance sheets. It provides the results of operations—an important part of the change in owner’s equity.
The Income Statement for Accounting Software Co. for the six days ended December 6 is:
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Accounting Equation for a Sole Proprietorship: Transactions 7–8
Sole Proprietorship Transaction #7.
On December 7, 2024, ASC used a temporary help service for 6 hours at a cost of $20 per hour. ASC will pay the invoice when it is due in 10 days. The effect on its accounting equation is:
ASC’s liabilities increased by $120 and the expense caused owner’s equity to decrease by $120.
The liability will be recorded in Accounts Payable and the expense will be recorded in Temp Service Expense. The journal entry for recording the use of the temp service is:
The effect of the first seven transactions on the accounting equation can be viewed here:
The totals indicate that as of midnight on December 7, the company had assets of $17,200 and the sources were $7,120 from the creditors and $10,080 from the owner of the company. The accounting equation totals also tell us that the company had assets of $17,200 with the creditors having a claim of $7,120. This means that the owner’s residual claim was $10,080.
ASC’s balance sheet as of midnight on December 7, 2024 is:
**The income statement (which reports the company’s revenues, expenses, gains, and losses for a specified time interval) is a link between balance sheets. It provides the results of operations—an important part of the change in owner’s equity.
Accounting Software Co.’s income statement for the first seven days of December is:
Sole Proprietorship Transaction #8.
On December 8, 2024, ASC received $500 from the clients it had billed on December 6, 2024. The collection of accounts receivables has this effect on the accounting equation:
The company’s asset (cash) increased and another asset (accounts receivable) decreased. Liabilities and owner’s equity were not affected. (There are no revenues on this date. The revenues were recorded when they were earned on December 6.)
The general journal entry to record the increase in Cash, and the decrease in Accounts Receivable is:
The combined effect of the first eight transactions is shown here:
The totals for the first eight transactions indicate that the company had assets of $17,200. The creditors provided $7,120 and the owner provided $10,080. The accounting equation also indicates that the company’s creditors had a claim of $7,120 and the owner had a residual claim of $10,080.
ASC’s balance sheet as of midnight December 8, 2024 is:
**The income statement (which reports the company’s revenues, expenses, gains, and losses during a specified period of time) is a link between balance sheets. It provides the results of operations—an important part of the change in owner’s equity.
The income statement for ASC for the eight days ending on December 8 is shown here:
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Calculating a Missing Amount within Owner’s Equity
The income statement for the calendar year 2024 will explain a portion of the change in the owner’s equity between the balance sheets of December 31, 2023 and December 31, 2024. The other items that account for the change in owner’s equity are the owner’s investments into the sole proprietorship and the owner’s draws (or withdrawals). A recap of these changes is the statement of changes in owner’s equity. Here is a statement of changes in owner’s equity for the year 2024 assuming that the Accounting Software Co. had only the eight transactions that we covered earlier.
Example of Calculating a Missing Amount
The format of the statement of changes in owner’s equity can be used to determine an unknown component. For instance, if the net income for the year 2024 is unknown, but you know the amount of the draws and the beginning and ending balances of owner’s equity, you can calculate the net income. (This might be necessary when a company does not have complete records of its revenues and expenses.) Let’s demonstrate this by using some new hypothetical amounts:
Step 1.
The owner’s equity at December 31, 2023 can be computed using the accounting equation:
Step 2.
The owner’s equity at December 31, 2024 can be computed as well:
Step 3.
Insert into a statement of changes in owner’s equity format the information that was given and the amounts calculated in Step 1 and Step 2:
Step 4.
The “Subtotal” can be calculated by adding the last two numbers on the statement: $94,000 + $40,000 = $134,000. After this calculation we have:
Step 5.
Starting at the top of the statement we know that the owner’s equity before the start of 2024 was $60,000 and in 2024 the owner invested an additional $10,000. As a result we have $70,000 before considering the amount of Net Income. We also know that after the amount of Net Income is added, the Subtotal has to be $134,000 (the Subtotal calculated in Step 4). The Net Income is the difference between $70,000 and $134,000. Net income must have been $64,000.
Step 6.
Insert the previously missing amount (in this case it is the $64,000 of net income) into the statement of changes in owner’s equity and recheck the math:
Since the statement is mathematically correct, we are confident that the net income was $64,000.
The remaining parts of this Explanation will illustrate similar transactions and their effect on the accounting equation when the company is a corporation instead of a sole proprietorship.
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Accounting Equation for a Corporation: Transactions C1–C2
The accounting equation (or basic accounting equation) for a corporation is:
Examples
In our examples below, we show how a given transaction affects the accounting equation for a corporation. We also show how the same transaction will be recorded in the company’s general ledger accounts.
In addition, we show the effect of each transaction on the balance sheet and income statement.
Our examples assume that the accrual basis of accounting is being followed.
In the examples that follow, we will use the following accounts:
We also assume that the corporation is a Subchapter S corporation in order to avoid the income tax accounting that would occur with a “C” corporation. (In a Subchapter S corporation the owners are responsible for the income taxes instead of the corporation.)
Corporation Transaction C1
Assume that members of the Ott family form a corporation called Accounting Software, Inc. (ASI). On December 1, 2024, several members of the Ott family invest a total of $10,000 to start ASI. In exchange, the corporation issues a total of 1,000 shares of common stock. (The stock has no par value and no stated value.) The effect on the corporation’s accounting equation is:
Since ASI’s assets increase by $10,000 and stockholders’ equity increases by the same amount the accounting equation is in balance.
The accounting equation tells us that ASI has assets of $10,000 and the source of those assets were the stockholders. Alternatively, the accounting equation tells us that the corporation has assets of $10,000 and the only claim to the assets is from the stockholders (owners).
This transaction is recorded in the asset account Cash and in the stockholders’ equity account Common Stock. The general journal entry to record the transaction is:
After the journal entry is recorded in the accounts, a balance sheet will show ASI’s financial position at the end of December 1, 2024:
Since ASI has not yet earned any revenues nor incurred any expenses, there are no amounts to be reported on an income statement.
Corporation Transaction C2.
On December 2, 2024, ASI purchases $100 of its stock from one of its stockholders. The stock will be held by the corporation as Treasury Stock. The effect of the accounting equation is:
The purchase of its own stock for cash causes ASI’s assets to decrease by $100 and its stockholders’ equity to decrease by $100.
This transaction is recorded in the asset account Cash and in the stockholders’ equity account Treasury Stock. The accounting entry in general journal form is:
Since the transactions of December 1 and December 2 were in balance, the sum of both transactions should also be in balance:
The totals indicate that ASI has assets of $9,900 and the source of those assets is the stockholders. The accounting equation also shows that the corporation has assets of $9,900 and the only claim against the assets is the stockholders’ claim.
The December 2 balance sheet will communicate the corporation’s financial position as of midnight on December 2:
The purchase of a corporation’s own stock will never result in an amount to be reported on the income statement. Therefore, there is no transaction involving the income statement for the two-day period of December 1 through December 2.
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Accounting Equation for a Corporation: Transactions C3–C4
Corporation Transaction C3.
On December 3, 2024, ASI spends $5,000 of cash to purchase computer equipment for use in the business. The effect of this transaction on ASI’s accounting equation is:
The accounting equation shows that one asset increased and one asset decreased. Since the amount of the increase is the same as the amount of the decrease, the accounting equation remains in balance.
This transaction is recorded in the asset accounts Equipment and Cash. The Equipment account increases by $5,000 and the Cash account decreases by $5,000. The journal entry for this transaction is:
The effect on the accounting equation from the first three transactions is:
The totals tell us that the corporation has assets of $9,900 and the source of those assets is the stockholders. The totals tell us that the company has assets of $9,900 and that the only claim against those assets is the stockholders’ claim.
The balance sheet dated December 3, 2024, reflects the financial position of the corporation as of midnight on December 3:
The purchase of equipment is not an immediate expense. It will become part of depreciation expense only after the equipment is placed in service. We will assume that as of December 3 the equipment has not been placed into service. Therefore, there is no expense (or revenue) to be reported on the income statement for the period of December 1-3.
Corporation Transaction C4.
On December 4, 2024, ASI obtains $7,000 by borrowing money from its bank. The effect of this transaction on the accounting equation is:
As you see, ACI’s assets increased and its liabilities increased by $7,000.
This transaction is recorded in the asset account Cash and the liability account Notes Payable with the following journal entry:
The following shows the effects on the accounting equation from the first four transactions:
These totals indicate that the transactions through December 4 result in assets of $16,900. There are two sources for those assets: the creditors provided $7,000 of assets, and the stockholders provided $9,900. You can also interpret the accounting equation to say that the corporation has assets of $16,900 and the creditors have a claim of $7,000. The stockholders have a residual claim of $9,900.
The balance sheet dated December 4 reports the corporation’s financial position as of the final moment on December 4:
The receipt of money from the bank loan is not revenue since ASI did not earn the money by providing services, investing, etc. As a result, there is no income statement effect from this or earlier transactions.
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Accounting Equation for a Corporation: Transactions C5–C6
Corporation Transaction C5.
On December 5, 2024, Accounting Software, Inc. pays $600 for ads that were run in recent days. The effect of the advertising transaction on the corporation’s accounting equation is:
Since ASI is paying $600, its assets decrease. The second effect is a $600 decrease in stockholders’ 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 stockholders’ equity decreases because of an expense, the transaction is not recorded directly into the retained earnings account. Instead, the amount is initially recorded in the expense account Advertising Expense and in the asset account Cash.
The journal entry for this transaction is:
The combined effect of the first five transactions is shown here:
The totals now indicate that Accounting Software, Inc. has assets of $16,300. The creditors provided $7,000 and the stockholders provided $9,300. Viewed another way, the corporation has assets of $16,300 with the creditors having a claim of $7,000 and the stockholders having a residual claim of $9,300.
The balance sheet as of the end of December 5 is:
**The income statement (which reports the company’s revenues, expenses, gains, and losses for a specified time period) is a link between balance sheets. It provides the results of operations—an important part of the change in retained earnings and stockholders’ equity.
Since this transaction involves an expense, it will be reported on ASI’s income statement. The corporation’s income statement for the first five days of December is presented here:
Because we assumed that Accounting Services, Inc. is a Subchapter S corporation, income tax expense is not reported on the corporation’s income statement.
Corporation Transaction C6.
On December 6, 2024, ASI performed consulting services for its clients. The clients were billed for the agreed upon amount of $900. The amounts are to be paid within 30 days. The effect on ASI’s accounting equation is:
Since ASI has completed the services, it has earned revenues and it has the right to receive $900 from its clients. This right increases the asset accounts receivable. The earning of revenues also causes stockholders’ equity to increase.
Although revenues cause stockholders’ equity to increase, the revenue transaction is not recorded directly into a stockholders’ equity account. Rather, the amount earned is recorded in the revenue account Service Revenues. At some point, the amount in the revenue accounts will be transferred to the retained earnings account.
The general journal entry for Transaction #6 is:
The effect on the accounting equation from the first six transactions can be viewed here:
The totals tell us that at the end of December 6, the corporation had assets of $17,200 of which $7,000 came from creditors and $10,200 came from stockholders. The totals can also be viewed another way: ASI had assets of $17,200 with its creditors having a claim of $7,000 and the stockholders having a residual claim for the remainder of $10,200.
The balance sheet as of midnight on December 6 is presented here:
**The income statement (which reports the company’s revenues, expenses, gains, and losses for a specified time period) is a link between balance sheets. It provides the results of operations—an important part of the change in retained earnings and stockholders’ equity.
The income statement for Accounting Software, Inc. for the six days ended December 6 is shown here:
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Accounting Equation for a Corporation: Transactions C7–C8
Corporation Transaction C7.
On December 7, 2024, ASI uses a temporary help service for 6 hours at a cost of $20 per hour. ASI records the invoice immediately, but it will pay the $120 when it is due in 10 days. This transaction has the following effect on the accounting equation:
The accounting equation shows that ASI’s liabilities increased by $120 and the expense caused stockholders’ equity to decrease by $120.
The liability will be recorded in Accounts Payable and the expense will be recorded in Temp Service Expense. The general journal entry for utilizing the temp service is:
The effect of the first seven transactions on the accounting equation can be viewed here:
The totals show us that the corporation had assets of $17,200 with $7,120 provided by the creditors and $10,080 provided by the stockholders. The accounting equation also reveals that the corporation’s creditors had a claim of $7,120 and the stockholders had a residual claim for the remaining $10,080.
The financial position of ASI as of midnight of December 7 is presented in the following balance sheet:
**The income statement (which reports the corporations’ revenues, expenses, gains, and losses for a specified time period) is a link between balance sheets. It provides the results of operations—an important part of the change in stockholders’ equity.
The income statement for the first seven days of December is shown here:
Corporation Transaction C8.
On December 8, 2024, ASI received $500 from the clients it had billed on December 6. The effect on the accounting equation is:
The corporation’s cash increased and one of its other assets (accounts receivable) decreased. Liabilities and stockholders’ equity were not affected. (There are no revenues on this date. The revenues were recorded when they were earned on December 6.)
The general journal entry to record the increase in Cash and the decrease in Accounts Receivable is:
The effect on the accounting equation from the transactions through December 8 is shown here:
The totals after the first eight transactions indicate that the corporation had assets of $17,200. The creditors provided $7,120 and the company’s stockholders provided $10,080. The accounting equation also indicates that the company’s creditors had a claim of $7,120 and the stockholders had a residual claim of $10,080.
ASI’s balance sheet as of midnight of December 8 is shown here:
**The income statement (which reports the corporation’s revenues, expenses, gains, and losses for a specified time period) is a link between balance sheets. It provides the results of operations—an important part of the change in stockholders’ equity.
The income statement for ASI’s first eight days of operations is shown here:
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Expanded Accounting Equation for a Sole Proprietorship
The owner’s equity in the basic accounting equation is sometimes expanded to show the accounts that make up owner’s equity: Owner’s Capital, Revenues, Expenses, and Owner’s Draws.
Instead of the accounting equation, Assets = Liabilities + Owner’s Equity, the expanded accounting equation is:
The eight transactions that we had listed under the basic accounting equation for a Sole Proprietorship Transaction #8 are shown in the following expanded accounting equation:
With the expanded accounting equation, you can easily see the company’s net income:
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Expanded Accounting Equation for a Corporation
The stockholders’ equity part of the basic accounting equation can also be expanded to show the accounts that make up stockholders’ equity: Paid-in Capital, Revenues, Expenses, Dividends, and Treasury Stock.
Instead of the accounting equation, Assets = Liabilities + Stockholders’ Equity, the expanded accounting equation is:
The eight transactions that we had listed under the basic accounting equation for a Corporation Transaction C8 are shown in the following expanded accounting equation:
With the expanded accounting equation, you can easily see the corporation’s net income:
Where to Go From Here
We recommend taking our Practice Quiz next, and then continuing with the rest of our Accounting Equation materials (see the full outline below, after the following Disclaimer).
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Disclaimer
You should consider our materials to be an introduction to selected accounting and bookkeeping topics (with complexities likely omitted). We focus on financial statement reporting and do not discuss how that differs from income tax reporting. Therefore, you should always consult with accounting and tax professionals for assistance with your specific circumstances.
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The 500 year-old accounting system where every transaction is recorded into at least two accounts.
That part of the accounting system which contains the balance sheet and income statement accounts used for recording transactions.
The accounting term that means an entry will be made on the left side of an account.
To enter an amount on the right side of an account. Normal entries to revenue accounts are credits. Liabilities normally have credit balances.
One of the main financial statements. The balance sheet reports the assets, liabilities, and owner’s (stockholders’) equity at a specific point in time, such as December 31. The balance sheet is also referred to as the Statement of Financial Position.
An asset account is a general ledger account used to sort and store the debit and credit amounts from a company’s transactions involving the company’s resources.
A current asset account which includes currency, coins, checking accounts, and undeposited checks received from customers. The amounts must be unrestricted. (Restricted cash should be recorded in a different account.)
A current asset resulting from selling goods or services on credit (on account). Invoice terms such as (a) net 30 days or (b) 2/10, n/30 signify that a sale was made on account and was not a cash sale.
A current asset whose ending balance should report the cost of a merchandiser’s products awaiting to be sold. The inventory of a manufacturer should report the cost of its raw materials, work-in-process, and finished goods. The cost of inventory should include all costs necessary to acquire the items and to get them ready for sale.
When inventory items are acquired or produced at varying costs, the company will need to make an assumption on how to flow the changing costs. See cost flow assumption.
If the net realizable value of the inventory is less than the actual cost of the inventory, it is often necessary to reduce the inventory amount.
A liability account is a general ledger account in which a company records the following which resulted from business transactions:
Amounts owed to suppliers for goods and services received on credit
Principal amounts owed to banks and other lenders for borrowed funds
Amounts owed for wages, interest, taxes, and amounts incurred but not yet processed
Amounts that customers have prepaid, customers’ deposits, etc.
Certain deferred corporate income taxes
Contingent obligations that are probable and can be estimated
The amount of principal due on a formal written promise to pay. Loans from banks are included in this account.
This current liability account will show the amount a company owes for items or services purchased on credit and for which there was not a promissory note. This account is often referred to as trade payables (as opposed to notes payable, interest payable, etc.)
This current liability account reports the amount of interest the company owes as of the date of the balance sheet. (Future interest is not recorded as a liability.)
The type of stock that is present at every corporation. (Some corporations have preferred stock in addition to their common stock.) Shares of common stock provide evidence of ownership in a corporation. Holders of common stock elect the corporation’s directors and share in the distribution of profits of the company via dividends. If the corporation were to liquidate, the secured lenders would be paid first, followed by unsecured lenders, preferred stockholders (if any), and lastly the common stockholders.
Generally speaking, retained earnings is a stockholders’ equity account that reports the net income of a corporation from its inception until the balance sheet date less the dividends declared from its inception to the date of the balance sheet.
Allowance for Doubtful Accounts is a contra current asset account associated with Accounts Receivable. When the credit balance of the Allowance for Doubtful Accounts is subtracted from the debit balance in Accounts Receivable the result is known as the net realizable value of the Accounts Receivable.
The credit balance in this account comes from the entry wherein Bad Debts Expense is debited. The amount in this entry may be a percentage of sales or it might be based on an aging analysis of the accounts receivables (also referred to as a percentage of receivables).
When the allowance account is used, the company is anticipating that some accounts will be uncollectible in advance of knowing the specific account. As a result the bad debts expense is more closely matched to the sale. When a specific account is identified as uncollectible, the Allowance for Doubtful Accounts should be debited and Accounts Receivable should be credited.
The amount of a long-term asset’s cost that has been allocated to Depreciation Expense since the time that the asset was acquired. Accumulated Depreciation is a long-term contra asset account (an asset account with a credit balance) that is reported on the balance sheet under the heading Property, Plant, and Equipment.
The contra owner’s equity account used to record the current year’s withdrawals of business assets by the sole proprietor for personal use. This is a temporary account with a debit balance. It will be closed at the end of the year to the owner’s capital account.
An account with a balance that is the opposite of the normal balance. For example, Accumulated Depreciation is a contra asset account, because its credit balance is contra to the debit balance for an asset account. Another example is the owner’s drawing account. This is an owner’s equity account and as such you would expect a credit balance. However, the drawing account has a debit balance. Other examples include (1) the allowance for doubtful accounts, (2) discount on bonds payable, (3) sales returns and allowances, and (4) sales discounts. The contra accounts cause a reduction in the amounts reported. For example net sales is gross sales minus the sales returns, the sales allowances, and the sales discounts. The net realizable value of the accounts receivable is the accounts receivable minus the allowance for doubtful accounts.
Things that are resources owned by a company and which have future economic value that can be measured and can be expressed in dollars. Examples include cash, investments, accounts receivable, inventory, supplies, land, buildings, equipment, and vehicles.
Assets are reported on the balance sheet usually at cost or lower. Assets are also part of the accounting equation: Assets = Liabilities + Owner’s (Stockholders’) Equity.
Some valuable items that cannot be measured and expressed in dollars include the company’s outstanding reputation, its customer base, the value of successful consumer brands, and its management team. As a result these items are not reported among the assets appearing on the balance sheet.
Obligations of a company or organization. Amounts owed to lenders and suppliers. Liabilities often have the word “payable” in the account title. Liabilities also include amounts received in advance for a future sale or for a future service to be performed.
Fees earned from providing services and the amounts of merchandise sold. Under the accrual basis of accounting, revenues are recorded at the time of delivering the service or the merchandise, even if cash is not received at the time of delivery. Often the term income is used instead of revenues.
Examples of revenue accounts include: Sales, Service Revenues, Fees Earned, Interest Revenue, Interest Income. Revenue accounts are credited when services are performed/billed and therefore will usually have credit balances. At the time that a revenue account is credited, the account debited might be Cash, Accounts Receivable, or Unearned Revenue depending if cash was received at the time of the service, if the customer was billed at the time of the service and will pay later, or if the customer had paid in advance of the service being performed.
If the revenues earned are a main activity of the business, they are considered to be operating revenues. If the revenues come from a secondary activity, they are considered to be nonoperating revenues. For example, interest earned by a manufacturer on its investments is a nonoperating revenue. Interest earned by a bank is considered to be part of operating revenues.
Costs that are matched with revenues on the income statement. For example, Cost of Goods Sold is an expense caused by Sales. Insurance Expense, Wages Expense, Advertising Expense, Interest Expense are expenses matched with the period of time in the heading of the income statement. Under the accrual basis of accounting, the matching is NOT based on the date that the expenses are paid.
Expenses associated with the main activity of the business are referred to as operating expenses. Expenses associated with a peripheral activity are nonoperating expenses or other expenses. For example, a retailer’s interest expense is a nonoperating expense. A bank’s interest expense is an operating expense.
Generally, expenses are debited to a specific expense account and the normal balance of an expense account is a debit balance. When an expense account is debited, the account credited might be Cash (if cash was paid at the time of the expense), Accounts Payable (if cash will be paid after the expense is recorded), or Prepaid Expense (if cash was paid before the expense was recorded.)
Gains result from the sale of an asset (other than inventory). A gain is measured by the proceeds from the sale minus the amount shown on the company’s books. Since the gain is outside of the main activity of a business, it is reported as a nonoperating or other revenue on the company’s income statement.
Losses result from the sale of an asset (other than inventory) for less than the amount shown on the company’s books. Since the loss is outside of the main activity of a business, it is reported as a nonoperating or other loss. To learn more, see Explanation of Income Statement. The term losses is also used to report the writedown of asset amounts to amounts less than cost. It is also used to refer to several periods of net losses caused by expenses exceeding revenues.
A long-term asset account reported on the balance sheet under the heading of property, plant, and equipment. Included in this account would be copiers, computers, printers, fax machines, etc.
This is the bottom line of the income statement. It is the mathematical result of revenues and gains minus the cost of goods sold and all expenses and losses (including income tax expense if the company is a regular corporation) provided the result is a positive amount. If the net amount is a negative amount, it is referred to as a net loss.
The amount of principal due on a formal written promise to pay. Loans from banks are included in this account.
This is an owner’s equity account. The balance in this account reflects the owner’s investment in this sole proprietorship plus the net income and minus the owner’s draws since the company began. (The current year net income and draws may not yet be recorded in this account. The net income may still be in the temporary revenue and expense accounts and the draws may still be in J. Ott, Drawing, also a temporary account. The temporary accounts will be closed to J. Ott, Capital after the year’s financial statements are prepared.)
This is a contra owner’s equity account, because it has a debit balance if draws were made. Even though it is a balance sheet account, it is a temporary account. At the end of each year the account’s debit balance is closed to J. Ott, Capital.
Under the accrual basis of accounting, the Service Revenues account reports the fees earned by a company during the time period indicated in the heading of the income statement. Service Revenues include work completed whether or not it was billed. Service Revenues is an operating revenue account and will appear at the beginning of the company’s income statement.
Advertising Expense is the income statement account which reports the dollar amount of ads run during the period shown in the income statement. Advertising Expense will be reported under selling expenses on the income statement.
Under the accrual basis of accounting, this account reports the cost of the temporary help services that a company used during the period indicated on its income statement.
The systematic allocation of the cost of an asset from the balance sheet to Depreciation Expense on the income statement over the useful life of the asset. (The depreciation journal entry includes a debit to Depreciation Expense and a credit to Accumulated Depreciation, a contra asset account). The purpose is to allocate the cost to expense in order to comply with the matching principle. It is not intended to be a valuation process. In other words, the amount allocated to expense is not indicative of the economic value being consumed. Similarly, the amount not yet allocated is not an indication of its current market value.
Gains result from the sale of an asset (other than inventory). A gain is measured by the proceeds from the sale minus the amount shown on the company’s books. Since the gain is outside of the main activity of a business, it is reported as a nonoperating or other revenue on the company’s income statement.
A bill issued by a seller of merchandise or by the provider of services. The seller refers to the invoice as a sales invoice and the buyer refers to the same invoice as a vendor invoice.
This current liability account will show the amount a company owes for items or services purchased on credit and for which there was not a promissory note. This account is often referred to as trade payables (as opposed to notes payable, interest payable, etc.)
A corporation’s own stock that has been repurchased from stockholders. Also a stockholders’ equity account that usually reports the cost of the stock that has been repurchased.
A tax status allowed by the U.S. Internal Revenue Service.
The income statement account which contains a portion of the cost of plant and equipment that is being matched to the time interval shown in the heading of the income statement. (There is no depreciation expense for land.)
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. He is the sole author of all the materials on AccountingCoach.com.
