Chapter 1: Accounting Equation

The accounting equation is the foundation of double-entry accounting, which is the fundamental concept behind bookkeeping and accounting. Every business transaction will have an effect on a company's financial position. The financial position of a company is measured by the following items:

• 1. Assets (Stuff)

  2. Liabilities (owe)

  3. Owner's Equity (own)

Assets are also identified as property. Property is anything of value that a person or business owns and therefore controls. Any item of property has at least one financial claim against it. A financial claim is a legal right to property. This simply means that someone owns the property (owner's equity) or owes money for the property (liabilities). 

The relationship between property and financial claims is Property = Financial Claims. 

The right to own property is basic to a free enterprise system. Both individuals and businesses have right to own property. One purpose of accounting is to provide financial information about property and financial claims to that property. Property is measured in dollars in America. 

When you buy property with cash, you acquire all of the financial claims to that property at the time of purchase. When you buy something and agree to pay for it later, you are buying on credit. This happens frequently and is most common when one purchases a house. The house represents the property and the bank represents the creditor (the person giving credit to buy the house).

The accounting equation is fairly simple to understand as it represents ownership of a house in terms of dollars.

Asset = House (160,000) = Property - Property or items of value owned by a business.

Owner's Equity = Money ($32,000) = Owner's Claim to the House - The owner's claim to the asset. 

Liabilities = Debt ($128,000) = Creditor's Claim to the House - The creditors claim to the asset.

Assets = Equity

Assets = Liabilities + Owner's Equity

Owner's Equity = Assets - Liabilities

Liabilities = Assets - Owner's Equity

A business transaction is an economic event that causes a change in - either an increase or decrease - in assets, liabilities, or owner's equity. The change is reflected in the accounting system of the business. Business transactions, such as buying supplies, are recorded in individual accounts. Accounts are subdivisions under assets, liabilities, and owner's equity. It shows the balance for a specific item and is a record of the increase and decrease for that item. The following are examples of accounts that could be used by a business:

• 1. Assets

     1. • Cash in Bank

        • Accounts Receivable - money to be received later because of the sale of goods/services on credit.

        • Computer Equipment

        • Office Equipment

        • Delivery Equipment

        • Inventory

  2. Liabilities

     1. • Account Payable - amount owed, or payable, to the creditors of a business. 

  3. Owner's Equity

     1. • • Capital

Let's break down the Capital account. The capital account represents the owners investment into the business. This amount goes up with revenue or investments into the business and down due to expenses or if the owner withdraws cash. 

Remember, you are working as an accountant now. When we are tracking capital, it is for the business. We do not care about the individuals personal assets. We are only tracking the ownership of assets within the business. 

The owner invests $1,000 into the business. This would increase Cash in Bank and Capital by $1,000. This is a business transaction.

The individual would lose $1,000 in personal assets but this is not a business transaction. Therefore, we would do nothing for this event. 

Income earned from the sale of goods and services is called revenue. Examples of revenue are fees earned for services performed and cash received from the sale of merchandise. Revenue increases the owner's equity because it increases the assets of the business. 

To generate revenue most businesses must also incur expenses to buy goods, materials, and services. An expense is the cost of products or services used to operate a business. It's literally the cost of doing business. Examples include:

• • rent

  • utilities

  • advertising

Vocabulary