ACCOUNTING EQUATION

From the large, multi-national corporation down to the corner beauty salon, every business transaction will have an effect on a companys financial position. The financial position of a company is measured by the following items: 1. Assets (what it owns) 2. Liabilities (what it owes to others) 3. Owners Equity (the difference between assets and liabilities) The accounting equation (or basic accounting equation) offers us a simple way to understand how these three amounts relate to each other. The accounting equation for a sole proprietorship is: Assets = Liabilities + Owners Equity Here is your handy, at-a-glance table to help you remember the rules for debits and credits in accounting. Keep it by your calculator and never get confused again!

The accounting equation for a corporation is: Assets = Liabilities + Stockholders Equity Assets are a companys resourcesthings the company owns. Examples of assets include cash, accounts receivable, inventory, prepaid insurance, investments, land, buildings, equipment, and goodwill. From the accounting equation, we see that the amount of assets must equal the combined amount of liabilities plus owners (or stockholders) equity.

Liabilities are a companys obligationsamounts the company owes. Examples of liabilities include notes or loans payable, accounts payable, salaries and wages payable, interest payable, and income taxes payable (if the company is a regular corporation). Liabilities can be viewed in two ways: (1) as claims by creditors against the companys assets, and (2) a sourcealong with owner or stockholder equityof the companys assets. Owners equity or stockholders equity is the amount left over after liabilities are deducted from assets: Assets Liabilities = Owners (or Stockholders) Equity. Owners or stockholders equity also reports the amounts invested into the company by the owners plus the cumulative net income of the company that has not been withdrawn or distributed to the owners. If a company keeps accurate records, the accounting equation will always be in balance, meaning the left side should always equal the right side. The balance is maintained because every business transaction affects at least two of a companys accounts. For example, when a company borrows money from a bank, the companys assets will increase and its liabilities will increase by the same amount. When a company purchases inventory for cash, one asset will increase and one asset will decrease. Because there are two or more accounts affected by every transaction, the accounting system is referred to as double entry accounting. A company keeps track of all of its transactions by recording them in accounts in the companys general ledger. Each account in the general ledger is designated as to its type: asset, liability, owners equity, revenue, expense, gain, or loss account. Balance Sheet and Income Statement The balance sheet is also known as the statement of financial position and it reflects the accounting equation. The balance sheet reports a companys assets, liabilities, and owners (or stockholders) equity at a specific point in time. Like the accounting equation, it shows that a companys total amount of assets equals the total amount of liabilities plus owners (or stockholders) equity.

The income statement is the financial statement that reports a companys revenues and expenses and the resulting net income. While the balance sheet is concerned with one point in time, the income statement covers a time interval or period of time. The income statement will explain part of the change in the owners or stockholders equity during the time interval between two balance sheets. Examples In our examples in the following pages of this topic, we show how a given transaction affects the accounting equation. We also show how the same transaction affects specific accounts by providing the journal entry that is used to record the transaction in the companys general ledger. Our examples will show the effect of each transaction on the balance sheet and income statement. Our examples also assume that the accrual basis of accounting is being followed. Debits and credits Debit and credit are the two fundamental aspects of every financial transaction in the double-entry bookkeeping system in which every debit transaction must have a corresponding credit transaction(s) and vice versa. Debits and credits are a system of notation used in bookkeeping to determine how to record any financial transaction. In financial accounting or bookkeeping, "Dr" (Debit) means left side of a ledger account and "Cr" (Credit) is the right side of a ledger account. To determine whether one must debit or credit a specific account we use the modern accounting equation approach which consists of five accounting elements or rules. An alternative to this approach is to make use of the traditional three rules of accounting for: Real accounts, Personal accounts, and Nominal accounts to determine whether to debit or credit an account.

Aspects of transactions Increase Asset Liability Income/Revenue Expense Equity/Capital Debit Credit Credit Debit Credit Decrease Credit Debit Debit Credit Debit

In summary: an increase (+) to an asset account is a debit. An increase (+) to a liability account is a credit. Conversely, a decrease (-) to an asset account is a credit. A decrease (-) to a liability account is a debit. Debits and credits form two opposite aspects of every financial transaction in doubleentry bookkeeping. Debits are entered on the left side of a ledger, and credits are entered on the right side of a ledger. Whether a debit increases or decreases an account depends on what kind of account it is. In the accounting equation: Assets = Liabilities + Equity (A = L + E), if an asset account increases (by a debit), then one must also either decrease (credit) another asset account, or increase (credit) a liability or equity account. For example, from a bank customer's perspective, when the customer deposits cash into his bank current account (US: checking account), this financial transaction has two aspects: the customer's cash-in-hand (the customer's asset) decreases and the customer's current account balance (the customer's asset) with the bank increases. The decrease in the cash-in-hand asset is the customer's credit while the increase in the asset balance in the bank current account is the customer's debit. The bank views that transaction using the same rules, but from its different perspective. In that example, the bank's vault cash (asset) increases which is a debit, and the corresponding increase in the customer's current account balance (bank's liability) is a credit. This is why a customer's bank statement issued by the bank shows the bank's liability to the customer, which increases (bank deposits) as credits, and decreases (bank withdrawals and cheques) as debits.

Terminology The words debit and credit are both used differently depending on whether they are used in a bookkeeping (accounting) sense, or non-accounting sense. In a non-accounting sense, "debit" is:

a sum of money taken from a bank account.

"credit" is

a sum of money placed into a bank account. Money available for a client to spend.

The reason why individuals see debits and credits in the above manner, is that the bank statement presented by the bank to the customer is the banks view of the account and so debits and credits appear reversed. And so credit refers to the banks view of the money, they extend credit as money placed in a customers account appears on the credit side of a bank statement. When recording numbers in accounting, a debit value is placed on the left side of a ledger for a debited account and a credit value is placed on the right side of a ledger for a credited account. A debit or a credit either increases or decreases the total balance in each account, depending on what kind of accounts they are. Each transaction (say, of value 100) is recorded by a debit entry of 100 in one account and a credit entry of 100 in another account. When people say, "debits must equal credits" they do not mean that the two columns of any ledger account must be equal. If that were the case, every account would have a zero balance (no difference between the columns) which is often not the case. The rule that total debits equal the total credits applies when all accounts are totalled. More than two accounts may be affected by the same transaction. A transaction for 100 can be recorded as a 100 debit in one account and as multiple credits that total 100 in other accounts.

Example: I owe creditors A and B 100 each. Thus my liability account for Creditor A has a credit balance of 100 and the same for Creditor B. I pay them off from my bank chequing account, which from my point of view is an asset. I withdraw 200 from my bank account and split it to pay off the two liabilities. In my records, "Creditor A" is one account, "Creditor B" is another account, and "Bank" is a third account. The following transactions affect all three-ledger accounts: Dr: Creditor A (100) Dr: Creditor B (100) Cr: Bank (200) When I write two 100 cheques for a total of 200, the balance in my bank account is reduced by 200. In my records, my "Bank" ledger account has an asset debit balance, which is reduced by the credit for 200. Amounts in my records for the two creditors are liabilities, which are reduced by the two debits totalling 200. Therefore for this transaction, the total amount debited = 200 and the total amount credited = 200. When all three accounts are totalled, the total debits equal the total credits. At the end of any financial period (say at the end of the quarter or the year), the total debits and the total credits for each account may be different and this difference of the two sides is called the balance. If the sum of the debit side is greater than the sum of the credit side, then the account has a "debit balance". If the sum of the credit side is greater, then the account has a "credit balance". If the two sides do equal each other (this would be a coincidence, not as a result of the laws of accounting), then we say we have a "zero balance".