THE ACCOUNTING EQUATION
A fundamental characteristic of every statement of financial position is that the total for assets
always equals the total of liabilities plus owners' equity. This agreement or balance of total
assets with the total of liabilities and owners' equity is the reason for calling this financial statement a balance sheet. But why do total assets equal the total of liabilities and owners' equity?
The dollar totals on the two sides of the balance sheet are always equal because they rep-
resent two views of the same business.
The listing of assets shows us what things the business
Short-term liabilities generally are those due within one year. Long-term liabilities are shown separately the balance sheet, after the listing of all short-term liabilities. Long-term liabilities are addressed in =owns; the listing of liabilities and owners equity tells us who supplied these resources to the business and how much each group supplied. Everything that a business owns has been supplied to it either by creditors or by the owners. Therefore, the total claims of the creditors plus
the claims of the owners always equal the total assets of the business.
The equality of the assets on the one hand and the claims of the creditors and the owners on
the other hand is expressed in the following accounting equation:
Assets= Liabilities + owner Equity
$.300,000 = S80.000 +$220,000
The amounts. listed in the equation were taken from the balance sheet illustrated in
Exhibit 2-1. The balance sheet is simply a detailed statement of this equation. To Westgate this
relationship, compare the balance sheet of Vagabond Travel Agency with the above equation.
Every business transaction, no matter how simple or how complex, can be expressed in
terms of its effect on the accounting equation. A thorough understanding of the equation and
some practice in using it are essential to the student of accounting.
Regardless of whether a business grows or contracts, the equality between the assets and
the claims on the assets is always maintained. Any increase in the amount of total assets is
necessarily accompanied by an equal increase on the other side of the equation that is, by an
increase in either the liabilities or the owners' equity. Any decrease in total assets is necessary accompanied by a corresponding decrease in liabilities or owners' equity. The continuing
quality of the two sides of the accounting equation can best be illustrated by taking a new
business as an example and observing the effects of various transactions.
THE EFFECTS OF BUSINESS TRANSACTIONS:
AN Illustration
How does a statement of financial position come about? What has occurred in the past for it
to exist at any point in time? The statement of financial position is a picture of the results of
past business transactions that has been captured by the company's information system and
organized into a concise financial description of where the company stands at
a point in time. The specific items and dollar amounts are the direct results of
the transactions in which the company has engaged. The balance sheets of two
separate companies would almost always be different due to the unique nature,
timing, and dollar amounts of each company's business transactions.
To illustrate how a balance sheet comes about, and later to show how the
income statement and statement of cash flows relate to the balance sheet, we
use an example of a small auto repair business, Overnight Auto Service.
The Business Entity
Assume that Michael McBryan , an experienced
auto mechanic, opens his own automotive repair business, Overnight Auto
Service. A distinctive feature of Overnight's operations is that all repair work
is done at night. This strategy offers customers the convenience of dropping
off their cars in the evening and picking them up the following morning.
Operating at night also enables Overnight to minimize labor costs. Instead
of hiring full-time employees, Overnight offers part-time work to mechanics
,who already have day jobs at major automobile dealerships. This eliminates the
need for costly employee training programs and for such payroll firing benefits as group health
insurance and employees' pension plans, benefits usually associated with full-time employment.
Overnight's Accounting Policies McBryan has taken several courses in accounting and maintains Overnight's accounting records himself. He knows that small businesses such as his are not required to prepare formal financial statements, but he prepares them anyway. He believes they will be useful to him in running the business. In addition, if Over night is successful, McBryan plans to open more locations. He anticipates needing to raise substantial amounts of capital from investors and creditors. He believes that the financial history provided by a series of monthly financial statements will be helpful in obtaining investment capital.
The Company's First Transaction McBryan officially started Overnight on January 20, 2015. On that day, he received a charter from the state to begin a snail, Cisco held corporation whose owners consisted of himself and several family members. Capita
stock issued to these investors included 8,000 shares at S10 per share. McBTyan opened a
bank account in the name of Overnight Auto Service, into which he deposited the s80,00
received from the issuance of the capital stock.
This transaction provided Overnight with its first asset-Cash-and also created the initial
Owners equity in the business entity. See the balance sheet showing the company's tenancies
position after this initial transaction in Exhibit 2-2.
EXHIBIT
OVERNIGHT AUTO SERVICE
Balance
BALANCE SHEET
JANUARY 20, 2015
Assets
Owners' Equity
Capital Stock
$80,000
Cash.
$80,000
Overnight's next two transactions involved the acquisition of a suitable site for its business
operations.
OVERNIGHT AUTO SERVICE
BALANCE SHEET
JANUARY 20, 2015
Assets
Owners' Equity
Cash
$80,000
Capital Stock
$80,000
Overnight s next two transactions involved the acquisition of a suitable site for its business operations. Purchase of an Asset for Cash Representing the business, McBryan negotiated with both the City of Santa Teresa and the Metropolitan Transit Authority (MTA) to purchase an abandoned bus garage. (The MTA owned the garage, but the city owned the land.) On January 21. Overnight purchased the land from the city for 8.52,000 cash. This transaction had two immediate effects on the company's financial position: first, Overnight's cash
was reduced by S52.000; and second, the compare acquired a new asset Land. We show the
company's financial partition after this transaction in Exhibit 2-3
OVERNIGHT AUTO SERVICE
BALANCE SHEET
JANUARY 21, 2015
Assets
Owners' Equity
Cash
$28,000
580 00
Capital tacks
and
S2,000
ra
$B0,000
0,U
2
Purchase of an Asset and Financing Part of the Cost On January 22, Overnight purchased the old garage building from Metropolitan Transit Authority for $36,000 Overnight made a cash down payment of S6,000 and issued a 90-day non-interest-bearing note payable for the 830,000 balance owed.
As a result of this transaction, Overnight had (1) S6,000 less cash; (2) a new asset, Building,
which cost $36,000; and (3) a new liability, Notes Payable, in the amount of $30,000. This
transaction is reflected in Exhibit 2-4.
Once a company has multiple assets and labilities, the question arises as to the proper
order of the items in the statement of financial position. Assets are ordinarily presented in
their order of "permanence," starting with cash. Next are other assets that are close to cash
(e.g., receivables from customers), followed by more permanent assets like equipment, buildings, and land, which is considered the most permanent asset. Liabilities are usually presented in the order in which they become due. we assess the subject of "classified balance sheets"
later in this text.
OVERNIGHT AUTOSERVICE
BALANCE SHEET
JANUARY 22, 2015
assets
Liabilities &Owners' Equity
C iireortdeinssio.5 22,000
Liabilities
Notes Payable,.
36,000
30,000
52,000
Owners' equity:
Capital 3och..r
80,000
de surds in sofa
of rureritoiris, 110,000
Total it
110,000
Purchase of an Asset on Account On January 23, Overnight purchased tools
and attentive repair equipment from Snappy Tools. The purchase price was 813,800, due
within 60 days. After this purchase, Overnight s financial position is depicted in Exhibit 2-Purchase of an Asset on Account On January 23, Overnight purchased tools
and automotive repair equipment from Snappy Tools. 1he purchase price was S73,800, due
within 60 days. After this purchase, Overnight's financial position 1s depicted in Exhibit 2-5.
OVERNIGHT AUTO SERVICE
BALANCE SHEET
JANUARY 23, 2015
Liabilities & Owners' Equity
Assets
Cash.
Liabilities:
$ 22,000
Tools and Equipment..
Notes Payable...
$ 30,000
13,800
Building
36,000
Accounts Payable...
13,800
Land.
52,000
Total liabilities
$ 43,800
Owners' equity:
Capital Stock
B0,000
Total
$123,800
Total
$123,800
Sale of an Asset
After taking delivery of the new tools and equipment, Overnight found that it had purchased more than it needed. Ace Towing, a neighboring business, offered
to buy the excess items. On January 24 Overnight sold some of its new tools to Ace 1or S1,800, a price equal to Overnights cost. Ace made no down payment but agreed to pay the amount due within 45 days. 1his transaction reduced Overnight's tools and equipment by S1.800 and created a new asset, Accounts Receivable, for that same amount. A balance sheet as of January 24 appears in Exhibit 2-6.
Collection of an Account Receivable On January 26, Overnight received S600 from Ace 1owing as partial settlement of its account receivable from Ace. This transaction caused an increase in Overnight's cash but a decrease of the same amount in accounts receivable. This transaction converts one asset into another of equal value; there is no change in the amount or total asset. After this transaction, Overnight 's financial position raised .
Payment of a Liability On January 27, Overnight made a partial payment ot S6,800 on its account payable to Snappy Tools. This transaction reduced Overnight's cash and
accounts payable by the same amount, leaving total assets and the total of liabilities plus owners' equity in balance. Overnight 's balance sheet at January 27 appears in Exhibit 2-8.
EXHIBIT
OVERNIGHT AUTO SERVICE
Balance
BALANCE SHEET
JANUARY 27, 2015
Assets
Liabilities &Owners' Equity
Cash. S15,800
Liabilities:
Accounts Receivable.
1,200
Notes Payable..
$ 30,000
Tools and Equipment..
12,000
7,000
Accounts Payable.
Building
36,000
Total liabilities.
37,000
Land.
52,000
Owners' equity:
80,000
Capital STOGK
$117,000
$117,000
Total
total..
By the last week in January, McBryan had acquired the assets.....
Earning of Revenue
Overnight needed to start operating, and he began to provide repair services for customers.
Rather than recording each individual sale of repair services, he decided to accumulate them
and record them at the end of the month. Sales of repair services for the last week of January
were $2,200, all of which was received in cash. Earning of revenue represents the creation of value by Overnight. It also represents an increase in the financial interest of the owners in the company. As a result, cash is increased by S2,200 and owners' equity is increased by the same amount. To distinguish owners' equity that is earned from that which was originally invested .by the owners, the account Retained Earnings is used in the owners' equity section of the balance sheet. The balance sheet in
Exhibit 2-9, as of January 31, reflects the increase in assets (cash) and owners' equity (retained earnings) from the revenue earned and received in cash during the last week of January. fore the payment of expenses (see next section).
Basic Financial Statements
OVERNIGHT Autos SERVICEBALANCE SHEET
JANUARY 31, 2015
Liabilities &Owners' Equity
Assets
Cash. . 18,000
Liabilities:
$ 30,000
1,200
Notes Payable....
Accounts Receivable..
7,000
Accounts Payable. . ..
Tools and Equipment. .. .
12,000
$ 37,000
Total liabilities
Building
36,000
Land..
52,000
Owners' equity:
$ 80,000
Capital Stock.
2,2005 82,200
Retained Earnings.
$119,200
Total s
$119,200
1otal.
Payment of Expenses In order to earn the S2,200 of revenue that we have just recorded, Overnight had to pay some operating expenses, namely utilities and wages. McBryan decided to pay all operating expenses at the end of the month. For January, he owed $200 for utilities and $1,200 for wages to his employees, a total of S1,400, which he paid on January 31. Paying expenses has an opposite effect from revenues on the owners' interest in the company their investment is reduced. Of course, paying expenses also results in decrease of cash. The January 31 baler neat, after the payment of utilities and wages, is
presented in Exhibit 2-10.
OVERNIGHT AUTO SERVICE
BALANCE SHEET
JANUARY 31, 2015
Liabilities & Owners' Equity
Assets
Liabilities:
Cash...... 16,600
Notes Payable....
Accounts Receivable
1,200
$ 30,000
Accounts. Payable. .
12,000
Tools and Equipment. . .
7,000
Building
Total liabilities
36,000
$ 37,000
Land.
Owners' equity:
52,000
Capital Stock..
$ 80,000
Retained Earrings.
80,800
800
Total
$117,800
$117,800
Total.
Notice that the expenses of $1,400 ($200 for utilities and $1,200 for wages) reduce the amount of retained earnings in the balance sheet. That balance was, formerly $2,200, representing the revenues for the last week of January. It is now $800, representing the difference between the revenues for the last week of January and the $1,400 of expenses that Overnight incurred during the same period of time. From this illustration we can see that revenues enhance or increase the financial interest of owners while expenses diminish or reduce the 1nterest of owners, In a corporation, the net effect of this activity is reflected in the balance sheet as retained earnings.
EFFECTs OF THESE BUSINESS TRANSACTIONS
ON THE ACCOUNTING EQUATION
s we learned earlier, the statement of financial position, or balance sheet, 1S a detailed
expression of the accounting equation:
Asset= Liabilities +Owner's Equity
Income Statement
As we have progressed through a series of business transactions, we have illustrated the
effects of Overnight's January transactions on the statement of financial position.
To review, Overnight's transactions during January were as follows, with the resulting balance sheet indicated in parentheses Jan. 20 Michael McBryan started the business by depositing $80,000 received from the sale of capital stock in a company bank account (Exhibit 2-2). Jan. 21 Purchased land for $52,000, paying cash (Exhibit 2-3). Jan. 22 Purchased a buildıng for S36,000, paying $6,000 in cash and issuing a note payable for the remaining $30,000 (Exhibit 2-4). Jan. 23 Purchased tools and equipment on account, $13,800 (Exhibit 2-5) Jan. 24 Sold some of the tools at a price equal to their cost, S1,800, collectible within 45 days (Exhibit 2-6) Jan. 26 Received S600 in partial collection of the account receivable from the sale of tools (Exhibit 2-7). Paid $6,800 in partial payment of an account payable (Exhibit 2-8). Jan. 27 Jan. 31 Received $2,200 of sales revenue in cash (Exhibit 2-9).
Jan. 31 Paid $1,400 of operating expenses in cashS200 for utilities and $1,200 for wages (Exhibit 2-10).
The expanded accounting equation in Exhibit 2-11 shows the effects of these transactions on the accounting equation. The effect of each transaction is shown in red. Notice that the "balances" shown in black, are the amounts appearing in Overnight's balance sheets in Exhibits 2-2 through 2-10. Notice also that the accounting equation is in balance after each transaction.
While this table represents the impact of Overnight's transactions on the accounting equation, and on its financial position as shown in its balance sheet, we can now learn how the income statement and statement of cash flows enter the picture. Specifically, the income statement is a separate financial statement that shows how the statement of financial position changed as a result of its revenue and expense transactions. The statement of cash flows show sow the company's cash increased and decreased during the period.
income Statement
The income statement is a summarization of the company's revenue and expense transactions for a period of time. The income statement is particularly important for the company's owners, creditors, and other interested parties to understand. Ultimately the company will succeed or fail based on its ability to earn revenues in excess of its expenses. Once the company's assets are acquired and business commences, revenues and expenses are important dimensions of the company's operations. Revenues are increases in the company's assets from its profit-directed activities, and they result in positive cash flows. Expenses are decreases in the company's assets from its profit-directed activities, and they result in negative cash flows. Net income is the difference between the revenues and expenses for a specified period of time.
Should a company find itself in the undesirable situation of having expenses greater than revenues, we call the difference a net loss. Overnight's income statement for January 20-31 is relatively simple because the company did not have a large number of complex revenue and expense transactions. Taking information directly from the Retained Earnings column in Exhibit 2-11, and separating the total
expenses ofS1,400 into wages of $1,200 and utilities of $200, we can prepare the company's income statement as shown in Exhibit 2-12. In this illustration, only revenue and expense transactions change the amount of owners' equity from the original S80,000 investment of the owner. Examples of other events and transactions that affect the amount of owners equity, but that are not included in net income, are the sale of additional shares of capital stock and the payment of dividends to shareholders. These subjects are covered in later chapters.
OVERNIGHT AUTO SERVICE
EXHIBIT
INCOME STATEMENT
Income
FOR THE PERIOD JANUARY 20-31, 2015
Sales Revenues.
$2,200
Operating expenses
Wages. i. . .
$1,200
Utilities
1,400
200
Net Income.
$ 800
Notice that the heading for the income statement refers to a period of time rather than a
point in time, as was the case with the balance sheet. The income statement reports on the
financial performance of the company in terms of earning revenue and incurring expenses
over a period of time and explains, in part, how then company's financial position changed
between the beginning and ending of that period.
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