The Accounting Equation

Accounting is the language of business, and the more you understand, the greater your potential success will be.

Transactions are the "raw data" of business, much like runs, hits, and strikeouts are the raw data of baseball.

Transactions are the exchanges of goods or services between individuals, companies, and organizations.

Each transaction originates from a source document, such as a...

·         Receipt

·         Voucher

·         Invoice

·         Document that supports and explains the transaction

The source document is examined to determine the duel economic effect the transaction has on the business and to which general ledger account it should go. But the first place it goes, however, is in a General Journal. It is a chronological listing of the transaction and is like a diary. It is the "book of original entry."

Every business divides its accounts into five categories:

·         Assets

·         Liabilities

·         Owner's equity

·         Revenues

·         Expenses

The accounting equation: A = L + OE

Assets equal liabilities plus owner's equity.

The revenues and expenses are used in an accounting period, and their difference is the net income. The net income is added to owner's equity.

Assets are things of value:

·         Cash

·         Receivables

·         Inventory

Liabilities are debts:

·         Accounts payable

·         Loans from lenders

·         Business obligations

Owner's equity is the owners' claim on the resources of the business:

·         Capital to start the business

·         Profits left in as re-investments as retained earnings

The Balance Sheet accounts are a permanent record and are always in use.

The Income Statement includes revenues and expenses and contains information of the current accounting period (usually 12 months). These accounts are temporary and are used only for a specific time period.

Revenue accounts contain product sales, fees for services, interest earned, and commissions. This is money flowing into the business.

Expense accounts record the money flowing out of the business and include salaries, rent, advertising, etc.

Analyzing the effect of transactions on the accounting equation will help improve your decision making.

Quiz:

1. Every business divides their accounts into 5 categories. Which one doesn't belong?

·         Expenses

·         Revenues

·         Payables

·         Assets

·         Liabilities

·         Owner's Equity

2. Which is the accounting equation?

·         A = L + OE

·         NI = R - E

3. True or False: the first place a transaction is recorded is in the General Ledger.

4. True or False: Every transaction is recorded into an account.

5. True or False: Revenue and Expense accounts are permanent accounts.

6. What happens to the equation when someone is hired and a salary is paid?

7. What happens to the equation when inventory is purchased on account?

8. When a client is taken to lunch it is considered a business expense. What equation is used to show the change in Owner's Equity?

Answers:

1. Payables 2. A = L + OE 3. True 4. True 5. False - they are usually monthly accounts and used for that period only, so they are considered temporary. 6. Assets decrease (cash paid) and Owner's Equity decreases (because net income decreases due to the additional expenses) 7. Assets increase (inventory) and liabilities increase (accounts payable) 8. Net Income (NI) = R - E

Copyright 1989 Greatapes

Financial Video Series