The accounting equation and transactions
Accounting starts with one equation that every transaction keeps in balance. Mastering it makes everything else in accounting easier.
What accounting does
Accounting identifies, records, and communicates financial information about an organisation. Financial accounting produces reports for external users such as investors, lenders, and regulators; managerial accounting produces information for internal decisions. Bookkeeping is the recording part; accounting includes analysing and interpreting.
The accounting equation
The accounting equation is assets = liabilities + equity. Assets are resources the business controls that are expected to bring future benefits (cash, accounts receivable, inventory, equipment). Liabilities are obligations to others (accounts payable, loans, wages owed). Equity is the owners' residual claim.
Expanding equity
Equity increases with owner investments and revenues, and decreases with owner withdrawals (drawings or dividends) and expenses. So the expanded equation is assets = liabilities + owner's capital - drawings + revenues - expenses. Profit (revenues minus expenses) flows into equity.
Analysing transactions
Every transaction affects at least two accounts while keeping the equation balanced. If an owner invests 10,000 dollars cash, assets (cash) and equity each rise by 10,000. If the business buys equipment for 3,000 dollars on credit, assets (equipment) and liabilities (accounts payable) each rise by 3,000.
More transaction examples
Paying 1,000 dollars of rent decreases cash (an asset) and decreases equity through rent expense. Earning 2,500 dollars of revenue on credit increases accounts receivable and equity. Collecting that receivable later swaps one asset for another, cash up and receivables down, with no change in total assets.
Key principles
Accounting follows principles such as the business entity concept (business and owner finances are kept separate), the cost principle (assets are recorded at their original cost), the monetary unit assumption (records are in a stable currency), and the going concern assumption (the business will continue operating for the foreseeable future).
Users and ethics
Users rely on accounting information to be relevant and faithfully represented. Accountants must be objective and honest; manipulating figures, as in major accounting frauds, harms investors, employees, and markets. Professional bodies, such as the AICPA in the US, set codes of conduct.
Worked example
A new consulting business: the owner invests 20,000 dollars cash; buys a laptop for 2,000 cash; earns 5,000 from clients on account; pays 800 for utilities. Cash = 20,000 - 2,000 - 800 = 17,200; receivables 5,000; equipment 2,000. Total assets 24,200. Liabilities 0. Equity = 20,000 + 5,000 - 800 = 24,200. The equation balances.
Key takeaways
Accounting records and communicates financial information; financial accounting serves outsiders, managerial accounting insiders. Assets = liabilities + equity. Equity rises with investment and revenue and falls with drawings and expenses. Every transaction affects at least two accounts and keeps the equation balanced. Principles include the business entity concept, cost principle, monetary unit, and going concern.
Flashcard
Identifying, recording, communicating financial information
Check your understanding
A business buys supplies for 600 dollars on credit. How does this affect the accounting equation?