Foundations Of Accounting And Business

See the Business Through the Accounting Equation

A business can buy a delivery van, borrow money, make sales, and pay bills in the same week. Accounting records each event in a clear way so that the owner can answer a basic question: what does the business own, what does it owe, and what belongs to the owner?

The main tool for answering that question is the accounting equation:

Assets = Liabilities + Capital

You will use this equation to understand debit and credit rules, record journal entries, transfer information to ledger accounts, prepare a trial balance, and see how basic financial statements are built. These ideas connect the business activities studied earlier with the numbers used to describe those activities.

Learning Objectives

By the end of this section, you should be able to:

• Explain the accounting equation and its three parts.
• Apply debit and credit rules to simple transactions.
• Trace a transaction from a journal entry to a ledger and financial statement.

A useful way to think about accounting is to treat every transaction as a change that must remain balanced. If a business receives cash, something else must explain where that cash came from. It may have come from the owner, from a loan, or from a sale. Accounting does not record only one side of the event.

Assets - resources owned or controlled by the business that have value. Cash, equipment, inventory, bank money, and vehicles are assets.

Liabilities - amounts the business owes to other people or organizations. A bank loan and an unpaid supplier invoice are liabilities.

Capital - the owner’s investment in the business, plus profits kept in the business, less amounts taken out by the owner. Capital is also called owner’s equity.

The equation shows the relationship between these parts. If a business has assets of $12,000 and liabilities of $4,000, its capital is $8,000:

$12,000 = $4,000 + $8,000

A transaction may change several figures, but the equation must still balance. For example, when the owner puts $5,000 cash into a new business, cash increases by $5,000 and capital increases by $5,000. When the business buys equipment for cash, equipment increases while cash decreases. Total assets may stay the same, and the equation remains balanced.

Revenue - money earned from selling goods or providing services. A plumbing business earns service revenue when it completes a repair.

Expenses - costs used to run the business and earn revenue. Rent, electricity, wages, fuel, and advertising are common expenses. Expenses reduce profit and therefore reduce capital.

Drawings - cash or other assets taken from the business by the owner for personal use. Drawings reduce capital but are not a business expense.

Debit and credit are the two sides used to record every accounting entry. A debit is the left side of an account, and a credit is the right side. Debit does not automatically mean “increase,” and credit does not automatically mean “decrease.” The effect depends on the type of account.

A simple memory aid is that assets and expenses normally have debit balances. Liabilities, capital, and revenue normally have credit balances. Every journal entry must have total debits equal to total credits.

Journal entry - the first formal record of a transaction, showing the accounts affected and the debit and credit amounts.

Ledger account - a separate record for each account, such as Cash, Equipment, Rent Expense, or Sales Revenue. The ledger collects all entries relating to one account.

Trial balance - a list of ledger account balances used to check whether total debits equal total credits. A balanced trial balance does not prove that every transaction is correct, but it helps find recording and addition errors.

The accounting flow is:

Transaction → Journal entry → Ledger accounts → Trial balance → Financial statements

Financial statements - reports that summarize the financial results and position of a business. A basic set includes the income statement, statement of owner’s equity, and balance sheet. The income statement reports revenue, expenses, and profit. The statement of owner’s equity explains changes in capital. The balance sheet reports assets, liabilities, and capital at a particular date.

Consider a business that pays $300 rent in cash. Rent Expense increases, so it is debited. Cash decreases, so it is credited:

The entry records both the cost and the payment. Ask yourself: did an expense increase, and did an asset decrease? If so, the debit-credit choice follows the table.

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