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Accounting Equations

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In every business entity, every transaction has an effect on its financial position. Assets, liabilities, and owner’s equity or shareholders’ equity measures the financial position of a business. In a sole proprietorship, the accounting equation is as follows: assets = liabilities + owner’s equity, while a corporation’s accounting equation is assets = liabilities + shareholders’ equity (The Accounting equation, 2010).

In a business, an example of a transaction, which would increase an asset account and increase a liability account, would be purchase of inventory on credit. For example, assume Mr. Smith, a new business owner, acquires items for sale on credit from a supplier (we assume the items purchased are worth $100). Before the transaction, the accounting equation for the business would be, $0 capital + $0 liabilities = $0 assets. After making the transaction, the new accounting equation would appear as follows: $0 capital + $100 creditors = $100 stock.

To illustrate a transaction, which would increase an asset account and increase the owner’s equity account, we assume that at the beginning of year 2011, Mr. Smith brings in $ 1,000 as capital contribution. This transaction would result into increase in owner’s equity account (capital account) and increase in assets (cash). The new accounting equation for Mr. Smith would be as follows: $1,000 owner’s equity + $100 creditors = $1,000 cash + $100 stock.

We further assume that during the first week of operation, Mr. Smith sold the stock, and used the money from sales to pay his creditor. This transaction would result into reduction of inventory as well as the creditor’s balance. The new accounting equation for Mr. Smith’s business would be as follows: $1,000 owner’s equity + $0 liabilities = $1,000 cash + $0 stock.

If we assume that Mr. Smith took $200 from the business to purchase furniture for his business, this type of transaction would increase one asset account (furniture) and decrease the other asset account (cash account). The new accounting equation for Mr. Smith’s business would be $1,000 capital + $0 liabilities = $800 cash + $200 furniture.

To illustrate a transaction, which would decrease one liability account and increase another liability account, we assume that Mr. Smith takes a short-term loan from his bank to pay for accrued monthly rent for the business premises at the end of the month of May. This transaction would result into increase in liabilities (a credit entry in the short-term bank loan account), while the accrued rent account would decrease (a debit entry in accrued rent account).

We assume that in the month of May, Mr. Smith takes cash drawings from the business for personal use. This type of transaction would cause a decrease both in the owner’s equity account and in cash account. Assuming Mr. Smith takes $50 from the business, the owner’s equity account would be debited with cash $50, while the cash account would be credited with drawings $50. The new accounting equation would be $950 capital + $0 liabilities = $750 cash + $200 furniture.

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