The accounting equation can be expanded to incorporate the impact of drawings and profit ie income less expenses :. We will now consider an example with various transactions within a business to see how each has a dual aspect and to demonstrate the cumulative effect on the accounting equation. Example Anushka began a sole trade business on 1 January 20X1.
During the first month of trading, the following transactions took place:. Required Explain how each of the above transactions impact the accounting equation and illustrate the cumulative effect that they have.
Solution The impact of each of the above transactions has been outlined below, followed by a summary of the cumulative effect of these transactions on the accounting equation:.
Note that in the accounting records, the purchase of inventory may be recorded as an expense initially and then an adjustment made for closing inventory at the year-end. Any inventory not sold will ultimately be recorded as an asset though. As inventory asset has now been sold, it must be removed from the accounting records and a cost of sales expense figure recorded.
Note that, as above, the adjustment to the inventory and cost of sales figures may be made at the year-end through an adjustment to the closing stock but has been illustrated below for completeness. In the life of any business entity, there are countless transactions.
Each can be described by its impact on assets, liabilities, and equity. Note that no properly recorded transaction will upset the balance of the accounting equation. In day-to-day conversation, some terms are used casually and without precision.
Words may incorrectly be regarded as synonymous. Revenues are enhancements resulting from providing goods and services to customers. Conversely, expenses can generally be regarded as the costs of doing business. This gives rise to another accounting equation:.
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First, it can sell shares of its stock to the public to raise money to purchase the assets, or it can use profits earned by the business to finance its activities. Second, it can borrow the money from a lender such as a financial institution.
You will learn about other assets as you progress through the book. Liabilities are obligations to pay an amount owed to a lender creditor based on a past transaction. Liabilities are reported on the balance sheet. It is important to understand that when we talk about liabilities, we are not just talking about loans. Money collected for gift cards, subscriptions, or as advance deposits from customers could also be liabilities. Essentially, anything a company owes and has yet to pay within a period is considered a liability, such as salaries, utilities, and taxes.
Even though the company does not have to pay the bill until June, the company owed money for the usage that occurred in May. Therefore, the company must record the usage of electricity, as well as the liability to pay the utility bill, in May. Eventually that debt must be repaid by performing the service, fulfilling the subscription, or providing an asset such as merchandise or cash.
Some common examples of liabilities include accounts payable, notes payable, and unearned revenue. Accounts payable recognizes that the company owes money and has not paid. A notes payable is similar to accounts payable in that the company owes money and has not yet paid. Some key differences are that the contract terms are usually longer than one accounting period, interest is included, and there is typically a more formalized contract that dictates the terms of the transaction.
Thus, the account is called unearned revenue. The company owing the product or service creates the liability to the customer. These two components are contributed capital and retained earnings. The company will issue shares of common stock to represent stockholder ownership. You will learn more about common stock in Corporation Accounting.
These retained earnings are what the company holds onto at the end of a period to reinvest in the business, after any distributions to ownership occur. One tricky point to remember is that retained earnings are not classified as assets. Distribution of earnings to ownership is called a dividend. The dividend could be paid with cash or be a distribution of more company stock to current shareholders.
Either way, dividends will decrease retained earnings. Also affecting retained earnings are revenues and expenses, by way of net income or net loss. Revenues are earnings from the sale of goods and services. An increase in revenues will also contribute toward an increase in retained earnings. Expenses are the cost of resources associated with earning revenues. An increase to expenses will contribute toward a decrease in retained earnings.
Recall that this concept of recognizing expenses associated with revenues is the expense recognition principle. Some examples of expenses include bill payments for utilities, employee salaries, and loan interest expense.
For example, you will not recognize utilities as an expense until you have used the utilities. The difference between revenues earned and expenses incurred is called net income loss and can be found on the income statement. At the end of an accounting period -- say, a month, quarter or fiscal year -- financial managers close books and transfer net income into the retained earnings master account, which is an equity item. As a result, higher revenues increase equity and thus the entire accounting equation because income ultimately translates into cash, which is an asset.
Operating revenues and the primary accounting equality affect the whole financial reporting gamut. Assets and liabilities -- the first side of the accounting equation -- are part of a balance sheet, also referred to as a statement of financial position. Marquis Codjia is a New York-based freelance writer, investor and banker.
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