Principles of Financial Accounting: The Accounting Equation and Double Entry - The Accounting, Equation Assets Liabilities OwnersStockholders' Equity

What It Is

The Accounting Equation, also known as the Balance Sheet Equation, is a fundamental concept in financial accounting that represents the relationship between a company's assets, liabilities, and owner's equity. It is expressed as: Assets = Liabilities + Owner's/Stockholders' Equity. This equation is essential in understanding a company's financial position and is used to prepare the balance sheet. For example, if a company buys $10,000 of inventory and pays $5,000 cash, the accounting equation would be: Assets = $10,000 (Inventory) + $5,000 (Cash) = Liabilities + Owner's Equity.

Key Concepts & Formulas

• Assets: Resources owned or controlled by a company, expected to generate future economic benefits. Example: A company purchases a new machine for $20,000. The machine is an asset because it is expected to generate future economic benefits.
• Liabilities: Debts or obligations a company owes to others. Example: A company borrows $10,000 from a bank to purchase a new machine. The loan is a liability because the company owes money to the bank.
• Owner's/Stockholders' Equity: The residual interest in a company's assets after deducting its liabilities. Example: If a company has $50,000 in assets and $20,000 in liabilities, the owner's equity would be $30,000 ($50,000 - $20,000).
• Gross Profit: Gross Profit = Sales - Cost of Goods Sold (COGS). Example: A company sells $100,000 in products and has a COGS of $60,000. The gross profit would be $40,000 ($100,000 - $60,000).
• Debit: A left-side entry in a T-account, increasing assets, expenses, and losses. Example: A company purchases a new machine for $20,000. The machine is an asset, so the debit entry would be: Dr. Machine $20,000.
• Credit: A right-side entry in a T-account, increasing liabilities, owner's equity, and revenues. Example: A company borrows $10,000 from a bank to purchase a new machine. The loan is a liability, so the credit entry would be: Cr. Loan Payable $10,000.
• Retained Earnings: The portion of a company's equity that is reinvested in the business, rather than distributed to shareholders. Example: A company has $50,000 in net income and $20,000 in dividends. The retained earnings would be $30,000 ($50,000 - $20,000).

Journal Entry Examples

1. Dr. Inventory $10,000 Cr. Cash $10,000

Explanation: The company purchases $10,000 of inventory and pays cash for it. The debit entry increases the inventory asset, and the credit entry decreases the cash asset.

1. Dr. Loan Payable $10,000 Cr. Cash $10,000

Explanation: The company borrows $10,000 from a bank to purchase a new machine. The credit entry increases the loan payable liability, and the debit entry decreases the cash asset.

Common Mistakes

1. Mistake: Confusing debits and credits for expense accounts. Correction: Remember that debits increase assets, expenses, and losses, while credits increase liabilities, owner's equity, and revenues. Use the mnemonic "ADE" (Assets, Drawings, Expenses) to help you remember.
2. Mistake: Not considering the normal balance of an account when making a journal entry. Correction: Always consider the normal balance of an account when making a journal entry. For example, if a company has a normal balance of $10,000 in cash, a debit entry would increase the cash asset, while a credit entry would decrease it.
3. Mistake: Not using the correct account title when making a journal entry. Correction: Always use the correct account title when making a journal entry. For example, if a company purchases a new machine, the correct account title would be "Machine" rather than "Equipment".

Exam Tips

1. Tip: Remember that a debit increases assets AND expenses – remember "ADE" (Assets, Drawings, Expenses).
2. Tip: Be careful when reversing normal balances. For example, if a company has a normal balance of $10,000 in cash, a debit entry would increase the cash asset, while a credit entry would decrease it.
3. Tip: Use the accounting equation to help you solve problems. For example, if a company has $50,000 in assets and $20,000 in liabilities, the owner's equity would be $30,000 ($50,000 - $20,000).

Quick Practice

1. A company purchases $5,000 of office supplies. What is the adjusting entry? Answer: Dr. Office Supplies $5,000; Cr. Cash $5,000. Explanation: The company purchases office supplies, which is an asset, so the debit entry increases the office supplies asset, and the credit entry decreases the cash asset.

2. A company borrows $10,000 from a bank to purchase a new machine. What is the adjusting entry? Answer: Dr. Cash $10,000; Cr. Loan Payable $10,000. Explanation: The company borrows money from a bank, which is a liability, so the credit entry increases the loan payable liability, and the debit entry decreases the cash asset.

3. A company has $50,000 in net income and $20,000 in dividends. What is the retained earnings? Answer: $30,000 ($50,000 - $20,000). Explanation: The company has net income, which increases retained earnings, and dividends, which decrease retained earnings.

Last-Minute Cram Sheet

1. Assets: Resources owned or controlled by a company, expected to generate future economic benefits.
2. Liabilities: Debts or obligations a company owes to others.
3. Owner's/Stockholders' Equity: The residual interest in a company's assets after deducting its liabilities.
4. Gross Profit: Gross Profit = Sales - Cost of Goods Sold (COGS).
5. Debit: A left-side entry in a T-account, increasing assets, expenses, and losses.
6. Credit: A right-side entry in a T-account, increasing liabilities, owner's equity, and revenues.
7. Retained Earnings: The portion of a company's equity that is reinvested in the business, rather than distributed to shareholders.
8. Dividends are NOT an expense – they go directly to retained earnings.
9. Assets are increased by debits and decreased by credits.
10. Liabilities are increased by credits and decreased by debits.