The Accounting Equation:

The balance sheet is considered the heart of the accounting system.  The accounting equation represents the relationships on the Statement of Financial Condition in terms of a mathematical statement. 

    Assets =  Liabilities  + Owners' Equity

Or,

  Assets - Liabilities = Owners' Equity

The term 'equities' means claims.  Therefore,  what you own less what you owe equals the owner's net claim or equity in the business.

The accounting equation can be expanded into more detail and still be in balance.  For example,

    Cash  +   A/R  +  Supplies + Equipment  =    A/P   +   John Doe, Capital

A/R is short for Accounts Receivable.  A/P is short for Accounts Payable. 

All transactions which occur in a business can be analyzed in terms of their impact on the balance sheet by using the accounting equation.  Study each line of the chart below to understand how ABC Company's transactions during the year changed the Balance Sheet.

John Doe Company,  Architectural Drawing  --  Transactions for January 2001.

 
  Cash A/R Supplies Equipment A/P John Doe, Capital
1. John invests $10,000 cash in the business +10,000         +10,000 (Initial Investment)
NEW BALANCE +10,000 0 0 0 0 +10,000
2. John buys equipment for $2,000. -2,000     +2,000    
NEW BALANCE +8,000     +2,000   +10,000
3. John orders $3000 of supplies on credit, open account.  (Note no effect based on just the order, because the company may be out of stock.)            
4. The $3,000 of supplies arrives through the mail. (Now,  the company records the asset and the debt.)     +3,000   +3,000  
NEW BALANCE +8,000   +3,000 +2,000 +3,000 +10,000
5. The company does $1000 of work for a client and sends them a bill. (Note: The $1,000 recorded under capital is a revenue.)   +1,000       +1,000

  (Revenue)
NEW BALANCE +8,000 +1,000 +3,000 +2,000 +3,000 +11,000
6. John Doe pays $2,000 on the bill for supplies -2,000       -2000  
NEW BALANCE +6,000 +1,000 +3,000 +2,000 +1,000 +11,000
7. John Doe pays $800 rent for the month. (An expense decreases owners claims.) -800         -800

(Expense)
NEW BALANCE +5,200 +1,000 +3,000 +2,000 +1,000 +10,200
8. John writes a check from the business to pay his personal car payment for the month of $400.  (Note, this is considered a reduction in his capital even though the withdrawal is not to him directly.) -400         -400

(Owners Withdrawal)
NEW BALANCE +4,800 +1,000 +3,000 +2,000 +1,000 +9,800
9. John pays the remainder of the supply bill. -1,000       -1,000  
NEW BALANCE +3,800 +1,000 +3,000 +2,000 0 +9,800
10. The customer pays $800 of the $1000 they owe John. (Not treated as revenue, already recorded as revenue when earned.) +800 -800        
NEW BALANCE $4,600 $200 +3,000 +2,000 0 +9,800

 

The information above can be used to prepare end of the month financial statements as shown below:

 

John Doe, Architectural Drawing Firm-- Balance Sheet --January 31, 2001
Cash   $4,600     
Accounts Receivable        200 Accounts Payable  $0
Supplies     3,000    
Equipment     2,000 John Doe, Capital 9,800
    TOTAL ASSETS  $9,800 TOTAL LIABILITIES & CAPITAL $9,800

Information to prepare the income statement comes from the last column, by selecting only those items of revenue and expense:

 

John Doe,  Architectural Drawing Firm - Income Statement -- For Month Ending January 31, 2001
Revenues 1,000
Expenses -800
 NET INCOME  200

Small business owners typically prepare only the balance sheet and income statement for day to day purposes.  If the company uses a professional accountant, the accountant may also prepare a statement of cash flows. To prepare the cash flow statement the accountant  would analyze each cash transaction in terms of whether it was an operating, financing, or investing type of transaction.  Detailed preparation of the statement of cash flows is beyond the scope of  this training course.  However,  you should be able to read and understand the statement which follows:

 

John Doe, Architectural Drawing Firm -- Statement of Cash Flows -- For Month Ending January 31, 2001
Operating Activities:
      Cash received from customers $800
      Cash paid to landlord (800) $0
Financing Activities:
     Owners Investment $10,000
     Owners Withdrawal       (400)

$9,600
Investing Activities:
      Paid for Supplies ($3,000)
      Paid for Equipment (2,000)

($5,000)
       NET INCREASE IN CASH

$4,600

Together,  the three statements show that the new firm is having a difficult time getting started.  The Balance Sheet shows the company assets increased during the month.  The Income Statement and Statement of Cash Flow show that the increases were primarily due to John's adding new capital to the business.  The company earned a net income of only $200 during January,  but only broke even on operating cash flows because the one customer did not pay his entire bill.  In addition, John was out $5,000 purchasing equipment and supplies. 

   CLICK HERE TO TRY ANALYZING SOME TRANSACTIONS ON YOUR OWN.