- Let's begin our analysis of transactions
by reviewing some of the basics.
First, remember the fundamental accounting equation,
assets must equal liabilities
plus owner's equity.
That is a company's resources
can be financed using two sources,
creditors or owners.
As we said previously,
the accounting equation must always remain in balance.
To see how this balance is maintained
when accounting for business transactions,
consider the following activities.
In the first transaction,
$50,000 is invested by owners.
This would cause our assets,
specifically cash to increase
and our equity, specifically capital stock to increase
both by $50,000.
In the second transaction we borrow $25,000
from a bank, again our assets, cash,
increased by $25,000
and our liabilities since we will have
to repay this notes payable increased
by $25,000 as well.
Note that so far our accounting equation balances
after each transaction
and in fact, we can always count on that.
The accounting equation will always balance.
The only instance in which it will not balance
is when we've done something wrong.
To the third transaction,
inventory, that is an item
that we will resell later is purchased on credit.
We will pay for our inventory at a later date,
our assets, specifically inventory increased
by $14,000 and our liabilities,
specifically accounts payable increased
by $14,000 as well
as we now owe money to a creditor
at some point in the future.
In the fourth transaction, we purchased equipment
by paying cash.
In this instance, we are trading one asset,
cash for another asset, equipment.
Cash is going down by $15,000
and equipment is going up by a corresponding amount.
For each transaction,
the accounting equation remains in balance
because identical amounts are added
to both sides, subtracted from both sides
or added to and subtracted
from the same side of the equation.
Following each transaction we can ensure
that the accounting equation balances.
Note in this spreadsheet
how after each transaction,
we can track the balance for our assets,
our liabilities and our owner's equity
to ensure that the accounting equation balances.
After transaction one,
assets equal $50,000
and owner's equity equals $50,000.
After transaction number two,
assets now equal $75,000
with liabilities equaling $25,000
and owner's equity equaling $50,000.
After transaction three,
where we bought inventory on account,
assets equal $89,000,
liabilities equal $39,000
and owner's equity still equals $50,000.
Finally, after the fourth transaction,
where we purchased equipment paying cash,
in other words we traded one asset for another,
our accounting equation still balances.
Assets equal $89,000,
liabilities equal $39,000
and owner's equity equals $50.000.
The accounting equation balances.
Hold onto that concept.
When things get complicated
and they can, knowing that the accounting equation
must always balance
helps us to determine
if we've considered all the effects of a transaction.