Bookkeeping – The Accounting Equation (Lesson 24)

Lesson 24

The accounting equation is a simple formula used frequently in business.   The formula is:

Assets = Liabilities plus Equity
OR
Equity = Assets minus Liabilities

The owner is interested in increasing the equity position as this is his wealth in the business.   There are only two ways to increase the equity value.

One the owner may contribute money from his personal assets; and/or via the second method earn additional equity by generating profits from operations.

Obviously, the second method of earning the money is preferred over the first since contributing money doesn’t necessarily increase the owner’s overall wealth.   It is simply shifting some personal wealth to the business.

So how does earning higher profits build wealth in the business?   There are two different ways including asset accumulation or liability reduction.  Before explaining these two forms of equity increase from earning profits the reader must first understand the economic transaction effect as it relates to the formula.

Transaction Effect

A core business transaction is a sale of a product for cash.   Credit sales and debit cash to record the entry.   If no other issues are involved the profit increases the exact same amount.   Therefore, the profit automatically increases the ‘current earnings’ in the equity section.   Since the cash increases the same amount the balance sheet stays in balance.   The accounting equation is intact.

Assets (Increase) = Liabilities plus Equity (Increases)

But most transactions are not this simple.    Sticking with the same transaction with the sale of a product, the bookkeeper debits cost of sales for the item sold.   This reduces the net profit.   At the same moment with this entry the credit is to inventory, a current asset account.

So now via ‘current earnings’ equity decreases and so do assets via inventory.   The accounting equation remains intact.

The net effect of the sale is an increase in net profit of Z dollars.   The asset side has an increase in cash equal to the total sale and a decrease in inventory equal to the cost of that sale.   The net effect between these two current assets equals the change in equity (via current earnings) of the Z value.

Every transaction made has a similar effect on the balance sheet.   It is very rare for a transaction to affect the income statement only with both debits and credits.   In general most transactions change the profit which changes the equity value.   The accounting equation requires an equal change with assets and/or liabilities.

Asset Accumulation

The asset section of the balance sheet is divided into three groups:

  • Current – liquid in nature, i.e. can be turned into cash within one year;
  • Fixed – long-term in nature and typical tangible; AND
  • Other – held for use in the future or intangible in nature requiring amortization.

Naturally the number one asset to have is cash.

In business liquidation of assets is the process of converting assets on the balance sheet into cash.   If the only asset is cash, liquidation is not an issue.  If the primary purpose of business is profit in the form of cash to the owner, then it is of the utmost importance that the bookkeeper understand how the business ultimately generates cash.

The best example of this conversion process is the hot dog cart vending business.   But even here, there are three assets each day and the conversion process can get fuzzy.  Note the three primary assets of the hot dog vendor:

  1. Cash   –   Current Asset
  2. Food Inventory – Current Asset
  3. Hot Dog Cart – Fixed Asset

Think of each day’s activity.   In the morning the vendor uses cash to purchase hot dogs and buns.   So this transaction increases inventory and decreases cash.   This is simply a reclassification of one current asset (cash) into another current asset (inventory).   Now he rolls the cart to his spot, cooks the dogs and sells out.   There is no inventory and only two assets remain on the books of record – cash and the cart.   Naturally the cash is higher than in the morning before purchasing his inventory because the difference is equal to his profit earned that day.

The physical operation repeats itself every day.   Here wealth accumulates in the form of cash.

This type of business operation is actually rare.   Honestly most small businesses are much more complex.   In general the goal in asset accumulation is to expand the asset pool from the profits earned from business activity.   The higher the quality of the asset the easier it is to turn the asset into cash.   In general accountants use a ranking system on the balance sheet.   Current assets are easier to turn into cash than fixed assets.   Fixed assets are easier to turn into cash than other assets; think of how difficult it is to turn an intangible asset into cash.

To illustrate this, let’s complicate the business activity a little more.   Suppose you own an auto parts store.   Your best customers are local repair shops.   To facilitate ease of activity your customers are extended credit via accounts receivable (A/R).   So upon the sale of a part the entry looks like this:

Sales Journal
Date        Ledger        Description                            DR            CR
09/15/15  Sales             Muffler to Joe’s Muffler                         ZZ.ZZ

              A/R – Joes      Muffler & Harness System    ZZ.ZZ

In addition to recording the sale; the business must also record the cost of the sale as follows:

Inventory Journal
Date        Ledger          Description                           DR            CR
09/15/15  Cost of Sales   Muffler to Joe’s Muffler        ZZ.ZZ

               Inventory        Muffler & Harness System                   ZZ.ZZ

Hopefully the store made a profit and equity increases via ‘current earnings’.   Remember over on the income statement sales is a credit, cost of goods sold is a debit and therefore if sales is greater than costs the profit is a credit.   This credit value automatically increases the credit balance in the equity section of accounts over on the balance sheet.   To maintain the accounting equation, assets must increase.

In this case the inventory decreases and the accounts receivable increases equal to the value of the sale (cost of item sold plus the profit).   Basically the business swapped one asset (an inventory item) for another (accounts receivable value owed by Joe’s Muffler).   The newer asset includes the profit earned.  Let’s look at this mathematically.

In this situation, the muffler was sold to Joe’s for $45 at a cost of $25.   Therefore the profit earned is $20.

Balance Sheet                     Before             After
Inventory                               $25.00                 -0-
Accounts Receivable               -0-                $45.00
Total Assets                           $25.00            $45.00

Equity                                    $25.00            $45.00 

Sales                                         -0-              $45.00
Cost of Sales                              -0-               25.00
Profit                                         -0-              $20.00

The $20 profit increases the equity balance from the original $25 value by the current earnings associated with the sale.   The accounting equation is in balance and intact.  To comply with the accounting equation either assets increase or liabilities decrease.   Since there are no liabilities, assets must increase.   This is asset accumulation.  Imagine this same transaction or a similar transaction several hundred times a day.

Now Joe’s Muffler owes $45 to the auto parts store.   When he pays the accounts receivable balance is reclassified as cash; current assets do not change; they simply take a different form.

Over long periods of time the auto parts store will purchase more assets such as inventory; fixed assets like storage racks, forklifts, registers, shelving systems and more; intangible assets such as rights to another store or some kind of franchise right.   This is how profits are reinvested into the business to accumulate more assets.

Sometimes though profits are used to reduce liabilities.

Liability Reduction

As assets are ultimately turned into cash, the question arises as what to do with this cash.   Well there are three choices.    The obvious is to disburse the cash to the owners as their reward for the risk they took.   The second choice is to purchase more assets to expand operations in order to make even more profit at a faster rate.   The third choice is to reduce liabilities.

With choice number one assets decrease and so does equity dollar for dollar maintaining the accounting equation.   With choice number two the business is merely reclassifying one asset for another.   Again, there is no change in the accounting equation as the dollar value for assets does not change; therefore equity does not change either.   The third choice reduces assets and liabilities at the same rate (amount).   The equation stays in balance.

So how is this done?

Let’s continue with the auto parts store.   To expand their inventory to 100 mufflers they order them from the supplier.   When delivered the parts store owes (accounts payable) $2,500 to the supplier ($25 each).   Here is the entry:

Purchases Journal
Date          Ledger         Description                           DR           CR
09/15/15  Inventory          Purchase of 100 Mufflers      2,500
               A/P – Hotshot   100 Mufflers/Brackets                           2,500

Notice the balance sheet stays in balance?   See below:

                              Auto Parts Store
                               Balance Sheet
                                     09/15/15
ASSETS
Accounts Receivable                      $45
Inventory                                     2,500
Total Assets                                           $2,545

LIABILITIES
Accounts Payable                     $2,500
Total Liabilities                                      $2,500
EQUITY
Owner’s Investment                         25
Current Earnings                              20
Total Equity                                                   45
Total Liabilities & Equity                       $2,545

Now as the mufflers are sold and the accounts receivable turns into cash the cash is available for the three options.   Yes you can disburse the cash to the owner and not pay Hotshot for the mufflers.   Hotshot’s response is to refuse the next order of mufflers putting the store out of business.   Not to mention some kind of lawsuit against the business and owner.   But the store wants to continue business so the cash is used to pay the vendor and reduce the liability.   How does this help to accumulate wealth?   Let’s find out.

Assume the store sold all the mufflers and all the customers paid their customer balance, her is the short summary version of the balance sheet:

                            Auto Parts Store
                             Balance Sheet
                                  09/16/15
ASSETS
Cash                                    $4,545
Inventory                                  -0-
Total Assets                                    $4,545

LIABILITIES
Accounts Payable                $2,500
Total Liabilities                               $2,500
EQUITY
Owner’s Investment                   25
Current Earnings                   2,020
Total Equity                                       2,045
Total Liabilities & Equity                $4,545

In case you want to do the math, the  store sold 101 units (100 from the recent purchase of mufflers and the original muffler in stock) for $4,545 total which it collected in cash.   Cost of sales are 101 units at $25 each or $2,525.   The profit generated is $2,020.   Remember the profit flows over to current earnings on the balance sheet.   Here the wealth accumulation exists in cash but the parts store needs to pay back the original supplier.   Once paid there remains $2,045 in cash with no liabilities.   The cash equals equity at this point.   The accounting equation stays true, without liabilities, assets equals equity as follows.

   Assets  = Liabilities plus Equity
   $4,545 = $2,500 + $2,045

Once the supplier is paid, the equation changes to:

   Assets  = Liabilities plus Equity
   $2,045 =     -0- + $2,045
   $2,045 = $2,045

Summary

The accounting equation is active in every economic transaction affecting the business.   The equation is Assets equals Liabilities plus Equity.   Any transaction impacting the income statement automatically changes equity via current earnings.   The other side of that transaction affects assets or liabilities in an equal amount.   Act on Knowledge.

If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org.  I would love to hear from you. If interested in my services as an accountant/consultant; click on My Services in the footer of this article.

 

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About David J Hoare 429 Articles

I spent 12 Years as a Certified Public Accountant,
Over 20 Years of Practice in Accounting and Consulting,
Controller in Management of Closely Held Operations,
Masters of Science in Accounting,
Prepared over 1,000 Business Tax Returns and Hundreds of Individual Returns