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7-8 Accounting [CH 7

Casually one can see that this equation, as with all equations, has a left side and a
right side; each side is separated by the equal sign. The parts of this equation are
defined as: An asset is anything of value owned by the business and used for its

operation. Cash, accounts receivable, inventory for sale, and notes receivable (amounts
asset owed to the business through credit sales), equipment and machinery, store fixtures,
Anything of value owned a inventory in production, buildings and land, and marketable securities, patents, bonds,
business and used for its and copyrights; all are assets.
operation.
A liability for a business is any amount owed to creditors—these are the claims of
creditors against the assets of the business; they are the debts of the business. A
liability liability represents an encumbrance against the assets of the business. When the firm
Claim of the firm's creditors. makes credit purchases for inventory, machinery and equipment or land, the creditors'

claims are shown as either an account payable, a note payable or a mortgage. Wages
equity and salaries owed to employees also represent liabilities (known as wages payable).
That potion of the assets The equity represents the proprietor('s) (Owner(s') Equity) unencumbered
not encumbered by debt. ownership; the individual owner, the partners', or the stockholders' claims on that

owners' equity portion of the assets not incumbered by debt (liability). For the firm, it is the excess of
Claims of the proprietor, the all assets over all liabilities.
partners, or the The basic accounting equation reflects the financial position of any firm at any
stockholders against the point in time:
assets of the firm; the
excess of assets over Assets = Liabilities + Equity
liabilities. and for the Owner(s) Equity the equation becomes:

accounting equation Assets - Liabilities = Equity
Basic accounting concept
that assets are equal to
liabilities plus owners' TRANSACTIONS: An Exchange of Assets
equity. With the accounting equation it is noted that the equality of the equation must be
maintained; the left side of the equation must equal the right side of the equation.

Every business transaction involves two or more assets and is an EXCHANGE of
assets. Every transaction involves a buyer and seller. Purchase a truck and this
exchange involves the truck and cash; both are assets, one is owned (equity) by the
buyer and the other is owned (equity) by the seller. Thus, when a farmer purchases

some land (an asset) to farm, the farmer gives in exchange either cash (an asset), or
some other item of value which he owns (equity) or a promise to pay at a future time.
This exchange of assets in a business transaction is fundamental to the correct
procedure in recording and keeping and accounting for the business firm.

The Effect of Transactions on the Accounting Equation

To illustrate the effect of various transactions on the accounting equation
consider the following transactions as John Newell opens a supply store. Study the
arithmetic in the Figure 7.5 transactions recorded using the balance sheet as they

follow the Accounting Equation.
Transaction 1) John Newell deposits $150,000 of his capital (cash) into an

account for his feed store.
Transaction 2) John Newell purchases $7,500 of equipment using his cash.

Transaction 3) John Newell purchases $45,000 of merchandise to sell, paying
cash.

Transaction 4): John Newell acquires $9,000 of merchandise from DuPont
Note that at the end of the Chemical Co. and gives then a promissory note to pay, creating a
transactions John Newell’s debt (liability); thus, DuPont Chemical is extending credit.
equity increased from
$150,000 to $157,050; Transaction 5) John Newell pays DuPont Chemical Co. $3,900 against his
business was good. promissory note.

Transaction 6) John Newell sells $11,250 of his merchandise valued on his
books as $5,800.

Transaction 7) John Newell pays $3,500 for operating expenses over the month.

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