Recording Business Events under the Accounting Equation

Businesses obtain assets/ resources from 3 sources:

  1. Profitable operations
  2. From owners
  3. Borrow assets

Asset source transactions and the accounting equation

Asset source transactions is another way of asking, “Where does the increase in asset come from?” Increases in assets come from either increase in liability or increase in equity.

To keep the accounting equation in balance after an asset source transaction has occurred, a change on one side of the equation, has to correspond with a change on the other side.

In asset source transactions, an increase in assets cause a corresponding increase in liability or equity. For example:

Joe Inc. was formed on January 1, 2014, when it acquired $100,000 cash from issuing common stock

Assets = Liabilities + Equity

Corporations raise cash by issuing common stock. Shares of common stock is the same as owning part of a corporation. When a company issues common stock for cash, there is an increase in cash at the same time the number of outstanding shares increases. Outstanding shares are the shares that have been authorized, issued and purchased by investors. In a corporation, the investors hold the shares of stock and in exchange the corporation gets cash.

As shown in a previous post, cash is an asset and common stock is equity. However, imagine if we used the elements of financial statements as categories, the financial reports will be too broad and will fail to relate any meaningful information. As a result, when posting transactions into the general ledger we use accounts name and not the financial element. The financial element give us a big brush stroke overview and the accounts allow us to be more specific.

There are no standard way to name accounts. Accounts are named as a business sees fit. So with this in mind, let us restate the accounting equation so we have related accounts under the 3 main elements that represent the accounting equation:

Asset = Liability + Equity

Cash = Liability + Common Stock + Retained Earnings

In this transaction only the liability section and the equity section was affected. As we run into more transactions, we will expand the accounting equation even more so more accounts are included.

So $100,000 in cash was received in exchange for $100,000 shares of common stock. This is represented in the accounting equation as follows:

$100,000 = Liability + $100,000 + 0

    We see a change on one side equaled the change on the other side. Thereby leaving the accounting equation equal.


Liability: An asset source transaction

Joe Inc. Borrowed $20,000 from his local bank.

Joe Inc. increased its cash by $20,000 and at the same time increased its liability by $20,000

To illustrate this using the accounting equation we have:

Assets = Liabilities + Equity

Cash = Bank Loan + Equity

20,000 = 20,000 + 0

Both sides of the equation are balanced.

Revenue: An asset source transaction

Revenue is an economic benefit to a business received from customers in exchange for goods and services. Revenue transaction increase retained earnings, an equity account. Revenue is represented in the accounting equation as follows:

Assets = liabilities + owners’ equity

Assets = liabilities + Investment by owners + retained earnings

Assets = liabilities + Investment by owners + prior earnings (beginning retained earnings balance) +revenue – expenses

Remember – retained earnings is the accumulation of prior earnings retained in the business.

Let’s do an example,

Joe Co. received $25,000 from first customer in exchange for consulting services.

Assets = liabilities + Investment by owners + prior earnings +revenue – expenses

Cash = liabilities + Investment by owners + revenue

$25,000 = Liabilities + Investment by owners + $25,000

Both sides of the equation are balanced.


Asset Exchange Transactions

Previously we talked about asset source transactions. Next we discuss the asset exchange. An asset exchange transaction is a transactions that involves only assets. In other words an asset is exchanged for another asset. For example, cash is exchanged for equipment.

Only one side of the accounting equation is affected (the asset side). There is no change on the liability or equity side. For example:

Joe Inc. paid $25,000 to purchase an equipment he needs for his business.

This transaction is represented in the accounting equation as follows:

Asset = Liabilities + Equity

Cash + Equipment = Liabilities + Equity

Cash is reduced by $25,000 because he pays it to a vendor in exchange for equipment

-25,000 + 25,000 = Liabilities + Equity


Asset Use Transactions

There are 3 main categories, businesses use assets like cash:

  • Assets are used in the process of generating revenue (expenses).
  • Assets are used to pay off liabilities
  • Assets are also transferred to owners.

Examples of asset use transactions

Joe Inc. paid $2,000 as wage expense.

Let’s represent this in the accounting equation

Assets = Liabilities + Equity

Cash = liabilities + Investment by owners + prior earnings +revenue – expenses

-2000 = liabilities + Investment by owners + prior earnings + revenue -2000

There is a reduction of $2,000 on both sides of the equation, thus balancing the equation


Example 2: Joe Inc. paid $3,000 in cash dividends to its owners

A dividend is a transfer of assets to the owner. Dividends are not used in the revenue production process so are not expenses. Dividends are a transfer of earnings and not return of the assets acquired from the issuing of common stock.

Dividends are recorded in the dividends account and reduce the retained earnings of the corporation.

To represent this in the accounting equation:

Assets = Liabilities + Equity

Assets = Liabilities + Investment by owners + retained earnings – dividends

-3000 = Liabilities + Investment by owners+ retained earnings – 3000

Therefore both sides of the equation are balanced.

Example 3:

Joe co paid off his $5000 of his bank loan

In this case, cash was used to reduce business liabilities

Assets = Liabilities + Equity

-5000= -5000+ Equity

Both sides of the equation balance