Assets = Liabilities + Equity
Accounts are created that fall under one of these three categories. Each account has its own ledger to book transactions, and each ledger flows into a general ledger that keeps track of the account balances at a higher level. Cash $10
Accounts Payable $10
Here we have debited $10 to the Cash account and credited $10 to the Accounts Payable account. Both accounts balance. Revisiting the accounting equation, we can see how it still balances: Assets = Liabilities + Equity
10 = 10 + 0
Now if we dive into the Cash account at a deeper level, we can represent it with a t-chart: Cash
---------
10 |
Similarly for Accounts Payable (A/P) A/P
---------
| 10
Both Cash and Accounts Payable carry a balance of $10. Since Cash is an asset account that carries a debit balance, we represent it in t-chart form by adding 10 to the left side of the t-chart (matching up with assets being on the left side of the accounting equation). Accounts Payable carries a credit balance since it is a liability account, so we represent it by adding the 10 to the right side of the account (matching up with liabilities being on the right side of the accounting equation). Accounts Payable $5
Cash $5
Now we have debited Accounts Payable and credited Cash, which is the opposite of their account types. This reduces the balance of the accounts, as demonstrated by their t-charts: Cash A/P
--------- ---------
10 | | 10
| 5 5 |
The accounting equation is now: Assets = Liabilities + Equity
5 = 5 + 0
Finally, let's look at an equity account. Suppose when the business was formed, we gave it $10 of widgets (Inventory asset account) in exchange for equity in the business: Inventory $10
Equity $10
Inventory Equity
--------- ---------
10 | | 10
Equity
---------
| 10
Pretending that the founding equity has now been introduced (because it would have normally been the first entry in the company's books), the accounting equation is updated as so: Assets = Liabilities + Equity
15 = 5 + 10
Now suppose we receive $20 in cash from the sale of all of our widgets valued at $10. Our business was formed to sell these widgets, so the sale is revenue. Revenue is an equity account. The sale would be booked with the following entry: Cash $20
Inventory $10
Revenue $10
Since Revenue is an equity account, we have increased its balance by crediting it $10, which is the difference between the cash received and the value of the widgets we sold. The t-charts for the account balances in the transaction are the following: Cash Inventory
--------- ---------
10 | 10 |
| 5 | 10
20 |
Inventory
---------
10 |
| 10
Revenue
---------
| 10
What do you think the accounting equation looks like at this point? Think on it for a second. Cash Inventory
--------- ---------
10 | 10 |
| 5 | 10
20 | ---------
--------- $0
30 | 5 ---------
--------- ---------
$25
---------
---------
Liabilities:
A/P
---------
| 10
5 |
---------
$5
---------
---------
Equity: Revenue Equity
--------- ---------
| 10 | 10
--------- ---------
$10 $10
--------- ---------
--------- ---------
At this point, the accounting equation remains perfectly balanced still: Assets = Liabilities + Equity
25 = 5 + 20
From here, we could create a Balance Sheet (B/S), which is a look at the balances of our accounts at a point in time. ---------------
Balance Sheet
---------------
Assets:
Cash 25
Inventory 0
---------------
Total $25
---------------
Liabilities:
A/P 5
---------------
Total $5
---------------
Net assets: $20
---------------
Equity:
Equity 10
R/E 10
---------------
Total $20
We can see a shift of the accounting equation on the B/S with the net assets equaling the equity (Assets - Liabilities = Equity).
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