How to Use the Accounting Equation for Properly Recording Business Transactions

A basic review of business transactions and financial accounting

The accounting equation is a self-balancing method by which companies manage financial information. I wrote a detailed hub regarding the use of the accounting equation to compute different parts of accounting information. Here, I will demonstrate how to actually record business transactions into a general ledger. This hub will not go into the specifics of journal entries. It will, rather, present the accounting equation in the analysis of business transactions. All transactions can fit into this format. Knowing the individual parts will lead to the greater knowledge of how to actually maintain accounting ledgers. Both accrual and cash basis accounting systems can use the accounting equation format for recording business transactions.

Now, the accounting equation is: Assets = Liabilities + Equity. Assets represent any item a company owns and uses to generate revenue through business activity. Liabilities are the claims outside individuals and businesses have against a company’s assets. Equity is the owner or shareholder’s rights to the company’s net assets (assets – liabilities). Once you can define each item in a business transaction using these definitions, you can begin updating the company’s general ledger. Let’s look at a few examples on how to complete this accounting activity.

Sample business transactions to explain how to use the accounting equation

John Smith decided to start an exploration company. He placed $20,000 of his own money into the company’s coffers for future use.

In this scenario, we have a sole proprietorship – presumably – started by John Smith. The cash represents an asset based on the description above. John now has equity in his business as well, commonly called owner’s capital in a sole proprietorship. Let’s use the accounting equation to place the transaction into the company’s general ledger.

Sample Accounting Equation 1

Assets
=
Liabilities
+
Equity
Cash
=
 
+
Owner's Capital
$30,000
=
 
+
$30,000

Smith purchases land to place a building for his exploration company. He pays $20,000 in cash for the one-acre parcel and building near the town center.

Smith is now starting to generate activity for his business. Purchasing land and a building with cash is an asset-exchange transaction. In short, he is replacing one asset with another. (Or two, in this case) Here is the entry into his general ledger. You will see we modify the accounting equation slightly, but it all balances, which is the main requirement for this process.

Sample Accounting Equation 2

Asset
+
Asset
=
Liabilities
+
Equity
Cash
 
Land
=
 
+
Owner's Capital
$10,000
 
$20,000
=
 
+
$30,000

To start offering guided tours, Smith purchases $1,000 of trail supplies from the general store. Smith offers to pay for the goods in full after one month.

Okay, we need to figure out the verbiage here first before entering the transaction into the accounting ledger. Since Smith does not pay cash, he now has a payable in his accounting books. Let’s see how this looks under the accounting equation.

Sample Accounting Equation 3

Asset
+
Asset
+
Asset
=
Liabilities
+
Equity
Cash
 
Supplies
 
Land
=
 
+
Owner's Capital
$10,000
+
$1,000
+
$20,000
=
$1,000
+
$30,000

Bill Johnson hired Smith for a private exploration trip. Johnson paid $1,000 cash to Smith for the trip.

Here, John earns his first revenue for his company. This is a relatively simple and repeatable transaction for many companies.

Sample Accounting Equation 4

Asset
+
Asset
+
Asset
=
Liabilities
+
Equity
 
Equity
Cash
 
Supplies
 
Land
=
 
+
Revenue
 
Owner's Capital
$10,000
+
$1,000
+
$20,000
=
$1,000
+
$1,000
+
$30,000

Conclusion on business transactions and the accounting equation

We have seen through these business transaction examples how a company uses the accounting equation to manage its ledger. Many other types of business transactions go through a similar process. The business transactions entered into the accounting ledger will continue until the accounting cycle ends, which is mostly likely a month or quarter year.

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