Accounting Equation for a Sole

Proprietorship: Transactions 12
We present nine transactions to illustrate how a company's accounting equation stays in balance.
When a company records a business transaction, it is not entered into an accounting equation, per
se. Rather, transactions are recorded into specific accounts contained in the company's general
ledger. Each account is designated as an asset, liability, owner's equity, revenue, expense, gain, or
loss account. The general ledgeraccounts are then used to prepare the balance sheets and
income statements throughout the accounting periods.
In the examples that follow, we will use the following accounts:
Cash
Accounts Receivable
Equipment
Notes Payable
Accounts Payable
J. Ott, Capital
J. Ott, Drawing
Service Revenues
Advertising Expense
Temp Service Expense
(To view a more complete listing of accounts for recording transactions, see theExplanation of
Chart of Accounts.)

Sole Proprietorship Transaction #1.

Let's assume that J. Ott forms a sole proprietorship called Accounting Software Co. (ASC). On
December 1, 2015, J. Ott invests personal funds of $10,000 to start ASC. The effect of this
transaction on ASC's accounting equation is:

As you can see, ASC's assets increase by $10,000 and so does ASC's owner's equity. As a result,
the accounting equation will be in balance.
You can interpret the amounts in the accounting equation to mean that ASC has assets of $10,000
and the source of those assets was the owner, J. Ott. Alternatively, you can view the accounting
equation to mean that ASC has assets of $10,000 and there are no claims by creditors (liabilities)
against the assets. As a result, the owner has a claim for the remainder or residual of $10,000.

This transaction is recorded in the asset account Cash and the owner's equity account J. Ott,
Capital. The general journal entry to record the transactions in these accounts is:

After the journal entry is recorded in the accounts, a balance sheet can be prepared to show ASC's
financial position at the end of December 1, 2015:

The purpose of an income statement is to report revenues and expenses. Since ASC has not yet
earned any revenues nor incurred any expenses, there are no transactions to be reported on an
income statement.

Sole Proprietorship Transaction #2.

On December 2, 2015 J. Ott withdraws $100 of cash from the business for his personal use. The
effect of this transaction on ASC's accounting equation is:

The accounting equation remains in balance since ASC's assets have been reduced by $100 and so
has the owner's equity.
This transaction is recorded in the asset account Cash and the owner's equity account J. Ott,
Drawing. The general journal entry to record the transactions in these accounts is:

Since the transactions of December 1 and 2 were each in balance, the sum of both transactions
should also be in balance:

The totals indicate that ASC has assets of $9,900 and the source of those assets is the owner of the
company. You can also conclude that the company has assets or resources of $9,900 and the only
claim against those resources is the owner's claim.
The December 2 balance sheet will communicate the company's financial position as of midnight on
December 2:

Before recording transactions into the journal, we should first know what accounts to use.
This is where a chart of accountscomes in handy.
A chart of accounts is a list of all accounts used by a company in its accounting system. It
makes the bookkeeper's work easier.
The accounts included in the chart of accounts must be used consistently to prevent clerical
or technical errors in the accounting system.
Nevertheless, take note that chart of accounts vary from company to company. The contents
depend upon the needs and preferences of the company using it.
Accounts are classified into assets, liabilities, capital, income, and expenses; and each is
given a unique account number. A coding system is used to organize the accounts. Here's a
sample chart of accounts for a small sole proprietorship business:

Chart of Accounts Example

Gray Electronic Repair Services
Chart of Accounts

ASSETS (1000-1999)
1000

Cash

1010

Accounts Receivable

1011

Allowance for Doubtful Accounts

1020

Notes Receivable

1030

Interest Receivable

1040

Service Supplies

1510

Leasehold Improvements

1520

Furniture and Fixtures

1521

Accumulated Depreciation Furniture and Fixtures

1530

Service Equipment

1531

Accumulated Depreciation Service Equipment

LIABILITIES (2000-2999)
2000

Accounts Payable

2010

Notes Payable

2020

Salaries Payable

2030

Rent Payable

2040

Interest Payable

2050

Unearned Revenue

2060

Loans Payable

OWNER'S EQUITY (3000-3999)

3000

Mr. Gray, Capital

3010

Mr. Gray, Drawing

REVENUES (4000-4999)
4000

Service Revenue

4010

Interest Income

4020

Gain on Sale of Equipment

4999

Income Summary

EXPENSES (5000-5999)
5000

Rent Expense

5010

Salaries Expense

5020

Supplies Expense

5030

Utilities Expense

5040

Interest Expense

5050

Taxes and Licenses

5060

Depreciation Expense

5070

Doubtful Accounts Expense

Additional accounts can be added as the need arises. For bigger companies, the accounts
may be divided into several sub-accounts.
For example, employee salaries may have various accounts for different departments and be
included in the chart of accounts as:
5011 Salaries Expense Administrative,
5012 Salaries Expense Servicing,
5013 Salaries Expense Marketing, etc.
Again, take note that the chart of accounts of one company may not be suitable for another
company. It all depends upon the company's needs. In any case, the chart of accounts is a
useful tool for bookkeepers in recording business transactions.

For additional practice and exposure in journalizing transactions, here are some more
examples of business transactions and their journal entries.
The transactions here pertain to Gray Electronic Repair Services, our imaginary small sole
proprietorship business.
For account titles, we will be using the chart of accounts presented in an earlier lesson.
All transactions are assumed and simplified for illustration purposes.
Note: We will also be using this set of transactions and journal entries in later lessons when
we discuss the other steps of the accounting process.
Let's start.
Transaction #1: On December 1, 2014, Mr. Donald Gray started Gray Electronic Repair
Services by investing $10,000. The journal entry should increase the company's Cash, and
increase (establish) the capital account of Mr. Gray; hence:
Date

Particulars

2014

Dec

Cash

Debit

Credit

10,000.00

Mr. Gray, Capital

10,000.00

Transaction #2: On December 5, Gray Electronic Repair Services paid registration and
licensing fees for the business, $370.
First, we will debit the expense (to increase an expense, you debit it); and then, credit Cash
to record the decrease in cash as a result of the payment.
5

Taxes and Licenses

370.00

Cash

370.00

Transaction #3: On December 6, the company acquired tables, chairs, shelves, and other
fixtures for a total of $3,000. The entire amount was paid in cash.
There is an increase in an asset account (Furniture and Fixtures) in exchange for a decrease
in another asset (Cash).
6

Furniture and Fixtures

3,000.00

Cash

3,000.00

Transaction #4: On December 7, the company acquired service equipment for $16,000. The
company paid a 50% down payment and the balance will be paid after 60 days.
This will result in a compound journal entry. There is an increase in an asset account
(debit Service Equipment, $16,000), a decrease in another asset (credit Cash, $8,000, the
amount paid), and an increase in a liability account (credit Accounts Payable, $8,000, the
balance to be paid after 60 days).
7

Service Equipment

16,000.00

Cash

8,000.00

Accounts Payable

8,000.00

Transaction #5: Also on December 7, Gray Electronic Repair Services purchased service
supplies on account amounting to $1,500.

The company received supplies thus we will record a debit to increase supplies. By the terms
"on account", it means that the amount has not yet been paid; and so, it is recorded as a
liability of the company.
7

Service Supplies

1,500.00

Accounts Payable

1,500.00

Transaction #6: On December 9, the company received $1,900 for services rendered. We will
then record an increase in cash (debit the cash account) and increase in income (credit the
income account).
9

Cash

1,900.00

Service Revenue

1,900.00

Transaction #7: On December 12, the company rendered services on account, $4,250.00. As
per agreement with the customer, the amount is to be collected after 10 days. Under
the accrual basis of accounting, income is recorded when earned.
In this transaction, the services have been fully rendered (meaning, we made an income; we
just haven't collected it yet.) Hence, we record an increase in income and an increase in a
receivable account.
12

Accounts Receivable

4,250.00

Service Revenue

4,250.00

Transaction #8: On December 14, Mr. Gray invested an additional $3,200.00 into the
business. The entry would be similar to what we did in transaction #1, i.e. increase cash and
increase the capital account of the owner.
14

Cash

3,200.00

Mr. Gray, Capital

3,200.00

Transaction #9: Rendered services to a big corporation on December 15. As per agreement,
the $3,400 amount due will be collected after 30 days.
15

Accounts Receivable

3,400.00

Service Revenue

3,400.00

Transaction #10: On December 22, the company collected from the customer in transaction
#7. We will record an increase in cash by debiting it. Then, we will credit accounts receivable
to decrease it. We are reducing the receivable since it has already been collected.
17

Cash

4,250.00

Accounts Receivable

4,250.00

Actually, we simply transferred the amount from receivable to cash in the above entry.
Transaction #11: On December 23, the company paid some of its liability in transaction #5 by
issuing a check. The company paid $500 of the $1,500 payable.
To record this transaction, we will debit Accounts Payable for $500 to decrease it by the said
amount. Then, we will credit cash to decrease it as a result of the payment. The entry would
be:
20

Accounts Payable

500.00

Cash

500.00

Accounts payable would now have a credit balance of $1,000 ($1,500 initial credit in
transaction #5 less $500 debit in the above transaction).
Transaction #12: On December 25, the owner withdrew cash due to an emergency need. Mr.
Gray withdrew $7,000 from the company.
We will decrease Cash since the company paid Mr. Gray $7,000. And, we will record
withdrawals by debiting the withdrawal account Mr. Gray, Drawings.
25

Mr. Gray, Drawings

7,000.00

Cash

7,000.00

Transaction # 13: On December 29, the company paid rent for December, $ 1,500. Again, we
will record the expense by debiting it and decrease cash by crediting it.
29

Rent Expense

1,500.00

Cash

1,500.00

Transaction #14: On December 30, the company acquired a $12,000 short-term bank loan;
the entire amount plus a 10% interest is payable after 1 year.
Again, the company received cash so we increase it by debiting Cash. The company now has
a liability. We will record it by crediting the liability account Loans Payable.
30

Cash

12,000.00

Loans Payable

12,000.00

Transaction #15: On December 31, the company paid salaries to its employees, $3,500.
For this transaction, we will record/increase the expense account by debiting it and decrease
cash by crediting it. (Note: This is a simplified entry to present the payment of salaries. In actual
practice, different payroll accounting methods are applied.)
31

Salaries Expense
Cash

3,500.00
3,500.00

There you have it. You should be getting the hang of it by now. If not, then you can always
go back to the examples above. Remember that accounting skills require mastery of
concepts and practice.

An accounting system must record all business transactions to ensure complete and reliable
information when the financial statements are prepared.
Before going to the recording process, let us understand and analyze business transactions
first.

What is a business transaction?

A business transaction is an activity or event that can be measured in terms of money and
which affects the financial position or operations of the business entity. In other words, it has
an effect on any of the accounting elements assets, liabilities, capital, income, and
expense.
Transactions may be classified as exchange and non-exchange. Exchange transactionsinvolve
physical exchange such as purchasing, selling, collection of receivables, and payment of
accounts.
Non-exchange transactions are events that do not involve physical exchanges but where
changes in monetary values are determinable, e.g. wear and tear of equipment, fire loss,
typhoon loss, etc.
To qualify as an accountable/recordable business transaction, the activity or event must:

1. Be a transaction involving the business entity

The separate entity concept or accounting entity assumption clearly establishes a distinction
between transactions of the business and those of its owner/s.
If Mr. Bright, owner of Bright Productions, buys a car for personal use using his own money, it
will not be reflected in the books of the company. Why? Because it does not have anything
to do with the business. Now if the company purchases a delivery truck, then that would be
a business transaction of the company.
If Mr. Grim invests $20,000 into the company, would that be recorded in the books of the
business? Ask this: Does it have anything to do with the company? Yes. Then, that would be
a recordable business transaction.

In any case, always remember that a business is treated as an individual entity, separate
and distinct from its owners.

2. Be of a financial character (in a certain amount of money)

Transactions must involve monetary values, meaning a certain amount of money must be
assigned to the elements or accounts affected.
For example, Bright Productions renders video coverage services and expects to collect
$10,000 after 10 days. In this case, it's explicit. The income and receivable can be measured
reliably at the $10,000.
Fire, typhoon and other losses may be estimated and assigned with monetary values.
The mere request (order) of a customer is not a recordable business transaction. There
should be an actual sale or performance of service first to give the company a right over the
income or revenue.

3. Have a dual or "two-fold" effect on the accounting elements

Every transaction has a dual or two-fold effect. For every value received, there is a value
given; or for every debit, there is a credit. This is the concept of double-entry accounting.
For example, Bright Productions purchased tables and chairs for $6,000. The company
received tables and chairs thereby increasing its assets (increase in Office Equipment). In
return, the company paid cash; thus, there is an equal decrease in assets (decrease in
Cash). For more illustration and examples, check out the lesson about the Accounting
Equation here.

4. Be supported by a source document

As part of good accounting and internal control practice, business transactions must be
supported by source documents. The source documents serve as bases in recording
transactions in the journal.
Examples of source documents are: Official Receipt issued whenever cash is received, Sales
Invoice for sales transactions, Cash Voucher for payment in cash, Statement of Account from
suppliers, Vendor's Invoice, Promissory Notes, and other business documents.

The first step in the accounting process is actually to prepare the source document and
determine the effects of the business transaction to the accounts of the company. After
which, the accountant records the transaction through a journal entry.
Examples of business transactions will be given and explained in detail as you go through
the lessons in this chapter. To see how business transactions are actually analyzed, you may
jump to Accounting Equation, Journal Entries, and More Journal Entry Examples. The next
lessons will discuss the rules of debit and credit, and chart of accounts first.