Introduction to bookkeeping and accounting

how does paying a liability in cash affect the accounting equation

Typically bills for items such as internet expense will be first recorded into accounts payable, a liability account. Accounts payable tracks all of the bills before they are paid for in cash. Say a $500 internet bill arrives for May service, but is not due until next month. The $500 internet expense is recorded in May with a debit and a $500 AP is recorded with a credit. When the bill is paid for in cash the next month, AP will decrease with a $500 debit and cash will decrease with a $500 credit.

If we analyse the transaction, Peter’s Photographic Enterprises has received £175 cash from the customer, so that means net assets are increased by £175. Included in the firm’s stock account at the beginning of the year are seven cameras that cost £100 each. On the second day of the year, the business sells one of these cameras for £175 cash.

What Is the Effect Dividend Payments Have on a Corporation’s Balance Sheet?

Even if you have an accountant who handles the numbers for you, you should have a basic understanding of the accounting equation. The accounting equation is the foundation of the double-entry accounting system. Therefore, the basic accounting equation helps businesses around the world create financial statements. Let’s learn more about what the basic accounting equation is, why it exists, and how to use it in the expanded accounting equation. Assets, liabilities and owners’ equity are the three components of the accounting equation that make up a company’s balance sheet. This version of the accounting equation shows the relationship between shareholder’s equity and debt. The shareholder’s equity is what remains after all liabilities are subtracted.

What happens when a portion of an account payable is paid?

When an account payable is paid, Accounts Payable will be debited and Cash will be credited. Therefore, the credit balance in Accounts Payable should be equal to the amount of vendor invoices that have been recorded but have not yet been paid.

Owner’s equity also represents the net assets of the company. Companies will segregate their liabilities by their time horizon for when they are due. Current liabilities are due within a year and are often paid for using current assets. Non-current liabilities accounting equation are due in more than one year and most often include debt repayments and deferred payments. Considering the name, it’s quite obvious that any liability that is not near-term falls under non-current liabilities, expected to be paid in 12 months or more.

Other Definitions of Liability

The accounting equation is most often stated as ____. Recording and reporting a business’s financial information separately from the owner’s financial information is an application of the accounting concept ____. When a business pays cash for insurance, a liability is increased.

how does paying a liability in cash affect the accounting equation

You notice there is already a credit in Accounts Payable, and the new record is placed directly across from the January 5 record. In the journal entry, Accounts Receivable has a debit of $5,500. This is posted to the Accounts Receivable T-account on the debit side.

Expanded accounting equation

The cash account is used to summarize information about the amount of money the business has available. A record summarizing all the information pertaining to a single item in the accounting equation is an account. In the United States, business transactions are recorded in U.S. dollars. When cash is paid on account, a liability is increased. When a company pays insurance premiums in advance to an insurer, it records the payment as a liability because the insurer owes future coverage.

  • You will notice that the transactions from January 3, January 9, January 12, and January 14 are listed already in this T-account.
  • Continuing the example, after paying off the $10,000 in accounts payable, you would be left with $290,000 in total liabilities, or $300,000 minus $10,000.
  • These equations, entered in a business’s general ledger, will provide the material that eventually makes up the foundation of a business’s financial statements.
  • This is posted to the Cash T-account on the credit side beneath the January 14 transaction.
  • OpenStax is part of Rice University, which is a 501 nonprofit.

At the same time, capital is increased as a result of the income . As we’ve mentioned in the Accounting Elements lesson, income increases capital. Sole proprietors hold all of the ownership in the company. If your business has more than one owner, you split your equity among all the owners. Include the value of all investments from any stakeholders in your equity as well. Subtract your total assets from your total liabilities to calculate your business equity.


Closing entries move the credit balances of revenue accounts into Retained Earnings and cause that account to increase. Closing entries also transfer the debit balances of expense accounts into Retained Earnings, causing it to decrease.

Cash is an asset and will decrease on the credit side. Cash is an asset, which in this case is increasing. On January 30, 2019, purchases supplies on account for $500, payment due within three months. It is not taken from previous examples but is intended to stand alone.

What is the Accounting Equation?

The net income amount that appears on the retained earnings statement comes from the income statement ($13,000 in the sample above). The ending retained earnings balance ($40,000 in the sample above) feeds to the stockholders’ equity section of the balance sheet. Using this version, it’s easier to highlight the relationship between liabilities and equity. A company’s equity is what remains after a business has paid all of its creditors. A creditor is any party that lends money to the business.

how does paying a liability in cash affect the accounting equation

On January 9, 2019, receives $4,000 cash in advance from a customer for services not yet rendered. On January 3, 2019, issues $20,000 shares of common stock for cash. Skip a space after the description before starting the next journal entry. The titles of the credit accounts will be indented below the debit accounts.

The corresponding $950,000 debit is made to the income summary account, which closes the income statement for the period. The closing records income statement activity for the period on the balance sheet, using retained earnings. Note that the closing of the income summary is a process largely automated by accounting software. Here are some transactions that will affect only the right side of the accounting equation. 1) A company refinances its short-term debt with long-term debt.

When Can a Decrease in an Asset Account Occur?

Liabilities are amounts a company owes, such as loans and accrued expenses. For example, if your small business has $1 million in total assets and $300,000 in total liabilities, its net worth is $700,000. The asset, liability, and shareholders’ equity portions of the accounting equation are explained further below, noting the different accounts that may be included in each one. In traditional double-entry accounting, the left column in the register is used for debits, while the right column is used for credits. Accountants record increases in asset and expense accounts on the debit side, and they record increases in liability, income, and equity accounts on the credit side. The income statement shows net income for the month.

  • The dividend could be paid with cash or be a distribution of more company stock to current shareholders.
  • The impact of this transaction is a decrease in an asset (i.e., cash) and an addition of another asset (i.e., building).
  • Capital investments and revenues increase owner’s equity, while expenses and owner withdrawals decrease owner’s equity.
  • Instead, they are a component of the stockholder’s equity account, placing it on the right side of the accounting equation.
  • In this form, it is easier to highlight the relationship between shareholder’s equity and debt .
  • Discover what goes into these meticulous ways of keeping records and the significance of journal entries and trial balance to accurate accounting.
  • Cash had a debit of $20,000 in the journal entry, so $20,000 is transferred to the general ledger in the debit column.

Accounting equation explanation with examples, B. Explain why you debited and credited the accounts you did. This similarity extends to other retailers, from clothing stores to sporting goods to hardware. No matter the size of a company and no matter the product a company sells, the fundamental accounting entries remain the same.

The heading of the balance sheet lists the address of the business. Individuals or other businesses to whom a business owes money have rights to the business’s assets. Summary reports of financial activities are used by the owners and managers of a business to make business decisions.

Assume a business has an $80,000 loss for the year. Retained earnings will be reduced with an $80,000 debit and the income summary closed with an $80,000 credit. The company’s accounting system has already recorded an accrual of this amount. Thus, insurance expense and the related liability were recognized as incurred.

This increases the cash account as well as the capital account. Investment of $15,000into the business cash account. Rieva is a small-business contributor for Fundbox and CEO of GrowBiz Media, a media company focusing on small business and entrepreneurship. She has spent 30+ years covering, consulting, and speaking to small businesses owners and entrepreneurs. Balance, go back and check for an accounting or data entry error. GnuCash is easy enough to use that you do not need to have a complete understanding of accounting principles to find it useful. However, you will find that some basic accounting knowledge will prove to be invaluable as GnuCash was designed using these principles as a template.

In liability, equity and income accounts, credits increase the balance and debits decrease the balance. There’s no perfect balance of liabilities and equity.

Cash is a resource that a business reports in the current assets section of the balance sheet. When it uses cash to repay accounts payable, it reduces its cash balance, which in turn, reduces its total assets.

How do liabilities affect the accounting equation?

All else being equal, a company's equity will increase when its assets increase, and vice-versa. Adding liabilities will decrease equity while reducing liabilities—such as by paying off debt—will increase equity. These basic concepts are essential to modern accounting methods.

Profit flows directly into equity; if a company reports $100,000 in net income, for example, then its equity grows by $100,000. Therefore, an increase in expenses means a reduction in equity — although, for profitable companies, this reduction really just translates into a smaller increase.

Accounting Equation

First, the liability part of the accounting equation decreases along with the decrease in the asset part. Cash is a company’s asset; this asset will also minimize by the same value as a liability. Net income reported on the income statement flows into the statement of retained earnings. If a business has net income for the period, then this will increase its retained earnings for the period.

In the last column of the Cash ledger account is the running balance. This shows where the account stands after each transaction, as well as the final balance in the account. How do we know on which side, debit or credit, to input each of these balances? Salaries are an expense to the business for employee work. This will increase Salaries Expense, affecting equity. Expenses increase on the debit side; thus, Salaries Expense will increase on the debit side. Cash was used to pay for salaries, which decreases the Cash account.

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