HOSP 1210 (Financial Acct) Learning Centre

The Accounting Equation &

Transaction Analysis

Economic transactions must be classified into categories: assets, liabilities, and net
worth. Assets (A) are resources owned by a business, liabilities (L) are debts owed by
the business, and net worth (NW) represents the owners’ net assets or what the
owners would receive if the company was sold off and all the liabilities were paid. A
business must always have a balance between what it owns and what it owes. This is
shown by the basic accounting equation:
Assets = Liabilities + Net Worth

You could make up a mnemonic device to help you remember the equation: AELPN or
All Elephants Like Purple Noodles. Each letter stands for something: assets equals
liabilities plus net worth. The next step is memorizing the types of accounts that will be
categorized as A, L or NW.

Assets are resources that business uses to produce services. Common asset accounts
are: cash, accounts receivable (or any receivables), equipment, building, land,
accumulated depreciation, inventory, supplies, and prepaid expenses. Phrases like
“billed on account” or “performed service on account” indicate a receivables account.
Liabilities are loans or debts. L accounts often have the word “payable” in the name:
accounts payable, notes payable, mortgage payable. Long-term debt is also a liability.
Phrases like “purchased on credit” or “purchased on account” indicate liabilities.
Net worth is how much of the value of the business remains if all the liabilities are paid
off. Other phrases that mean the same thing as net worth are owner’s equity (for
proprietorships and partnerships) and shareholders’ equity or stockholders’
equity (for corporations).

Net worth is determined by the owners’ contribution of money to the business (either
through investments by owners/partners or issue of stock/shares in corporations),
revenues, expenses, and owner withdrawals. Owners’ contribution means investing
money in the company which increases net worth. Revenues also increase the value of
net worth. Expenses reduce the value of net worth. Owner withdrawals decrease the
value of net worth. In a corporation, owner withdrawals are called dividends (payments
to shareholders).

Net worth = owners’ contribution + (revenues − expenses) − withdrawals

Net worth = owners’ contribution + net income/loss − withdrawals

Note that net income/loss is the difference between revenues and expenses.

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The last thing we need to know is how transactions affect the basic accounting equation.
Any change on one side of the equation must be balanced by an equal change on the
other side of the equation. You may have to use your algebra skills to figure out one of
the unknown categories (A, L or NW) or to figure out the change in one side of the
equation or figure out what must happen to A, L, or NW given set information.
Example 1: If assets are valued at $25,000 and stockholders’ equity at $10,000 what is
the value of liabilities?

Solution: Let’s identify what we know: we know the value of assets ($25,000) and
stockholders’ equity, which is the same as net worth ($10,000).
Plan: plug the numbers into the equation and solve for the unknown:

A = L + NW
25,000 = L + 10,000 To solve for L, move the 10,000 to the other side.
L = 25,000 − 10,000 = $15,000 The value of liabilities is $15,000.

Example 2: Assets undergo a $5,000 increase and liabilities undergo a $3,000

decrease. What is the change in owners’ equity?

Solution: Any changes in assets, liabilities, or net worth must be balanced in the
accounting equation.
Plan: Show the change in values in the accounting equation and figure out the unknown
(owner’s equity, same as net worth)
A = L + NW
+5,000 = −3,000 + NW To solve for NW, move the 3,000 to the other side.
NW = 5,000 + 3,000 = +8,000
Since the number is positive, owner’s equity increased by $8,000.

Example 3: At the beginning of 2013, a partnership’s assets are valued at $850,000

and liabilities are $375,000. If net income for 2013 is $125,000 and owners’ withdrawals
are $60,000, what is the net worth of the partnership at the end of the 2013?

Solution: Any changes in net worth must be due to a change in owner’s contributions,
net income/loss, and owner’s withdrawals.
lan: Find the net worth at the beginning of the year and adjust its value based on any of
the above three events.

A = L + NW NW = A − L = 850,000 − 375,000 = $475,000

Net worth end = net worth beginning + owner contributions + net income − owner
withdrawals

Net worth end = 475,000 + 0 + 125,000 − 60,000 = $540,000

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For every transaction, there will always be AT LEAST 2 accounts affected. Practice
recognizing basic transactions that will come up again and again.

Example 4: A business paid $500 cash for inventory. Analyze the transaction.

Solution: The two accounts involved in the transaction are cash and inventory. Cash is
being paid out, so the account value decreases. The amount of inventory on hand is
increasing, so the account value increase. Both of these are asset accounts; the $500
cash decrease and the $500 inventory increase produces a net change of $0 to assets.

Example 5: A hotel provides catering services of $2,500 for customers. Customers pay
$1,000 cash and the remainder is billed on account. Analyze the transaction.

Solution: By providing a service, the company has earned service revenue of $2,500.
This increases the value of NW. The hotel also receives $1,000 cash which increases
the value of the cash account. The remainder billed on account indicates that the rest of
the revenue ($1,500) goes to accounts receivable. The overall change in the equation is
a $2,500 increase in assets (cash + accounts receivable) and a $2,500 increase in NW.

Tip: If you have to pay any kind of bill — hydro, electricity, rent, advertising, etc. — that
should automatically make you think “EXPENSE”.

Practice Problems

1. Classify each item as an asset, liability, or net worth:

a. Accounts payable f. Taxes payable
b. Wage expense g. Accumulated depreciation
c. Unpaid revenue h. Kitchen equipment
d. Prepaid insurance i. Sales revenue
e. Accounts receivable j. Owner withdrawal

2. At the beginning of the year, Starmac Corp had total assets of $800,000 and total liabilities
of $550,000. Answer the following questions:
(Note: Each question must be treated separately.)
a. What was the value of stockholder’s equity at the beginning of the year?
b. During the year, total liabilities increased $150,000, and stockholders’ equity
decreased $35,000. What is the amount of total assets at the end of the year?

3. Presented below are six business transactions. Indicate whether the transactions increased
(+), decreased (−), or had no effect (NE) on assets, liabilities and stockholders’ equity.
a. Purchased $500 hotel supplies on account
b. Received $300 cash for providing catering services
c. Paid $200 on accounts payable
d. Issued shares of stock valued at $70,000
e. Paid $100 for hotel supplies
f. Customers prepaid for $1000 of service
g. Received $200 bill for utilities
h. Provide $500 worth of prepaid service

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4. During the year, Hassan’s accounting practice showed an increase in net worth from
$40,000 to $50,000. Hassan did not make any new investments in the business and had a
net income of $12,000. What was the amount of owner withdrawals that Hassan made
during the year?

5. Anne’s Cake House was formed in January 01, 2009. On January 31, the balance sheet
showed: Cash $7000; Accounts Receivable $2000; Supplies $500; Office Equipment $5000,
Accounts Payable $5,500, Common Stock $7,500 and Retained Earnings $1,500, During
February, the following transactions occurred:
i. Collected $1,000 of accounts receivable
ii. Paid $1,200 cash on accounts payable
iii. Earned revenues of $10,000, of which $3,000 was collected in cash and the balance is
due in March
iv. Purchased additional office equipment for $2,000, paid $250 in cash and the balance
on account
v. Paid salaries $2,000, rent for February $1,500, and advertising expenses $450
vi. Paid dividends of $550
vii. Received $1,000 from Allied Bank-money borrowed on a note payable
viii. Incurred utility expense for the month on account $500.

Instructions: Prepare a tabular analysis of the February transactions in the table provided.
Prepare an income statement, a retained earnings statement, and a balance sheet for February.
ASSETS LIABILITIES STOCKHOLDERS’ EQUITY
No. Accounts Notes Accounts Common Retained
Cash Supplies Equipment
Receivable Payable Payable Stock Earnings
Starting
Amount
(if any)

Balance

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Solutions to Questions:
1. Classify each item as an asset, liability, or net worth:
a. Liability f. Liability
b. Net worth g. Asset
c. Liability h. Asset
d. Asset i. Net worth
e. Asset j. Net worth

2. a. NW = A − L = 800,000– 550,000 = $250,000

b. A = L + NW = (550,000 + 150,000) + (250,000 − 35,000) = $915,000

3.
Assets Liabilities Net Worth
a. + + NE
b. + NE +
c. - - NE
d. + NE +
e. NE NE NE
f. + + NE
g. NE + -
h. NE - +

4. The change in owner’s equity must come from a change in owner’s contribution, net
income/loss, and owner’s withdrawals.
$50,000 = $40,000 + 0 + 12,000 − Dividends
Dividends = $2,000

ASSETS LIABILITIES Net Worth

No. Accounts Notes Accounts Common
Cash Supplies Equipment Retained Earnings
Receivable Payable Payable Stock
Starting
$ 7,000 $ 2,000 $ 500 $ 5,000 $ 5,500 $ 7,500 $ 1,500
Amount
1 + 1,000 − 1,000

2 − 1,200 − 1,200

3 + 3,000 + 7,000 + 10,000 (Rev)

4 − 250 + 2,000 + 1,750

− 2,000 (Sal. Exp)
5 − 3,950 − 1,500 (Rent Exp)
− 450 (Adv. Exp)
6 − 550 − 550 (Div)

7 + 1,000 + 1,000

8 + 500 − 500 (Utl. Exp)

$ 6,050 $ 8,000 $ 500 $ 7,000 $ 1,000 $ 6,550 $ 7,500 $ 6,500
Balance
$ 21,550 $ 21,550

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 Anne’s Cake House
Income Statement
For the month ended February 28, 2009

Revenues
Service Revenue............................ ................. .... $ 10,000
Expenses
Salaries Expense ........................... ..... $ 2,000
Rent Expense ................................ ........ 1,500
Advertising Expense ...................... ........... 450
Utilities Expense ............................ ........... 500
Total Expenses ..................... ................. ...... $ 4,450
Net Income ........ .............................................. ................. ..... $ 5,550

Anne’s Cake House

Retained Earnings Statement
For the month ended February 28, 2009

Retained Earnings, February 1 ......................... ................. ...... $ 1,500

Add: Net Income .............................................. ................. ......... 5,550
.............................................. ................. ......... 7,050
Less: Dividends .............................................. ................. ........ __550
Retained Earnings, February 28 ....................... ................. ...... $ 6,500

Anne’s Cake House

Balance Sheet
February 28, 2009

Assets
Cash . ........ ........ .............................................. ..... $ 6,050
Accounts Receivable ......................................... ........ 8,000
Supplies..... ........ .............................................. ........... 500
Office Equipment .............................................. ........ 7,000
Total Assets ..................................... ................. .... $ 21,550

Liabilities and Stockholders’ Equity

Liabilities
Notes payable ......................................... ..... $ 1,000
Accounts payable .................................... ........ 6,550
Total liabilities ................................ ................. ...... $ 7,550
Stockholders’ Equity
Common Stock ........................................ ..... $ 7,500
Retained Earnings................................... ........ 6,500
Total Stockholders’ equity .............. ................. .... $ 14,000
Total liabilities and Stockholders’ equity .......... .... $ 21,550

Reference: Weygandt, J. et al. Hospitality Financial Accounting. Second Edition. John Wiley and Sons,
Inc, New Jersey. 2009

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