As I say in my newly posted article, “Equity Accounts – It’s Your Money“, the equity section of the balance sheet is the least understood. I give examples of the general ledger accounts that are found in the equity section for a sole proprietor, partnership, and corporation along with an explanation of how the accounts function.
The key to understanding these accounts is having a working knowledge of how debits and credits are recorded depending on whether a transaction calls for an increase or a decrease. Use the Accounting Model link in the article if you need brusing up.
For example, if you are a sole proprietor and you take money out of your business for personal purposes then you would record an entry on the debit side of the general ledger account “Owner’s Draw”. Increases to Equity require a credit entry, while decreases to Equity require a debit entry.
In the example, if you wrote yourself a check you would be decreasing Cash, which is an asset. Since you wrote the check to yourself, it makes sense that you decreased your Equity. Here is the tricky part and why you need to “think out” what you are doing using the Accounting Model:
You decreased your Equity by making a debit entry to Owner’s Draw and you decreased cash in your bank account when you withdrew money for personal reasons and made a credit entry to CASH. Seems straightforward doesn’t it?
But you increased the Owner’s Draw account while at the same time decreasing your equity. Sometimes this concept is hard for people to grasp. You just have to remember that Owner’s Draw is a general ledger account found within the Equity Section.
It is useful to remember the fundamental accounting equation:
ASSETS = LIABILITIES + EQUITY
When Cash, an asset, was decreased then either Liabilities or Equity would also have to be decreased in order to stay in balance. In this case, the decrease was in Equity.
The rule is that in any transaction recorded the DEBIT SIDE MUST EQUAL THE CREDIT SIDE of the ledger.