The accounting equation provides a business with a self-balancing financial tool. Like any algebraic tool, each side of the accounting equation must balance against itself. Individual business transactions will affect either one side or both sides at the same time. Owners who withdraw cash from their business will affect both sides of the equation.
The accounting equation is assets equal liabilities plus owner’s equity. Assets include all items a company owns. Through ownership, assets provide value as a company uses them to complete business operations. Liabilities represent money owed to creditors and vendors. In some cases, a liability can have a claim against assets. Owner’s equity is the capital an entrepreneur invests into his business or retains in the company from net profits earned.
For example, Sam, owner of Widgets, Inc, invests $10,000 to start his new business. He records a journal entry to debit cash and credit his personal capital account, which resides under the owner’s equity of Widgets, Inc. This increases both sides of the accounting equation. Sam then withdraws $500 to pay personal expenses. He enters a journal entry that debits a personal draw (also under owner’s equity) account and credits cash. This decreases both sides of the accounting equation.
Sole proprietorships are typically the only businesses that have an owner’s equity and personal draw accounts. This allows the owner to remove money from his business in order to pay personal expenses. In many cases, an owner is free to make as many personal deposits and withdrawals at any time. Keeping the entries to a minimum, however, is best, so the company will retain enough capital to pay for operational expenses.
Owner’s equity transactions do not affect a company’s income statement. Draws -- though a reduction to the company’s cash account -- do not represent an expense. Instead, they simply reduce the capital retained by the company for internal use. The balance sheet reports all necessary information regarding owner deposits and withdrawals from the business.