In this lesson we're going to go over some liability examples for our sample business, George's Catering. We'll first see how the accounting equation is affected when we enter into a liability, and then we'll see what happens when we pay this off.
Liability Example #1: Taking Out a Loan
In our first lesson George deposited $15,000 of his personal funds into the business. The accounting equation for George's Catering therefore stands at $15,000 assets and $15,000 owner's equity.
b) George realizes that he needs more money to create a really high-quality catering business. Yet he does not have any more personal funds available to invest in the business. He decides to take a loan from the bank to the value of $5,000.
This easiest part of working out what the impact is on the accounting equation is first looking at cash. As you can see, $5,000 more cash is available for the business. Since cash is an asset, this means that our assets are increasing.
The second part is looking at the source of this cash. In this case, the cash was obtained through a loan, which is a liability.
Are liabilities increasing or decreasing? Answer is that they're increasing - George's Catering has more debt now - they had $0 liabilities previously, but now they owe $5,000.
In our previous example the assets were funded by the owner, so assets and owners equity changed, with liabilities amounting to zero. This time the assets and liabilities changed, but not the equity.
The liability means that external parties (the bank) now have a $5,000 claim to the total assets of the business.
The owner’s stake in the assets of the business is unaffected - still $15,000. The owner now really owns only 75% of the assets ($15,000 / $20,000).
Want to see the journal entry for this transaction?
This second liability example is taken from a later section of my basic accounting book after a few other transactions already took place. At this stage, George's Catering consisted of:
$30,800 assets ($12,000 baking equipment and $18,800 bank),
$25,800 owner's equity and
$5,000 liabilities (the bank loan).
k) George sees that he has quite a bit of spare cash, and so decides to pay back most of the loan from the bank. He writes out a check for $4,000. What happens to our equation?
This second example is the exact opposite of the first one: instead of receiving money from the bank, we're paying them back.
Again the easiest part of this transaction is the cash component. A loan repayment of $4,000is made. This means that our cash or bank decreases.
Since cash or bank is an asset, our assets decrease by $4,000.
The second part is looking at what this payment is for. The payment is for the loan, a liability. Since we're paying it off, does this mean our loan is going to increase, decrease or stay the same? The answer is that the loan is going to decrease. This means that liabilities decrease by $4,000.
So both our bank (assets) as well as the loan (liabilities) are going to decrease:
George’s Catering now consists of assets of $26,800, made up of baking equipment to the value of $12,000, and $14,800 bank ($18,800 - $4,000).
The liability to the bank has decreased from $5,000 to $1,000.
Okay, so that's it for our accounting equation liability examples. I hope that all makes sense!
If you're having any difficulty with understanding the examples above, it would probably be a very good idea to check out our earlier lesson on the Basic Accounting Equation.