Accounting Equation: How Transactions

Affects Accounting Equation?

Accounting equation suggests that for

every debit there must be a credit.
Accounting is a way of getting information about the transactions and
events within the business in reports that are used by persons interested in
the entity.
Assets, liabilities and owners’ equity are the three components of the
accounting equation that make up a company’s balance sheet.

The form in which we see accounting today is possible because of Luca

Pacioli, a Renaissance-era monk. He developed a method that tracks the
success or failure of trading ventures over 500 years ago. This method is
known as the “double-entry system”.
In a double-entry system, the core theme is that an economic entity has a
collection of assets and corresponding claims against those assets. But these
claims are divided into 2; claims of creditors and owners.
For every debit, there must be a credit, and vice versa. This leads us, then, to
the basic equation of accounting;
Basic Accounting Equation
Assets, liabilities and owners’ equity are the three components that make up a
company’s balance sheet. The balance sheet, which shows a business’s
financial condition at any point, is based on this equation.
This equation is the framework of tracking money as it flows in and out of an
economic entity.
Assets
Assets or the economic resources of the entity which is owned by it. Items
like; cash, accounts receivable (amounts owed to a firm by its customers),
inventories, land, buildings, equipment, and even intangible assets like
patents and other legal rights and claims.
Liabilities
Liabilities means claims of creditors which are the amounts of a business
entity owed to 3rd parties like; money borrowed from the Lenders or creditors,
due wages payment, payable bills, and notes etc.
Owners’ Equity
Owners’ equity is known as the owner “interest” in the business. It is also
referred to as net assets because it is equivalent to assets minus liabilities
Accounting Equation demonstrates the dual aspect of a transaction and
proofs that Debit=Credit. Here is a table to show you the effects of transactions
on the accounting equation.
Transaction Type Assets Liabilities + Equity
Buy fixed assets on Fixed assets Accounts payable (liability)
credit increase increases
Accounts payable (liability)
Buy inventory on credit Inventory increases
increases
Accounts payable (liability)
Buy inventory on credit Inventory increases
increases
Retained earnings (equity)
Pay dividends Cash decreases
decreases
Pay rent Cash decreases Income (equity) decreases
Accounts payable (liability)
Pay supplier invoices Cash decreases
decreases
Sell goods on credit
Inventory decreases Income (equity) decreases
(effect 1)
Sell goods on credit Accounts receivable
Income (equity) increases
(effect 2) increases
Accounts receivable
Sell services on credit Income (equity) increases
increases
Sell stock Cash increases Equity Increases

Accounting Transactions - Effect on the Fundamental

Accounting Equation

Every accounting transaction effects the Fundamental Accounting

Equation
Every Business transaction which is to be considered for accounting i.e. every
Accounting transaction, has its effect on the fundamental accounting equation.

Each transaction alters the expressions forming the equation in such a way that
the accounting equation is satisfied after every such alteration.

The values forming the various terms of the expressions within the equation are
altered in such a way that the basic fact, rule or equation, Capital + Liabilities =
Assets is always satisfied.

Illustration
Go through the explanation to the following few transactions which have
occurred towards the beginning of a newly started business.

1. A business is proposed to be started by Mr. Oberoi.

Since the business has only been proposed and not yet started it has
neither assets nor liabilities.

Capital + Liabilities = Assets

0 + 0 = 0

The equation is satisfied.

2. He brought in a cash of 1,00,000 as his capital contribution for the

business.

This transaction in accounting books is read and interpreted as

Started business with a capital of 1,00,000 in cash.

Since capital in the form of cash is being brought into the business,

 The value of capital has increased from zero to 1,00,000 and

 The cash available with the business has also increased from zero to
1,00,000.

Cash, since it is capable of being liquidated, is an asset.

Capital + Liabilities = Assets

1,00,000 + 0 = 1,00,000 (Cash)

The equation is satisfied.

3. He then purchased some furniture for 25,000.

Accounting interpretation of the transaction

Bought Furniture for cash 25,000.

Since Furniture is being bought by paying cash,

 The value of Furniture has increased from zero to 25,000.

Furniture, since it is capable of being liquidated, is an asset.

 The cash available with the business would reduce by 25,000 to

75,000.

This transaction does not have any effect on either capital or liabilities.

Capital + Liabilities = Assets

1,00,000 + 0 = 75,000 (Cash)

+ 25,000 (Furniture)

The equation is satisfied.

4. He then purchased some goods for cash for 25,000 from M/s Roxy
Brothers.

Accounting interpretation of the transaction

Bought Goods for cash 25,000.

Vendor/Seller name irrelevant in cash purchase

When we make a cash purchase, the party from whom the purchase is
made is irrelevant unless when there is a substantial time gap between the
transaction of purchase and transaction of paying cash that it requires us
to view them as distinct transactions.
 The vendor's name may also be considered if the organisation intends to
record all purchases as credit purchases. In such a case, the cash paid for
the purchase would be treated as payment made to clear the due. In such
a case, there would be two transactions in place of one. One for purchase
and the other for clearing the due.

The name of the vendor M/s Roxy brothers would become irrelevant, since
the purchase is for cash.

Since goods are bought by paying cash,

 The value of Goods/Stock has increased from zero to 25,000 and

Goods/Stock, since it is capable of being liquidated, is an asset.

 The cash available with the business would reduce by 25,000 to

50,000.

This transaction does not have any effect on capital, liabilities and
furniture.

Capital + Liabilities = Assets

1,00,000 + 0 = 50,000 (Cash)

+ 25,000 (Furniture)
+ 25,000 (Stock)

The equation is satisfied.

5. He then purchased some goods valued 10,000 from Mr. Shyam Rao on
credit.

Accounting interpretation of the transaction

Bought Goods from Mr. Shyam Rao on credit for 10,000.

Since 10,000 worth of goods have been bought on credit,

  The value of Goods/Stock has increased from the existing 25,000 to
35,000.
 The liabilities of the business would increase from zero to 10,000.

Since they are bought on credit, the organisation owes this amount
to the seller.

This liability is identified by the name of the vendor who gave the goods
on credit i.e. Mr. Shyam Rao and he is a creditor for the business.

This transaction does not have any effect on capital, furniture or cash.

Capital + Liabilities = Assets

1,00,000 + 10,000 (Mr. Shyam Rao) = 50,000 (Cash)

+ 25,000 (Furniture)
+ 35,000 (Stock)

The equation is satisfied.

6. He then sold some goods for 20,000 on cash basis to Mr. Peter.

Accounting interpretation of the transaction

Sold Goods for cash 20,000.

Buyer name irrelevant in cash sale

When we make a cash sale, the party to whom the sale is made is
irrelevant unless there is a substantial time gap between the transaction of
sale and transaction of receiving cash that it requires us to view the two as
distinct transactions.

The buyer's name may also be considered if the organisation intends to

record all sales as credit sales. In such a case, the cash received for the
sale would be treated as receipt to clear the due. In such a case, there
would be two transactions in place of one. One for sale and the other for
receiving the amount to clear the due.

The name of the buyer Mr. Peter would become irrelevant, since the sale
is for cash.

Since 20,000 worth of goods are sold for cash,

 The value of Goods/Stock has decreased from 35,000 to 15,000.

 The cash available with the business would increase from 50,000 to
70,000.

This transaction does not have any effect on capital, furniture and
liabilities i.e. Mr. Shyam Rao.

Capital + Liabilities = Assets

1,00,000 + 10,000 (Mr. Shyam Rao) = 70,000 (Cash)

+ 25,000 (Furniture)
+ 15,000 (Stock)

The equation is satisfied.

Please ignore the profit being made on sale of goods for now. Assume that
they are being sold at cost.

7. He then sold some goods on credit to M/s Bharat & Co., for 10,000.

Accounting interpretation of the transaction

Sold Goods on credit to M/s Bharat & Co., for 10,000.

Since 10,000 worth of goods have been sold on credit,

 The value of Goods/Stock decreases from 15,000 to 5,000.

 The debtors (assets) of the business would increase from zero to 10,000.

Since they are sold on credit, the buyer owes this amount to the organisation.
 This asset (debtor) is identified by the name of the buyer who bought the goods on
credit i.e. M/s Bharat & Co. and he is a debtor for the business.

Since a debtor can be liquidated by collecting the amounts due, they can be
considered as an asset.

This transaction does not have any effect on capital, furniture, cash and Mr. Shyam
Rao.

Capital + Liabilities = Assets

1,00,000 + 10,000 (Mr. Shyam Rao) = 70,000 (Cash)

+ 25,000 (Furniture)
+ 5,000 (Stock)
+ 10,000 (M/s Bharat & Co)

The equation is satisfied.

Note
Please ignore the profit being made on sale of goods. Assume that they are being
sold at cost.

8. He then opened a bank account and paid 60,000 cash into the bank account.

Accounting interpretation of the transaction

Paid Cash into Bank 60,000.

The amount paid into the bank is held by the bank on behalf of the organisation. The
same has to be paid by the bank to the organisation whenever they ask for it. The
bank therefore stands in the position of a debtor to the organisation.

The new asset is identified as Bank, optionally prefixed by the name of the bank, if
there is only one bank account (Bank a/c or Grindlays Bank a/c). Where the number
of bank accounts is more than one, the name of the bank is used as a prefix to
identify them distinctly (State Bank a/c, Grindlay's Bank a/c etc).

Bank, as it can be liquidated (converted into cash) by withdrawing money from it, is
an asset.

Since cash is paid into bank,

  The available cash reduces from 70,000 to 10,000.
 The value of debtor or the amount of bank balance increases from zero to
60,000.

This transaction does not have any effect on capital, furniture, stock, Mr. Shyam Rao
and M/s Bharat & Co.

Capital + Liabilities = Assets

1,00,000 + 10,000 (Mr. Shyam Rao) = 10,000 (Cash)

+ 25,000 (Furniture)
+ 5,000 (Stock)
+ 10,000 (M/s Bharat & Co)
+ 60,000 (Bank)

The equation is satisfied.

9. He then paid 5,000 cash to Mr. Shyam Rao.

Accounting interpretation of the transaction

Paid cash to Mr. Shyam Rao, 5,000.

Since cash is paid to Mr. Shyam Rao,

 The available cash reduces from 10,000 to 5,000.

 The value of the liability, creditor, represented by Mr. Shyam Rao also
reduces from 10,000 to 5,000.

This transaction does not have any effect on capital, furniture, stock, M/s Bharat &
Co. and Bank.

Capital + Liabilities = Assets

1,00,000 + 5,000 (Mr. Shyam Rao) = 5,000 (Cash)

+ 25,000 (Furniture)
+ 5,000 (Stock)
+ 10,000 (M/s Bharat & Co)
 Capital + Liabilities = Assets

+ 60,000 (Bank)

The equation is satisfied.

10. He then received 8,000 payment from M/s Bharat & Co.

Accounting interpretation of the transaction

Received cash from M/s Bharat & Co., on account, 8,000.

Since cash is received,

 The available cash increases from 5,000 to 13,000.

 The value of the asset, debtors, represented by M/s Bharat & Co., also
reduces from 10,000 to 2,000.

This transaction does not have any affect on capital, furniture, stock, Mr. Shyam Rao
and Bank.

Capital + Liabilities = Assets

1,00,000 + 5,000 (Mr. Shyam Rao) = 13,000 (Cash)

+ 25,000 (Furniture)
+ 5,000 (Stock)
+ 2,000 (M/s Bharat & Co)
+ 60,000 (Bank)

The equation is satisfied.

The affected accounts can be on any side of the equation

The two accounts affected by an accounting transaction may both be on the same side of the
equation or one on each side of the equation. It is not a necessity that one on either side is
affected.

Conclusion
Each and every accounting transaction has its effect on the accounting equation. Every
transaction alters the constituents of the equation in such a way that the equation is satisfied after
every such alteration..

We can conclude that the accounting equation is satisfied at any point of time during the life time
of an organisation.

Practice Problems - Fundamental Accounting Equation

Note
The equation may also be presented in a horizontal form, just like a mathematical equation,
instead of as a statement, as below.

Capital + Liabilities = Assets

1,00,000 + Mr. Shyam Rao (5,000) = Cash (13,000) + Furniture (25,000) + Stock (5,000)
+ Bank (60,000) + M/s Bharat & Co (2,000)

Author : The Edifier

Notes 10