Effect of Transactions on the Accounting Equation

... From Page 8

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 even after such an alteration. The values forming the various terms of the expressions within the equation are altered in such a way that the basic fact/rule/equation (i.e. Capital + Liabilities = Assets) is always satisfied.

» Illustration

Consider the following few transactions explained one after the other in relation to a business in the starting stage.
  1. A business 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 Rs. 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 Rs. 1,00,000.

    Since capital is being brought into the business in cash, the value of Capital has increased from zero to Rs. 1,00,000 and the value of cash has also increased from zero to Rs. 1,00,000. Cash since it is capable of being liquidated is an asset.

    Capital+Liabilities=Assets
    1,00,000 + 0 = Cash (1,00,000)

    The equation is satisfied.

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

    Accounting interpretation of the transaction » "Bought Furniture for cash Rs. 25,000."

    Since Furniture is being bought by paying cash, the value of Furniture has increased from zero to Rs. 25,000 and the cash available with the business would reduce by Rs. 25,000 to Rs. 75,000. Furniture since it is capable of being liquidated is an asset. This transaction does not have any effect on either capital or liabilities.

    Capital+Liabilities=Assets
    1,00,000 + 0 = Cash (75,000) + Furniture (25,000)

    The equation is satisfied.

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

    Accounting interpretation of the transaction » "Bought Goods for cash Rs. 25,000."

    • Vendor Name irrelevant in Cash Purchase

    Though the goods have been purchased from M/s Roxy brothers, their name has no relevance while the transaction is being considered for accounting purposes, since the purchase is for cash.

    When we make a cash purchase, the party from whom the purchase is made is irrelevant unless there is a time gap between the transaction of purchase and transaction of paying cash.

    The vendor's name may also be considered if the organisation intends to have an accounting record of who purchases what and how much, in which case the purchase is recorded as a credit purchase and the due cleared immediately.

    Since goods are bought by paying cash, the value of Goods has increased from zero to Rs. 25,000 and the cash available with the business would reduce by Rs. 25,000 to Rs. 50,000. Goods since it is capable of being liquidated is an asset. This transaction does not have any effect on capital, liabilities or furniture.

    Capital+Liabilities=Assets
    1,00,000 + 0 = Cash (50,000) + Furniture (25,000) + Stock (25,000)

    The equation is satisfied.

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

    Accounting interpretation of the transaction » "Bought Goods from Mr. Shyam Rao on credit for Rs. 10,000."

    Since goods are bought, the value of Goods has increased from Rs. 25,000 to Rs. 35,000. Since they are bought on credit, the liabilities of the business would increase from zero to Rs. 10,000. This liability is identified by the name of the vendor who gave the goods on credit i.e. Mr. Shyam Rao. This transaction does not have any effect on capital, furniture or cash.

    Capital+Liabilities=Assets
    1,00,000 + Mr. Shyam Rao (10,000) = Cash (50,000) + Furniture (25,000) + Stock (35,000)

    The equation is satisfied.

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

    Accounting interpretation of the transaction » "Sold Goods for cash Rs. 20,000."

    • Buyer Name irrelevant in Cash Sale

    Though the goods have been sold to Mr. Peter, his name has no relevance while the transaction is being considered for accounting purposes, since the sale is for cash.

    When we make a cash sale, the party to whom the sale is made is irrelevant unless there is a time gap between the transaction of sale and transaction of receiving cash.

    The buyer's name may also be considered if the organisation intends to have an accounting record of who bought what and how much, in which case the sale is recorded as a credit sale and the due cleared immediately.

    Since goods are sold by taking cash, the value of Goods has decreased from Rs. 35,000 to Rs. 15,000. The cash available with the business would increase from Rs. 50,000 to Rs. 70,000. This transaction does not have any effect on capital, furniture or liabilities i.e. Mr. Shyam Rao.

    Capital+Liabilities=Assets
    1,00,000 + Mr. Shyam Rao (10,000) = Cash (70,000) + Furniture (25,000) + Stock (15,000)
    The equation is satisfied.

    Note

    Please ignore the profit being made on sale of goods. If needed assume that they are being sold at cost.
  7. He then sold some more goods on credit to M/s Bharat & Co., for Rs. 10,000.

    Accounting interpretation of the transaction » "Sold Goods on credit to M/s Bharat & Co., for Rs. 10,000."

    The value of Goods has decreased from Rs. 15,000 to Rs. 5,000. M/s Bharat & Co., being a debtor (those who owe us money) can be liquidated and therefore can be considered as an asset. Thus, a new asset in the form of M/s Bharat & Co., is created. The new asset is identified by the name of the organisation which purchased the goods on credit. This transaction does not have any effect on capital, furniture, liabilities i.e. Mr. Shyam Rao, or cash.

    Capital+Liabilities=Assets
    1,00,000 + Mr. Shyam Rao (10,000) = Cash (70,000) + Furniture (25,000) + Stock (5,000)
    + M/s Bharat & Co (10,000)

    The equation is satisfied.

    Note

    Please ignore the profit being made on sale of goods. If needed assume that they are being sold at cost.
  8. He then opened a bank account and paid Rs. 60,000 cash into the bank account.

    Accounting interpretation of the transaction » "Paid Cash into Bank Rs. 60,000."

    Since cash is paid into bank, the available cash reduces from Rs. 70,000 to Rs. 10,000. The amount paid into the bank is held by the bank on our behalf. The bank has to pay us the same whenever we ask for it. The bank therefore stands in the position of a debtor to us (those who owe us money).

    The new asset is identified as "Bank" if there is only one bank account. Where there are more than one bank account, each bank is identified by its name. Since "Bank" can be liquidated (converted into cash) by withdrawing money from it, can be treated as an asset. This transaction does not have any effect on capital, furniture, stock, Mr. Shyam Rao or M/s Bharat & Co..

    Capital+Liabilities=Assets
    1,00,000 + Mr. Shyam Rao (10,000) = Cash (10,000) + Furniture (25,000) + Stock (5,000)
    Bank (60,000) + M/s Bharat & Co (10,000)

    The equation is satisfied.

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

    Accounting interpretation of the transaction » "Paid Cash to Mr. Shyam Rao, Rs. 5,000."

    Since cash is paid to Mr. Shyam Rao, the available cash reduces from Rs. 10,000 to Rs. 5,000 and the liability in the name of Mr. Shyam Rao (the amount due to him) also reduces from Rs. 10,000 to Rs. 5,000. This transaction does not have any effect on capital, furniture, stock, M/s Bharat & Co., or Bank.

    Capital+Liabilities=Assets
    1,00,000 + Mr. Shyam Rao (5,000) = Cash (5,000) + Furniture (25,000) + Stock (5,000)
    Bank (60,000) + M/s Bharat & Co (10,000)

    The equation is satisfied.

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

    Accounting interpretation of the transaction » "Received cash from M/s Bharat & Co., on account, Rs. 8,000."

    Since cash is received from M/s Bharat & Co., the available cash increases from Rs. 5,000 to Rs. 13,000 and the asset identified as M/s. Bharat & Co (the amount receivable from them) also reduces from Rs. 10,000 to Rs. 2,000. This transaction does not have any affect on capital, furniture, stock, Mr. Shyam Rao or Bank.

    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)

    The equation is satisfied.

Conclusion

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

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

Practice Problems » Fundamental Accounting Equation

Author Credit : The Edifier ... Continued Page 10

♣ Copyright Krishbhavara. All rights reserved ♣ Site optimized for Internet Explorer 5.5 and above