Effect of Transactions on the Accounting Equation

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

Follow 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 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.

    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 value of cash 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.
    • The cash available with the business would reduce by 25,000 to 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 =    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 have an accounting record of from whom, what and how much is being purchased, in which case the purchase is recorded as a credit purchase and the due is considered to have been cleared immediately.

    Thus, 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.

    Since goods are bought by paying cash, the value of Goods/Stock has increased from zero to 25,000 and the cash available with the business would reduce by 25,000 to 50,000.

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

    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.

  1. 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, the value of Goods/Stock has increased from the existing 25,000 to 35,000.

    Since they are bought on credit, the organisation owes this amount to the seller and thereby the liabilities of the business would increase from zero to 10,000.

    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.

  2. 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 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 is considered to have been cleared immediately.

    Thus, 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.

    Since 20,000 worth of goods are sold by taking 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.

    Note

    Please ignore the profit being made on sale of goods. If needed assume that they are being sold at cost.

  3. 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, the value of Goods/Stock decreases from 15,000 to 5,000.

    Since they are sold on credit, the buyer owes this amount to the organisation and thus becomes a debtor to the organisation to the extent of the sale value 10,000.

    Since a debtor can be liquidated by collecting the amounts due, they can be considered as an asset. This asset is identified by the name of the buyer i.e M/s Bharat & Co. here.

    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. If needed assume that they are being sold at cost.

  4. 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.

    Since cash is paid into bank, the available cash reduces from 70,000 to 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" optionally prefixed by the name of the bank if there is only one bank account (Bank a/c or Grindlays Bank a/c). Where there are more than one bank accounts, 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 is an asset as it can be liquidated (converted into cash) by withdrawing money from it.

    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.

  5. 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 amount due to Mr. Shyam Rao, the value of the liability represented by his name i.e. creditors 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)
    + 60,000 (Bank)

    The equation is satisfied.

  6. 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 amount due from M/s. Bharat & Co, the value of the asset identified by its name i.e debtors also reduce 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

Note that the two accounts that are affected by the transaction may be both 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 the form of an 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)