# 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.

1. 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.

2. 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.

3. 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.

## Profit on Sale

Assume that goods costing 20,000 have been sold at a profit of 8,000 for 28,000.

Accounting interpretation of the transaction

Sold Goods for cash 28,000.

Since 20,000 worth of goods are sold for cash for 28,000 making a profit of 8,000,

• The value of Goods/Stock decreases from 35,000 to 15,000.
• The cash available with the business would increase from 50,000 to 78,000.
• Since there is a profit of 8,000, capital increases by 8,000 to 1,08,000.

Profits increase capital.

Capital + Liabilities = Assets
1,08,000 + 10,000 (Mr. Shyam Rao) =    78,000 (Cash)
+ 25,000 (Furniture)
+ 15,000 (Stock)

We ignored the profit element and considered the sale to be at cost to make the understanding a bit easier.

1. 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.

2. 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.

3. 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)
+ 60,000 (Bank)

The equation is satisfied.

4. 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.

• 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.

## 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)