Indicate How Each Business Transaction Affects the Basic Accounting Equation

The accounting equation represents the relationship between the assets, liabilities and uppercase of a concern and it is cardinal to the application of double entry bookkeeping where every transaction has a dual effect on the fiscal statements. The purpose of this article is to consider the fundamentals of the bookkeeping equation and to demonstrate how it works when practical to diverse transactions.

Yous should refer to your learning materials for more than detail and to acquire most the journal entries that would be required to record the transactions outlined below.

What is the accounting equation?

In its simplest class, the bookkeeping equation can be shown as follows:

Upper-case letter = Assets – Liabilities

Capital tin exist defined as beingness the residue interest in the avails of a business concern after deducting all of its liabilities (ie what would be left if the business concern sold all of its avails and settled all of its liabilities). In the case of a limited liability company, capital letter would be referred to every bit ‘Equity’.

Capital substantially represents how much the owners accept invested into the business forth with any accumulated retained profits or losses. For example, if you were to beginning a sole trade business organisation with a $1,000 investment then on the first day of trading the accounts of the business would show that it has $one,000 of cash available and that this came from an investment made past yous. The capital would ultimately belong to y’all as the business owner.

The accounting equation can also be rearranged in several ways, including:

Assets = Uppercase + Liabilities

In this format, the formula more clearly shows how the avails controlled past the business have been funded. That is, through investment from the owners (capital) or by amounts owed to creditors (liabilities). Yous may also notice ii other interesting points regarding the formula beingness laid out in this style:

1. It reflects the format of the statement of financial position (ie avails are presented outset and the full assets figure balances with the total amount of equity and liabilities); and
2. It more clearly reflects the fact that total debits will ever equal total credits (ie Assets (Dr) = Capital (Cr) + Liabilities (Cr))

What about drawings, income and expenses?

Drawings are amounts taken out of the business by the business owner. They will therefore result in a reduction in capital.

Income and expenses relate to the entity’s financial operation. Individual transactions which consequence in income and expenses being recorded will ultimately result in a profit or loss for the period. The term capital includes the capital introduced past the business owner plus or minus whatsoever profits or losses made past the business concern. Profits retained in the business will increase capital letter and losses will subtract majuscule. The bookkeeping equation will always balance because the dual attribute of bookkeeping for income and expenses will result in equal increases or decreases to assets or liabilities.

The accounting equation can be expanded to incorporate the impact of drawings and profit (ie income less expenses):

Assets = Capital introduced + (Income – Expenses) – Drawings + Liabilities

Practical example

We will now consider an example with various transactions within a business to see how each has a dual aspect and to demonstrate the cumulative effect on the accounting equation.

Instance
Anushka began a sole trade business on 1 January 20X1. During the first month of trading, the post-obit transactions took place:

1. She started the business with $5,000 of cash
2. She took out a loan from the banking company of $x,000
3. She purchased a van for $12,000 greenbacks
4. She purchased 100 units of inventory on credit at a total cost of $2,500 (ie $25 per unit of measurement)
5. She sold x units of inventory to a customer on credit for a full of $400 (ie $40 per unit)
6. She paid interest on the loan of $60
7. She repaid $250 of the loan
8. She took $x from the business organization bank account to encompass a personal expense

Required
Explain how each of the to a higher place transactions impact the accounting equation and illustrate the cumulative effect that they have.

Solution
The impact of each of the above transactions has been outlined below, followed past a summary of the cumulative consequence of these transactions on the accounting equation:

1. The greenbacks (asset) of the business organisation volition increase by $5,000 every bit will the amount representing the investment from Anushka equally the possessor of the business organization (capital).

ii. $ten,000 of cash (nugget) will exist received from the bank only the business must as well tape an equal amount representing the fact that the loan (liability) volition eventually need to be repaid.

3. The assets of the business will increment by $12,000 equally a result of acquiring the van (nugget) but will too decrease past an equal amount due to the payment of cash (nugget).

4. The inventory (asset) of the business volition increment by the $2,500 cost of the inventory and a merchandise payable (liability) will be recorded to represent the corporeality now owed to the supplier. (Note that in the accounting records, the purchase of inventory may be recorded as an expense initially and then an aligning made for endmost inventory at the year-end. Any inventory not sold volition ultimately be recorded equally an asset though).

five. Anushka volition tape revenue (income) of $400 for the auction made. A trade receivable (asset) will be recorded to correspond Anushka’south right to receive $400 of cash from the customer in the future. As inventory (nugget) has at present been sold, it must be removed from the bookkeeping records and a toll of sales (expense) figure recorded. The cost of this sale will be the cost of the ten units of inventory sold which is $250 (10 units x $25). The difference between the $400 income and $250 toll of sales represents a turn a profit of $150. The inventory (asset) will decrease by $250 and a cost of sale (expense) volition exist recorded. (Annotation that, every bit above, the adjustment to the inventory and toll of sales figures may be made at the year-end through an aligning to the closing stock but has been illustrated below for completeness).

6. Interest (ie finance costs) are an expense to the business. Therefore cash (nugget) volition reduce by $60 to pay the interest (expense) of $60.

7. The business organization has paid $250 greenbacks (asset) to repay some of the loan (liability) resulting in both the cash and loan liability reducing by $250.

8. Cash (nugget) will reduce past $ten due to Anushka using the cash belonging to the business to pay for her own personal expense. Equally this is not really an expense of the business, Anushka is finer beingness paid amounts owed to her equally the possessor of the business (drawings).

The cumulative effect of each of the above transactions on the bookkeeping equation has been summarised below:

As you can see, no thing what the transaction is, the accounting equation will always balance because each transaction has a dual aspect. Often, more than one chemical element of the accounting equation is impacted but sometimes, like with transaction 3, the same function of the equation (in this instance assets) goes up and down, making it look like nothing has happened. Even so, the detail of the transaction will exist presented in unlike places in the financial statements (ie the cash balance within electric current avails volition reduce and the motor vehicle cost balance inside non-current assets will increase).

Summary

Taking fourth dimension to larn the accounting equation and to recognise the dual aspect of every transaction volition assist you to empathise the fundamentals of accounting. If you are unsure almost what accounts will be afflicted by a particular transaction, it can sometimes exist helpful to think about just one of the accounts which might be affected, for example cash (asset), then employ your knowledge of the bookkeeping equation to work out the other i. Whatsoever happens, the transaction will always result in the accounting equation balancing.