The basis of accounting is accounting equation. It is necessary to understand its meaning to be able identifying how transactions impact accounting equation and financial position of the entity.
Properties (can be material, immaterial, monetary) owned by the entity are called assets. All the assets of the entity are financed by different means either owner’s means, which are called equity, either means provided by the creditors, called liabilities. These means of finance are claims of the financers to the assets of the entity. Therefore value of the assets in any entity must be equal to the sum of equity and liabilities creating equation:
Upon analyzing business transactions all the time it is required to identify how they impact each part of this equation, i.e. how they impact assets, equity or liabilities.
Examples below provide analysis of basic types of transactions and their impact on the accounting equation.
1st transaction: One shareholder establishes a company which will provide copying services. The shareholder invests 15000$ in cash opening entity’s bank account and transferring cash into bank account. The impact of this transaction on the equation is provided below, i.e. cash (assets) increases by 15000$ and share capital (owners’ equity) increases by 15000$, as investment is made from the own means of the shareholder.
2nd transaction: the entity acquires copying equipment for 8000$ paying in cash from its’ bank account. As a result cash decreases by 8000$ and equipment increases by 8000$. Before reflecting impact of this transaction on the equation, please note, that the equation starts from the figures transferred after the previous transaction was reflected, i.e. opening cash balance is 15000$ and opening owners’ equity balance is 15000$. This is done after each transaction is reflected. Please pay attention to the tact, that in this case owners’ equity does not change, as only structure of the assets changed, i.e. cash was exchanged into equipment. After reflecting impact of this transaction on the equation, you can see that still the equation remains, i.e. cash plus equipment is equal to owners’ equity, which is a must. If there is not equation, a mistake upon reflecting transaction in the equation was made.
3rd transaction: inventory is purchased to provide services. Price of inventory is 900$, the acquisition is made on credit, i.e. the suppliers will be paid after 30 days. In this case there is a change, i.e. increase in assets (inventory) by 900$. As the entity does not pay cash at once, but remains liable for the inventory liabilities of the entity increase, i.e. accounts payable increase by 900$. Again we have an equation.
4th transaction: part of the accounts payable, i.e. 500$ was paid from bank account to suppliers of inventory. In this case liabilities of the entity changed, i.e. decreased by 500$, as cash amounting to 500$ was paid to suppliers, causing decrease in assets.
5th transaction: services for 6000$ were provided to customers, who paid in cash. In this case the company receives income for the services provided. Income represents increase in owners’ equity, as belong to the owners. Therefore as a result of this transaction owners’ equity increases by 6000$ and assets (cash) increase by 6000$, as customers pay in cash.
6th transaction: inventory used in providing services (220$) was expensed, i.e. written off. In this case the company incurred expenses. Contrary to income, which cause increase in owners’ equity, expenses cause decrease in owners’ equity. Therefore there is a decrease in inventory by 220$ and decrease in owners’ equity by 220$. Once again after reflecting this transaction, there is an equation, i.e. assets are equal to the sum of liabilities and owners’ equity.
In order to have a full picture of all the transactions, below you can find a summary. The summary shows an impact of each transaction on the accounting equation and at the end there is a balance, i.e. equation between assets and sum of liabilities and owners’ equity.
Further through all the learning process the below company Alfa will be used. The following transactions occurred during June 2007 in Alfa:
1. June 1, 2007: Alfa was established to provide copying services and sell stationery. Invest own capital in cash to Alfa’s bank account – 20000$ and take a loan from bank in the name of Alfa – 15000$
2. June 2, 2007: Alfa acquired fixed assets: equipment – 19000$; current assets: inventory (for sale) – 5000$. Part of total acquisition price was paid in cash – 4000$, remaining part to be paid after 30 days
3. June 3, 2007: Alfa acquired office supplies for cash – 2500$
4. June 4, 2007: Alfa paid in cash for office insurance, insurance period - one year, insurance price 1500$
5. June 5, 2007: Alfa partly paid suppliers by cash for the equipment and inventory acquired on June 2, 2007 – 3500$
6. June 15, 2007: Alfa provided copying services to customers – 7000$. 5000$ was received in cash, remaining part to be received after 30 days
7. June 19, 2007: Alfa sold all stationery for cash, sales price – 6500$
8. June 21, 2007: customers, which acquired copying services on June 15, 2007 paid partly their debt – 1000$
Below there is an analysis how these transactions impact accounting equation.
1st transaction results increase in cash by 35000$ (investment of shareholder and loan from bank), increase in owners’ equity (share capital) by 20000$ and increase in liabilities (loan) by 15000$.
2nd transaction results increase in equipment by 19000$, inventory 5000$, decrease in cash by 4000$, as part of the acquisition price was paid in cash, and increase in liabilities (accounts payable) by 20000$ (total acquisition price 19000$+5000$ minus paid in cash 4000$).
3rd transaction results increase in office supplies (assets) by 2500$ and decrease in cash by 2500$ as all acquisition price of inventory was paid in cash.
4th transaction results increase in prepaid expenses (insurance) by 1500$. Prepaid expenses represent certain expenses which are paid in advance and which will be incurred in the future. As an example is insurance, for which Alfa pays in advance for the whole year and these expenses actually will be incurred through the whole year. As Alfa paid for insurance in cash, there is a decrease in cash by 1500$.
5th transaction results decrease in cash by 3500$ and decrease in liabilities (accounts payable) by 3500$, as Alfa paid part of its debt to the suppliers of the equipment and inventory acquired on June 2, 2007.
6th transaction results increase in owners’ equity by 7000$, as Alfa earned income, which as it was mentioned above belong to the owners. Also there is an increase in cash by 5000$ and in accounts receivable, i.e. debt from customers, by 2000$ (income 7000$ minus cash received 5000$). Debt from customers or accounts receivable represent assets, as these are rights of Alfa to claim cash from customers for the services provided.
7th transaction. This transaction is more complicated that the above described, as there are two parts:
1. sale of inventory represent income amounting to 6500$, which results increase in cash by 6500$ and increase in owners’ equity by 6500$.
2. Alfa sold all inventory, which was acquired on June 2, 2007. The cost of this inventory amounting to 5000$ represents expenses incurred, i.e. cost of inventory sold. Therefore upon selling this inventory there is a decrease in inventory by 5000$ and decrease in owners’ equity by 5000$. In total Alfa earned 1500$ profit on the sale of inventory, i.e. sales income (6500$) minus cost (5000$)
8th transaction results increase in cash by 1000$ and decrease in account receivable, i.e. debt from customers decreases as they paid their debt.
And finally there is a summary of all the transactions, indicating that at the end there is an equation between assets and sum of liabilities and owners’ equity.
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