Accounting Equation: How Transactions Affects Accounting Equation?

Accounting Equation: How Transactions Affects Accounting Equation?Accounting equation suggests that for every debit there must be a credit.

Accounting is a way of getting information about the transactions and events with in the business in reports that are used by persons interested in the entity.

Assets, liabilities and owners’ equity are the three components of accounting equation that make up a company’s balance sheet.

The form in which we see accounting today is possible because of Luca Pacioli, a Renaissance era monk. He developed a method that tracks the success or failure of trading ventures over 500 years ago. This method is known as the “double-entry system”.

In a double-entry system the core theme is that an economic entity has a collection of assets and corresponding claims against those assets. But this claims are divided into 2; claims of creditors and owners.

For every debit there must be a credit, and vice versa. This leads us, then, to the basic equation in accounting;

Basic Accounting Equation

Basic Accounting Equation

Assets, liabilities and owners’ equity are the three components that make up a company’s balance sheet. The balance sheet, which shows a business’s financial condition at any point, is based on this equation.

This equation is the framework of tracking money as it flows in and out of an economic entity.

Assets

Assets or the economic resources of the entity which is owned by it. Items like; cash, accounts receivable (amounts owed to a firm by its customers), inventories, land, buildings, equipment, and even intangible assets like patents and other legal rights and claims.

Liabilities

Liabilities means claims of creditors which are the amounts of a business entity owed to 3rd parties like; money borrowed from the Lenders or creditors, due wages payment, payable bills and notes etc.

Owners’ Equity

Owners’ equity is known as the owner “interest” in the business. It is also referred as net assets, because it is equivalent to assets minus liabilities

Accounting Equation demonstrates the dual aspect of a transaction and proofs that Debit=Credit. Here is a table to show you effects of transactions on accounting equation.

Transaction Type

Assets

Liabilities + Equity

Buy fixed assets on creditFixed assets increaseAccounts payable (liability) increases
Buy inventory on creditInventory increasesAccounts payable (liability) increases
Buy inventory on creditInventory increasesAccounts payable (liability) increases
Pay dividendsCash decreasesRetained earnings (equity) decreases
Pay rentCash decreasesIncome (equity) decreases
Pay supplier invoicesCash decreasesAccounts payable (liability) decreases
Sell goods on credit (effect 1)Inventory decreasesIncome (equity) decreases
Sell goods on credit (effect 2)Accounts receivable increasesIncome (equity) increases
Sell services on creditAccounts receivable increasesIncome (equity) increases
Sell stockCash increasesEquity increases