Transactions Analysis and Accounting Equations

Business transaction may affect only the assets, or only the assets and liabilities or only the assets and capital of the proprietor; they may affect only the liabilities or the liabilities and the capital together. A transaction may affect all the three elements of the accounting equation (i.e., A=L+C) at the same time. The cardinal rules of transactions analysis are: (1) The accounting equations must remain balanced at all times; the changes resulting from each transaction must also balance each other. (2) Expenses are recognized when resources are used up to create current revenues; whether cash is paid for these resources at the time they are used or earlier has no bearing on all question of when expenses take place. The following examples indicate some of the possibilities:

(i)    Increase in one asset, decrease in another:

Machinery increases and cash decreases due to purchase of machinery for cash; similarly cash increases and debtors decrease when cash is collected from customers.

(ii)    Increase in assets, increase in liabilities:

Stock of goods increases and creditors or bills payable increase when goods are purchased on credit. And also cash increases and creditors or bills payable increase when the enterprise obtains a loan.

(iii)    Increase in assets, increase in capital:

Land, Building, Furniture etc., increase and capital increases when the owner introduces these assets into the business as a part of his capital investments. Similarly if capital is introduced in cash, the transaction would increase the cash as well as the capital of the proprietor.

(iv)    Decrease in assets, decrease in liabilities:

Cash decreases, liabilities decreases when some creditor is paid an amount owed to him.

(v)    Decrease in assets, decrease in capital:

Depreciation of fixed assets or amortization of intangibles causes a corresponding decrease in capital. Similarly administrative and financial expenses like rent, salaries, commission, interest on borrowing etc., decrease the assets and also the capital.

(vi)    Increase and decrease in liability:

Bills payable accepted for creditors will reduce liabilities towards creditors and fresh liabilities creditors and fresh liability in the form of bills payable will come into existence.

(vii)    Increase in liability and decrease in capital:

When capital is converted into a loan or a liability. For example, when a partner retires from the firm, his account must be settled, i.e., paid in cash. But if it is not paid immediately, it is transferred to retiring partner’s loan accounts.

(viii)    Increase and decrease in capital:

Interest on capital is added to proprietor’s capital account and in this way the capital increases. But it is an expense of the business and so it will have to be borne by the owner and will therefore reduce the capital. The net result would be an increase and decrease in capital simultaneously with the same account.

(ix)    Increase in capital decrease in liability:

Conversion of loan into capital reduces the liability but increases the capital. But increases the capital. Conversion of debentures into shares is a typical example and so is the issue of share capital to creditors for goods.

(x)    Increase in one liability, decrease in another liability:

Conversion of a part of short term liability into long term liability by issuing of debentures to creditors for goods.

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