3.3 What are the effects of business transactions on the accounting equation?

Question 1

From whose point of view are all business transactions recorded?

Answer 1

From the point of view of the business, in accordance with the accounting entity concept.

Question 2

Why are all businesses transactions recorded from the point of view of the business?

Answer 2

In order to observe / comply with the accounting entity / business entity concept.

Question 3

Recap:

What does the accounting entity concept state?

Answer 3

The accounting entity / business entity concept states that the business is a separate entity from its owner, and that all transactions are recorded from the point of view of the business; or
only business transactions affecting the business are recorded in the books of the business. The personal transactions of the owner are not recorded.

Question 4

Do all business transactions have an effect on the accounting equation / balance sheet equation?

Answer 4

Yes.

Question 5

List the two effects that all business transactions will have on the accounting / balance sheet equation.

Answer 5

1. Each business transaction will have at least two effects on the accounting equation.
2. After each transaction is recorded, the accounting equation must maintain / keep its balance.

Note: If the above rules are not observed, there will be errors.

Question 6

Example 3 of Textbook (Page 35)
Marissa set up Sweet Candy, a sole proprietorship and has the following cash transaction.
Identify the effect of the following transaction on the accounting equation.

Transaction (a):
1 Feb - Marissa contributed $10000 of her personal cash into the business.

Answer 6

Cash contribution by owner
Assets = Cash +$10000
Equity = Capital +$10000

A = E

From the point of view of Sweet Candy, the business receives cash of $10000. Assets increase as cash is an asset. The cash is from Marissa, the owner. Any resources contributed by the owner are known as capital.Therefore equity increases as capital is an equity. Both assets and equity increase by $10000. This is in line with the rule of each transaction having at least two effects on the accounting equation.
After this transaction, the value of assets is $10000 and the value of equity is also $10000. The accounting equation A=L+E is balanced.

Question 7

Example 3 of Textbook (Page 35)
Marissa set up Sweet Candy, a sole proprietorship and has the following cash transaction.
Identify the effect of the following transaction on the accounting equation.

Transaction (b):
2 Feb - The business obtained from DEF Bank a loan of $5000.

Answer 7

Borrowing

Assets = Cash = +$5000 
Liabilities = Bank Loan = +$5000

A=L
Sweet Candy receives cash of $5000 and now owes DEF Bank $5000. Again, assets increase. The amount owed is a liability which is increased. Both assets and liabilities increase by $5000, and there are at least two effects on the accounting equation.

Question 8

Example 3 of Textbook (Page 35)
Marissa set up Sweet Candy, a sole proprietorship and has the following cash transaction.
What are the values of of Assets, Liabilities and Equity after transactions (a) and (b) are recorded?

Answer 8

After transactions (a) and (b) are recorded, the value of:
Assets = $10000+$5000 = $15000
Liabilities = $5000
Equity = $10000

The accounting equation is balanced.
A= L + E

Question 9

Example 3 of Textbook (Page 35)
Marissa set up Sweet Candy, a sole proprietorship and has the following cash transaction.
Identify the effect of the following transaction on the accounting equation.

Transaction (c):
7 Feb - The business purchased candies for $6000 cash.

Answer 9

Cash purchase of goods
Asset - Cash = -$6000
Asset - Inventory = +$6000

Sweet Candy pays cash of $6000 and now has goods of $6000. The candies bought are the business inventory (current asset). The business has changed one type of asset for another: from cash to inventory. Overall there is no change in the amount of asset.

Question 10

Example 3 of Textbook (Page 35)
Marissa set up Sweet Candy, a sole proprietorship and has the following cash transaction.
Identify the effect of the following transaction on the accounting equation.

Transaction (d):
12 Feb - The business sold candies for $2,600 cash. The cost of the candies was $1,800.

Answer 10

Cash sale of goods
Asset - Cash = +$2600
Asset - Inventory = -$1,800
Equity - Sales Revenue (Income) = +$2600
Equity - Cost of sales (Expense) = -$1800

Note: There are two values in this transaction: the selling price of $2,600 and cost price of $1,800.

Cash of $2,600 is received and inventory costing $1,800 is handed to the customer. Hence assets increase by $800 ($2600-$1800). Sweet Candy makes a profit of $800 from this transaction. Equity therefore increases as profit is part of equity.

Question 11

Example 3 of Textbook (Page 35)
Marissa set up Sweet Candy, a sole proprietorship and has the following cash transaction.
Identify the effect of the following transaction on the accounting equation.

Transaction (e):
15 Feb - Marissa withdrew $1,000 cash from the business for her personal use.

Answer 11

Cash drawings by owner

Assets - Cash = -$1000
Drawings (negative equity) = $1000
Equity = -$1000

Sweet Candy pays cash of $1000 and assets hence decrease. The cash is paid to Marissa, the owner.

Note: Any resources withdrawn by the owner for his / her personal / own / private use are called drawings. Equity hence decreases as drawings reduce the capital that Marissa contributed on 1 Feb.

Question 12

Example 4 of Textbook (Page 37)

Continuing from Example 3, during the second half of its first month of operations, Sweet Candy started to buy and sell on credit. Below are the business transactions during the second half of its first month of operations.

Transaction (f):
16 Feb - The business sold $5500 of candies on credit to Cafe Deli. The cost of the candies sold was $3700.

Answer 12

Credit sale of goods
Asset - Trade Receivable = +$5500
Asset - Inventory = -$3700
Equity: Sales Revenue (Income) = +$5500
Equity: Cost of Sales (Expense) = -$3700

There are two values in this transaction: selling price at $5000 and cost price at $3700.

The customer, Cafe Deli, owes Sweet Candy $5500 and inventory costing $3700 is handed to Cafe Deli. The amount owed by Cafe Deli is an asset and has increased. At the same time, inventory decreases. Equity increases by a profit of $1800.

Question 13

Transaction (g):
18 Feb - The business purchased a motor vehicle costing $6000 and paid $2000. The remaining $4000 was on credit from Lee Motors.

Answer 13

Purchase of Non-Current Assets
Assets- Motor Vehicle = +$6000
Asset - Cash = -$2000
Liability - Other Payable = +$4000
Sweet Candy now owns a motor vehicle that costs $6000. It has paid cash of $2000 and owes Lee Motors $4000. The motor vehicle owned by the business is an asset. Overall, assets increase by $4000 ($6000-$4000). Liabilities increase by $4000 from the amount owed to Lee Motors.

Question 14

Transaction (h):
19 Feb - Cafe Deli returned $200 worth of candies. The cost of candies returned was $130 and they were sold on 16 Feb.
Thinking Skill: Refer

Answer 14

Sales return of goods sold on credit previously
Assets - Trade Receivable = -$200
Assets - Inventory = +$130
Equity: Sales Returns (i.e. negative income) = -$200
Equity: Cost of Sales (i.e. expense) = +$130

There are two values in this transaction: selling price at $200 and cost price at $130. This is an opposite transaction to transaction (f). Part of the goods sold in (f) is returned by the customer.

The amount owed by the customer must now be reduced by $200 and inventory should increase by $130. Overall, assets decrease by $70. The profit recorded in (f) should be reduced too. Equity therefore decreases by $70.

Question 15

Transaction (i):

20 Feb - The business purchased $4000 of candies from Can Can Importer on credit.

Answer 15

Credit purchase of goods
Assets: Inventory = +$4000
Liabilities: Trade Payable = +$4000

Sweet Candy owes the supplier, Can Can Importer, $4000 and now has goods of $4000. The amount owed to Can Can Importer is a liability which has increased. Asset increase as the business has more inventory now.

Question 16

Transaction (j):

22 Feb - Cafe Deli paid $5300 to Sweet Candy.

Answer 16

Collection on Trade Receivable
Assets: Cash = +$5300
Assets: Trade Receivable = -$5300

From transactions (f) and (h), the credit customer, Cafe Deli, owes money to Sweet Candy. As Sweet Candy receives cash of $5300 from Cafe Deli, the amount owed by Sweet Deli should reduce as well. The business exchanges one kind of asset for another, from a trade receivable to cash, thus there is no change in the value of assets.

Question 17

Transaction (k):

23 Feb - The business returned $400 worth of candies to Can Can Importer. The candies were bought on 20 Feb.

Answer 17

Purchase return of goods bought on credit previously.

Assets: Inventory = -$400
Liabilities: Trade Payable = -$400

This is an opposite transaction to (i). Part of the goods bought in (i) is returned to the supplier, Can Can Importer. The amounts recorded in (i) must be reduced. Assets decrease by $400 as goods are returned to the supplier. Liabilities decrease by $400 as the amount owed to Can Can Importer is reduced.

Question 18

Transaction (l):

25 Feb - The business paid $3600 to Can Can Importer.

Answer 18

Payment on Trade Payable
Assets: Cash = -$3600
Liabilities: Trade Payable = -$3600
From transactions (i) and (k), Sweet Candy owes money to the credit supplier, Can Can Importer. Sweet Candy now pays cash of $3600 and the amount owned to Can Can Importer should reduce by $3600 as well. Therefore, assets and liabilities decrease.

Question 19

Transaction (m):
28 Feb: The following payments were made: Salary of $1200 to the shop assistant, $2000 for shop rental and $100 for interest on the bank loan.

Answer 19

Payment of Expenses
Assets: Cash = -$$3300
Equity = -$3300 (Salary Expense+Rental Expense+Interest Expense)
Note: Expenses increase, equity decrease

Sweet Candy pays cash totally $3300. Assets therefore decease. Of the same, $1200 goes to its staff for the work done in Feb, $2000 to its landlord as rent for Feb and $100 for interest on the money it borrowed from DEF Bank. The salaries, rent and interest paid are expenses which reduce the profit of the business. Hence, equity decreases.

Question 20

Transaction (n):

28 Feb: The business repaid $1000 of the loan borrowed on 2 Feb.

Answer 20

Repayment of borrowing:
Assets: Cash = -$1000
Liabilities (Non-current) : Bank Loan = -$1000

In transaction (b), Sweet Candy owes money to DEF Bank. As the business now repays $1000, the amount owed to DEF Bank should reduce as well. Assets and liabilities decrease.

Question 21

What happens to the accounting equation after every transaction?

Answer 21

The accounting equation is balanced. If the accounting equation is not balanced, there must be errors in the recording.

Question 22

What are the two rules on the effects of transactions on the accounting equation?

Answer 22

1. Each business transaction will have at least two effects on the accounting equation.
2. After each transaction is recorded, the accounting equation must maintain its balance.

For a Sole Proprietorship:
Total assets (A) = Total liabilities (L) + Total Equity (E)
Total Equity = Beginning Capital +(Income-Expenses)-Drawings

For a Company:
Total Assets (A) = Total Liabilities (L) + Total Equity (E)
Total Equity = Issued Share Capital + Retained Earnings
Retained Earnings = (Income-Expenses) - Dividends