TRANSACTIONS AND ACCOUNTING EQUATION The main function of an accountant is to record properly the financial transactions of a business concern in the books of accounts and to ascertain its true result at the year end, Thus transaction is the foundation of accounting - the first and formest element of accounting. In a word, it is the life and blood of ‘Accounting. Hence the accountant must have a fair idea about the term “transaction.” In ordinary language "transaction" means exchange of something. But in Accounting it is used in a special sense. If the financial position of a business concern changes on the happening of an event which is measurable in terms of money, that event is regarded as a "transaction" in Accounting. Or A business event which can be measured in terms of money and which must be recorded in books of account is called a "transaction", WHAT IS AN EVENT? EVENT: In ordinary language "Event" meé inything that happens. Human life is full of events. So many events take place in the family and social life of a person. The events may be classified into two: (@) — Monetary Events: Events which are related with money, i.e. which change the financial position of a person are known as "monetary events". For example, daily shopping, marriage ceremony, birthday anniversary, marriage anniversary etc, (b) —_ Non-Monetary Events: Events which are not related with money ie. which do not change the financial position of a person are known as "non-monetary events". For example, winning a game, delivering a lecture in a meeting etc. In business accounting only those events which change the financial position of the business and which call for accounting are recognised as "Events". In other words, all monetary events are regarded as “business transactions.” Remember, it is not that anything which results in exchange of something will be regarded as transaction. On the other hand, something may be regarded as a transaction even though it involves no xchange. For example, Rehman sends a price-list to his customer, Akram. This involves exchange of price- list between Rehman and Akram, yet it is not regarded as a transaction, because it is not measurable in ‘ems of money and it does not change the financial position of both the persons. Again, suppose, goods Worth Rs. 1000 are destroyed by fire. This does not involve any exchange, yet it is regarded as a transaction, ‘use it is measurable in terms of money and it changes the financial position of the business. Tt must be noted that an event, although measurable in terms of money, may not be regarded as a transaction. For example, we receive an order for supply of goods worth Rs. 1000. Although it is peasurable in terms of money, it is not regarded as a transaction, since it has not changed the financial Position. It will, however, be regard as a transaction when the goods are supplied according to the order.ppears i itions must be bove discussion that the following two conditio ne eta i ‘counting; that an event may be regarded as a transaction in a As | 1 ‘The event must be measurable in terms caedeeveus a | : i ition of the business must 2 The financial posi FEATURES: t To become a transaction an event must have the following features; BE TWO PARTIES: , 1. THERE nad ssible without two parties. Just as it takes two hands to Clap, so it takeg No transaction a take place. There cannot be a giver unless there is a Teceiver. Supp: parties i miagoe ata bank. This is a transaction, since there are two Parties here - X ang bang PS how THE EVENT MUST BE MEASURABLE IN TERMS OF MONEY: An event will not be Tegarded as a transaction, money. 3 unless it is capable of being Measured j | iD tem, ; THE EVENT MUST RESULT IN TR: ANSFER OF PROPERTY OR SERVICE: Suppose, we buy a motor-car from Saleem for Rs, 40000. This results in transfer of Prop | Saleem to i 80 itis a transaction, Again suppose, we Pay salary to our employee Rs, 2000. This rent transfer of service -- the employee renders service and We receive it. So it is @ transaction, ay 4, THE EVENTS MUST CHANGE THE FINANCIAL POSITION OF THE BUSINEss, Transaction takes Place only when there is a change in the financial Position of the business, 1 change in financial postion may be of we kinds: The} (a) Quantitative change: | This changes the total Value of assets and liabilities of a business Concern. Suppose, Machinery al Rs. 50,000 is destroyed. This reduces the total value of the assets of the business, As a Tesult, the finan | Position changes and hence it is a transaction, (b) Qualitative change: 1000. Thi ies K 80es out of our Possession and at the time machinery of an equal value comes into Our Possession. This does not Change the total Value of our asset, but this causes a qualitative. change in our financial Position, hence it isa transaction, CLASSIFICATION Transactions may be divided into three groups: a CASH TRANSACTION: | | If the value of a transaction in met is cash immediately, it is called cash transaction. For example, | we buy furniture, for Rs. 2000 from Asif and immediately Pay him in cash. It is a cash transaction, | 2 CREDIT TRANSACTION: If the value of the transaction is not Met in cash immediately, it is Called credit transaction a he above example, if we do not Pay Asif Rs. 2009 immediately, it will be credit transaction, |ease PAPER TRANSACTION: 3- shen there is no question of meeting the value of a transaction, it is regarded as a paper ansactioo- For example, I have Jost Rs. 500. This changes my financial position-my properties decrease in imive by Rs. 500. But there is no question of'meeting the value of such a transaction. This is a paper transaction ‘Transactions may again be divided into the following two classes; EXTERNAL TRANSACTIONS: A transaction taking place with an outside person ‘example, a machine is purchased for Rs. 20,000 from Kashil INTERNAL TRANSACTIONS: ‘A transaction with which no outside person or institution is involved, is called internal transaction. For example, loss of furniture by fire, decrease in the value of assets on account of use (depreciation) etc. RULES FOR DECIDING WHETHER A TRANSACTION IS CASH OR CREDIT: Sometimes transactions are worded in such a way that it becomes difficult to decide whether they are cash or credit transactions. The following rules will make the position clear; A transaction Is regard as a cash transaction if: (a) The word “cash” is mentioned in the transaction. For ¢ 5000 from Arshad. (b) The name of the seller or buyer is not mentior goods Rs.5000. 2. A transaction Is regarded credit transaction if:- ) The words “on credit” or “on account” are mentioned in the transaction. For ex: Bought goods Rs. 5000 on credit. (b) The name of the seller or buyer is mentioned in the transaction and the word mentioned. For example, Bought goods from Arshad Rs. 5000. Thus we may conclude from the above discussion that every business transaction brings a double change in the financial position of the business. It brings a change in the assets, liabilities, owner's equity, expenses or revenues of a business. ILLUSTRATION NO. 1 State with reasons whether the following events are transactions to my business; I started a business with Rs. 50,000. I bought furniture for Rs. 2,000 for business use. Submitted a tender for goods worth Rs. 10,000. Appointed a cashier on a salary of Rs. 2,000 per month. Paid salary to cashier Rs. 2,000. I took away goods worth Rs. 500 from the business for my private use. Paid salary Rs. 1,000 to Salesman of the business. Paid rent of my house from my own funds. or organisation, is called an external transaction. f Bros. This is an external transaction. 2 4. xample Bought goods for cash Rs. ned in the transaction. For example, Bought ample, (a) “Cash” is not PA AA REP7 Here transaction is to be considered from the viewpoint of my business ‘ewpoin. So, an event changing te financial position of my business wil be regarded eo TY P&tony 1. It is a transaction. It changes the financial position of the bus = Cash ( 7 by Rs. 50,000 and owner's equity increases by an equal amount, Astet) increage, 2. It is a transaction. It changes the financial position of m; busi inereases by RS. 2,000 and cash (an ase) decreases by an equal nomen Fe (10 tag, 3. Jcis not a transaction. It does not change the financial position of my business, 4 1: is not a transaction. Mere appointment of a cashier does not change the fr ‘i 7 of my business, ‘nancial position 5. It is a transaction. It changes the financial position of my business-- by Rs. 2,000 and an expense (salary) increases by an equal amount. ash (an asset) decreases 6. It is a transaction. It changes the financial position of my business - 500 and owners equity also decreases by an equal amount, &°°48 decrease by Ry 7. It is a transaction. It changes the financial Position of my business cash by Rs. 1,000 and owner's equity also decreases by an equal amoune sot #881) decrease, 8. _ Itis not a transaction. It does not change the financial position of : THE ACCOUNTING EQUATION The three basic elements of accounting are assets, liabilities and owners’ equi it assets represent the things of value that a business owns. The liabilities are the clan of te na ‘against those assets. The owner's equity (capital) is the claim of the owner against those assets, Whatever . not claimed by the creditors belongs to the owner. As a result, the total claims against the assets are al qual to the total assets. This equality between the assets and the liabilities and the owner's equity i expressed by the "accounting equation”. 3 Assets = Liabilities + Owner's Equity. The two sides of the accounting equation must always be equal because the rights to all the asses of a business are owned by someone. The creditors have a claim against the assets of a business until the liabilities have been paid. The owner has a claim against the remaining assets of the’ business. If i liabilities exist, then the owners’ equity will equal to the total assets. AA clear understanding of the accounting equation is essential, because most of accounting systems based on it. The equation actually identifies the claims (or rights) against the assets held by a business. The two sides represent different versions of the same thing. The left side of the equation, assets, consists of the “resources” (properties) held by the business; the right side of the equation, equities (creditor's claim and owner's claim against the assets) consists of the. "sources". Resources Sources Assets Claims against assets_ "The expression of the equality of an entity's assets with the claims against them is referred yy ” as the accounting equation. : always equal because these tw It should be remembered that the two sides of the equation ate us "whal OHS he sides are merely two views of the same business resources. The asse'S WS® 8 hose resOUeS" 0 the business owns, the other side (liabilities and owner's equity) tells us business and how much each group supplied. my business,AUT ANY AGCUUTI INE ByUAtiuTY = TRANSACTIONS UPON THE ACCOUNTING EQUATION: EFFECT OF BUSI Recall that every business transaction brings about a double change in the financial position of the pusiness. The financial position of a business is represented by the accounting equation: Assets = Liabilities + Owner's equity. Regardless of whether a business grows or contracts this equality between the assets and the claims against the assets is always maintained. Any increase in the amount of total assets is necessarily accompanied by an equal increase on the other side of the equation, that is, by an increase in either the tiabilities or the owner's equity. Any decrease in the amount of total assets is necessarily accompanied by an equal decrease in liabilities or owner's equity. Any expense incurred will decrease the owner's equity on one side and decrease cash on the other side of the equation. Any revenue earned will increase the owner's equity on one side and increase assets on the other side. ‘The effect of transactions upon the accounting equation can best be illustrated by taking a brand- new business as an example:- SETTING UP A BRAND - NEW BUSINESS : ‘Assume that Mr. Naveed decided to start a "shoes business” of his own, to be known as Naveed shoes Company.” The new business was started on Ist January, 2015, when Mr. Naveed invested Rs. 5,00,000 in his business. ‘Recall that the business entity is kept separate from its owner. ‘The business unit has borrowed Rs. 5,00,000 from its owner. This is a first transaction of the business It brought a double change in the financial position of the business-- a” Newt (cash) increased by Re. $,00,000 and a liability (owner's equity or capital) increased also by Rs. 5,00,000. In other words, this transaction is consisting of two elements; The receipt of Rs. 500,000 cash Supplied by the owner of the business. 1 2. TRANSACTION NO. 1 ‘The initial accounting equation of the new business then appeared as follows; = Liabilities + Owner's equity Assets = 2015 Ast Jan. Cash : Capital Rs. 500,000 = _Ni + Rs. 500,000 TRANSACTION NO. 2 : Mr. Naveed purchased a building for Rs. 2,00,000. This transaction brought two changes-~ cash (asset) decreased by Rs. 2,00,000 and Building (a new asset) increased by Rs. 2,00,000. Now the equation will be; ae Assets = Liabilities + Owner's equity Cash + Building : Capital j Rs. 300,000 + 200,000 = _Nil_+ Bs i It may be noted that there is no change on the right side of the equation. Simply one asset (cash) as been converted into another asset (Building). The two sides of the equation remains equal.TRANSACTION NO. 3 He purchased furniture for Rs. 30,000. This transaction brout decreased by Rs. 30,000 and furniture (a new asset) increased by Rs- 30,000. Liabilities + Owner’s equity —— : Capital ght two changes-- cash (asset) ‘The equation will be; Assets = Cash + Building + Furniture 5 et) is converted into a new Rs. 270, + 200, +30, = il ‘Again there is no change on the right side of the equation and cash (ass asset, furniture. ‘TRANSACTION NO. 4 : sw the business. This transaction brought 150,00 to stock wp the BOsneS, FT 50,000. Agi, He purchased goods (shoes) for Rs. {50,000 and goods (stock) # two changes - cash (asset) decreased by Rs. 1. there is no change on the right side of the equation. The equation will be: Assets = Liabilities + Owner's equity — : Capital Cash + Building + Furniture + Goods + Capit Rs, 120000+200000 + 30000 + 150000 = Nil + Rs. 500,000 TRANSACTION NO. 5” He sold goods’ costing Rs. 60,000 for Rs. 80,000 for cash. This transaction has brought three changes (a) cash (asset) increased by Rs. 80,000; (b) stock of goods decreased by Rs. 60,000; (c) the difference between sale price of goods (80,000) and cost price of goods (60,000) is profit of Rs. 20,000, it ‘would increase the owner's equity by Rs. 20,000. The equation will be; Assets si Liabilities + Owner’s equity Cash + Building + Furniture + Goods : Capital _ Rs, 120000+200000 + 30000 + 150000 500,000 £80000 = 60000 = Nil + 20,000 __ 200000 + 200000 + 30000 + 90000 TRANSACTION NO. 6 Nil_+ 520000 He purchased dust Geom Gund) Be ee Hee ae fe credit basis. This transaction has brought purchased on credit basis: The equation will be as ie (creditor ) is created, as goods have be Assets a Liabiliti 5 equi Cash + Building + Furniture + : abilities + Owner’s equity Credi : Rs, 200000+200000 + 30000 + 90000 ae +: Capital ——__—________+. 30000 __ ite 520,000 Bi 230000 as es —tinans oom somo + tama = | 9000+ sppg00 3 + 20,TRANSACTION NO. 7 He sold goods costing Rs. 50,000 for Rs. 70,000 on credit basis. The result of this transaction is -- tock of goods is reduced by Rs. 50,000; (b) A new asset (debtor) is increased by Rs. 70,000, as goods si rn sold on credit basis; () The owner's equity is increased by Rs. 20,000 ( the profit) -@ have beet -The equation will be; Ass = Liabilities + Owner's equi ash + Building + Furniture + Goods + Debtors = Creditors + : Capital +990000+200000+ 30000 + 120000 + Nil = 30000 + 520,000 = 50000 + 70000 = + 20000 200000 +.200000 + 30000 + 70000 + 70000 30000_+. 540000 TRANSACTION NO. 8 Creditor was paid Rs. 30, by Rs. 30,000 and cash (asset) is also 000. The result of this transaction is -- a liability (creditor) is decreased decreased by Rs. 30,000. Now, the equation is; Assets. = Liabil lities + Owner's equity Cash + Building + Furniture + Goods + Debtors = Creditors, +5 Capital ‘»99000+200000 + 30000 + 7000+ 70000 = 30000 + 540,000 = 30000 = = 30000 Nil__+ 540000, 170000 + 200000 + 30000 + 70000 + 70000 TRANSACTION NO. 9 * Cash received from the debtor Rs. 40,000. The result of this transaction is -- cash (asset) increased by Rs. 40,000 and debtor (asset) decreased by Rs. 40,000. The equation is; Assets = Liabilities + Owner's equity Cash + Building + Furniture + Goods + Debtors = Creditors + : Capital 170000+200000+ 30000 + 70000+ 70000 = Nil + 540,000 +4000 - 40000 = 210000 + 200000 + 30000 + 70000 + 30000 _= Nil_+ TRANSACTION NO. 10 Goods costing Rs. 25,000 were lost by fire. The result of this transaction is stock of goods is reduced by Rs. 25,000 and owner's equity is also decreased by Rs. 25,000 (as loss will be born by the owner). The equation is; 540000se a ———— = tte eae ure + Goods + Debtors = Ni + Cash + Building + Furnit 210000+200000 + 30000 + 70000 + 30000 = Nil Py 540,00 TRANSACTION NO. 1 salaries and telephone bill Rs. 7,000. The result of this transaction jg He paid e bi decreased by Rs. 7,000 and owner's equity 18 also decreased by Rs. 7,000 (The expenses na a K equity). The equation is; tee Cash + Building + Furniture + Goods + Debtors = + Capital 210000+200000 + 30000 + 45000+30000 = + 515,000 #7000 $$ TRANSACTION NO. 12 He borrowed money from a bank (as bank loan) Rs. 50,000. The result of this transaction is~; (asset) is increased by Rs. 50,000 and a new liability (bank loan) is created (increased) by Rs. 50,000, Assets = Liabilities + | Cash + Building + Furniture + Goods + Debtors = Bank loan + — Capital 203000+200000 + 30000 + 45000+.30000 = 0 + 508,000 #50000 + 50000 ais “253000 + +3 + 45000 + rae 0000+ 508 pestis = Sources; (Assets) = Equities) 558000 = ~—_.558000 It may be noted that equali . : transactions. e ty of the two sides was maintained throughout the recordné d=—— a’ /LLUSTRATION NO, 2 ‘Show the effect of the following transactions upon the Accounting equations 2015 June 1, Salman started his business with cash Rs. 1,00,000 5, Purchased furniture for cash Rs. 4,000 6, Purchased goods for cash Rs. 25,000 10. Paid Transportation on goods purchased Rs. 1,000 12. Sold goods for cash Rs. 15,000, costing Rs. 11,000 15. Purchased goods on credit basis for Rs. 15,000 19. Sold goods to Rashid on credit basis for Rs. 8,000, costing Rs. 6,500 25. Received cash from Rashid Rs. 4,000 28, Cash paid to creditor Rs. 9,000 30. Paid rent and salaries for the month Rs. 4,000 Solution: SALMAN ACCOUNTING EQUATION For the month of June 2015 2015 Cash’ +Purniture “Goods __-+Debtors = Creditors + June 1 +100,000 0 0 o = oO June 5 4000 +4000 = Balances 96000 4000 0 0 June 6 25000 #25000 Balances 71000 4000-25000 0 June 10 +1000 Balances: 70,000 4000 25000 oO June 12 #15000 11000 = Balances 85000 4000 - 14000 = 0 June 15 +15000 Ei 15000 ‘Balances 85000 4000 29000 = 15000 June 19 wea +6500 - ‘Balances 85000, 4000 22500 = 15000, June 25 +4000 r Balances 89000 4000 22500 = 15000 June 28 9000 —_—— = 2000 Balances 80000 4000 22500 = 6000 June 31 4000 - Balances: 76000 + 4000 + 22500 + 400 = Total Assets = Liabilities + Owner's equity 106500 = 6000 + 100500 ILLUSTRATION NO. 3 Mr. Salman commenced his business on Ist July, 2015. His assets, liabilities and capital are indicated by accounting equation given below. During July, 2015, he had various transactions which affected the accounting equation. Give the transactions which had affected the accounting equation:Goods purchased for cash Rs. 40,000 Goods sold for Rs. 15,000 costing Rs. 11,000 Goods sold for Rs. 14,000 costing Rs. 16,000 Cash paid to creditors Rs. 50,000 Building depreciated by 20 %. Goods purchased for Rs. 30,000 on credit basis Furniture depreciated by 20 %. Expenses paid Rs. 5,000.PAAUNEAYWH veeve gg ery gesye en aH OBJECTIVE QUESTIONS True / False: A transaction will be possible, when there will be at least two parties. All non-monetary events are regarded as business transactions. Assets must be equal to equities. Any revenue earned will increase assets on one side and capital on the other side, A person to whom money is owed for goods or services is called creditor. Amount deposited into bank will increase cash balance and decrease Bank balance. Properties owned by business are called owner’s equity. A change in which the value of assets and liabilities remains unchanged change. The excess of assets over liabilities is considered a profit. Sale of an asset less than the book value would reduce owner's equity. Fill in the Blanks: ‘A business event, which can be measured in terms of money, is called A transaction in which the word on account is mentioned is called A transaction in which word cash is mentioned is called ‘A transaction in which the name of buyer or seller is not mentioned is called a transaction. The two sides of accounting equation must be: Events, which are not related with money, are known as ganization is called an A transaction-taking place with an outside person or 1 A transaction with which no outside person or institution is involved is called transaction. If there is a change in total value of assets and liabilities of a business, it will be considered as change. The equities of ‘business mean liabilities In qualitative change total value of assets and liabilities remains —————- The three basic elements of accounting equation are ~~ wwned by the business are called equation expressed the equality Assets = —————_* ‘owner's equity. ‘The expression of equality of an.entity’s as is called quantitative transaction. transaction. events. $4—_—_— _—— Resources 01 of assets and liabilities + ‘owner's equity. sets with the claims against them is refered t0 as the equity for Rs. ——— J Sold goods costing Rs. 1250 for Rs. 1500 will increase the owner’s the owner's equity for Rs.25. Sold goods costing Rs.900 for Rs.875 will ————10. Encircle the most appropriate answer from the following four answers: ing the value of a transaction, it will be known ass ‘When there is no question of meet! (a) Cash ‘Transaction (b) Credit Transaction )— Paper Transaction (a) None of these if there is no change in total value of assets and liabilities of @ business concern it will be i as: a atiaive change (b) Quantitative change (©) Monetary change (d) Economic change ‘According to accounting equation capital is ‘equal to: (a) Assets + Liabilities (b) __Expenses-Income (©) __Liabilities-Assets (y~ Assets-Liabilities Expenses paid by a business decrease: (@) Cash (b) Capital (q) Cash & Capital (a) None of these Every transaction affects: (a) One item (B}— Two items (d) So many items (©) Four items ‘A person who owes money to a business is known as 9; (a) Creditor (by Debtor (c) Investor (d) Solvent If furniture purchased on credit basis, it will be: (a) _ Increase in assets and increase in capital () _ Increase in assets and increases in expenses (c) _ Increase in assets and increase in equity (d)—“ Increase in assets and increase in liabilities Resources owned by the business (Assets (b) Liabilities (c) Capital (@) Profit Furniture purchased for domestic use: (a) _ Increase in assets and increase in expenses (b) _ Increase in expenses and increase in liabilities or Decrease in capital and decrease in assets (d)__ Increase in assets and decrease in assets. Whep cash is paid to creditors, it will decrease.’ Cash (b) Capital (c) 1 Debtor (d) None of these Claims against assets owned by business are called: 8 asi (b) Liabilities p | : (d)_—-Equities A transaction taking place with an outside person or organization is called: (a) Internal Transaction (b)~ External Transaction (c) Paper Transacti ee a (@) None of these