Business Transactions and Accounting Equation

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In this lecture, we will learn about how businesses conduct transactions, how these transactions affect the financial
position of the business, and the concept of accounting equation.

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Let's begin by understanding what a transaction means.

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In a business, a transaction takes place when exchanging goods or services for money.

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In accounting, a transaction is defined as a completed sale or exchange of goods or services.

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In an exchange, the are at least two equal actions, something is given and something is received.

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For example, buying a computer, borrowing money for the business, making a sale and receiving money, paying salaries,
etc, are all business transactions that involve money and will need to be recorded.

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Let's take the case of Web Design Inc.

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and look at a few transactions After starting the business, David purchases a new laptop for $800 on June 5.

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This is a transaction as it involves exchange of goods for money.

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There are two equal actions, laptop is received and money is given.

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David takes up a new order to build a website for a restaurant near your office.

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David will provide the service of designing and developing the website for the restaurant.

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In exchange for this service of developing the website, David will be paid money.

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He received an advanced payment of $1000 now and will be paid the rest after the project is completed.

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This is a transaction, as it involves exchange of service for money.

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There are two equal actions, website is received and money is given.

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Here, it is important to note that initially, David may not have to record any transaction unless he receives an advance.

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A transaction will be recorded only if there is any money received or any money due.
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At this stage, David has got the order and received an advance of $1000.

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Every transaction has an impact on the businesses' resources.

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The resources of a business referred to its supply of goods, services, information, or expertise that allows the business to
operate and grow.

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In accounting, the resources of a business are classified into three broad categories, namely assets, liabilities, and
owner's equity.

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The term also refers to the three types of accounts in which a business records its transactions.

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Assets a what a business owns or what is owed to it.

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It includes items such as cash, accounts receivable, merchandise to be sold, supplies, equipment and land.

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Assets also include intangible items such as patents, franchises and copyrights.

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Liabilities or what the business owes to others.

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Some examples are payments to be made to suppliers, salaries to employees, taxes to government agencies, rent to
landlords, mortgage and loans and interest payments to financial institutions.

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Owners equity is the money that the owners of the business have put into the business.

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It also includes the owners' claim on the assets of the business.

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These three accounts are referred to as the balance sheet accounts as they relate to the three key items in the balance
sheet.

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Apart from this, we also have income and expense accounts that are related to the income statement of the business.

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For example, revenue from sales will go into income accounts, while expenses such as salaries paid and bill settled will go
into the expense accounts.

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In the accounting books of the business, there will be a separate account for recording transactions for each activity.

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When a transaction takes place, the transaction will affect the accounts of the business.

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Let's take a few transactions at web designing and see which accounts they belong to, and how these accounts are
affected.
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David has invested $10,000 of his personal money in the business.

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This is the owner's equity.

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We can inflow of $10,000, the owner's equity increases by $10,000.

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This money is also the cash available with the business, the cash is the asset.

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Then he purchased a new laptop for $800.

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The laptop becomes an asset of the business.

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However, $800 has been spent from the available cash to buy the laptop.

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The balance cash available is $9,200.

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After a few days, David got a new order to develop a website.

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He received an advance of $1,000.

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Since he has not yet developed a website, there is a liability on the company to develop the website equivalent of $1,000.

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This will remain a liability till the order is executed.

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One month is now over and David has to pay the rent of $500 for the office space.

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Since the rent is now due, expense will be recorded and a liability will be created.

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When the rent is actually paid later, the liability will be reduced.

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Businesses exchange items of equal value real or perceived.

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Imagine that an exchange is like balancing a scale.

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The left side goes down that is a services given and the right side reacts that is cash is received to maintain the balance of
the scale.

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Accounting uses a technique to show how a transaction changes the businesses' resources, while maintaining a balance
or showing the equal value of the exchange.
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This is called The Accounting Equation.

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The Accounting Equation is a simple tool that helps us understand how various transactions affect the asset, liability, an
owner's equity accounts and how these accounts are related to each other.

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The accounting equation is presented as assets equal to liabilities plus owner's equity.

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Note that in the case of a corporation, instead of owner's equity, we have shareholders equity, as many shareholders
invest money and have equity stake in the corporation.

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The equation will always be balanced, so if the business has assets worth $80,000, and owner's equity of $20,000, then
we can say that the liabilities are equal to $60,000.

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Every transaction will affect at least two of these accounts.

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If a transaction causes one side of the equation assets to increase, then the other side of the equation, liability or owners
equity must also increase to keep the equation in balance.

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It is also possible that an increase in one asset causes another asset to decrease.

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In any case, the accounting equation will always balance.

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Let's take the transactions at the Web Design Inc and see how they fit into the accounting equation.

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The very first transaction occurred when David invested $10,000 in the business.

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This $10,000 is the capital or owner's equity.

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In this transaction, an asset in the form of cash is created for the business.

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The next transaction happens when David buys a new laptop for $800.

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Both the laptop purchased as well as the cash paid are assets.

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So, in this transaction, there is an increase in one asset and a decrease in another asset.

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The third transaction happens when David receives a new order and along with it comes an advance of $1000.

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The cash received is an asset, at the same time since the order is not yet fulfilled this $1000 would be a liability.

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We saw that the accounting equation contains three accounts namely, assets, liabilities and owner's equity.
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However, what happens to the revenue and expense accounts related to the income statement?

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For example, when a sales guy is paid his travel expenses in cash, only one asset account is affected, that is the cash
account.

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The other account affected is the expense account.

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Then how does the accounting equation balance?

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A company incur several expenses in its normal course of operations, such as payment of salary, rent, insurance
premium, postage, wages, repairs, etc.

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Payment of these expenses reduces the cash.

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These expenses reduce the net income of the business.

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Since all the income of the company is added to the capital account, all these expenses are deducted from the capital
account as they reduce the income.

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Similarly, a company receives revenue during normal course of operations such as rent received, commission received
etc.

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Revenue is added to the cash balance as it is received in terms of cash.

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Revenue increases the net income of the business and hence it is added to the capital account.

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The accounting equation is represented on screen.

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Let's continue with our case study of Web Design Inc.

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The month has ended and the rent of $500 is due for the office space.

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Since the rent is not yet paid, there is no impact on assets.

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The rent will become a liability and at the same time the rent will be recognised as an expense.

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So the liabilities will increase by $500 and the capital will reduce by $500.

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This way, we can see that accounting equation is always balanced.

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You can anytime take the balances from the general ledger's asset accounts, liability accounts and the owner's equity
accounts and apply them in the equation.

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In the equation the accounts must balance.

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All transactions will affect the businesses assets, liabilities, and the owner's equity accounts.

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The accounting equation is applied to check that these three accounts balance.

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This is a fundamental rule of accounting.

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