Question

What is the role of the accounting equation in the analysis of business transactions?

Answer 1

Definition:

The accounting equation is at the root of transaction analysis in business. When a business executes any transaction like a sale to a customer, a purchase, a debt payment, a stock sale. The accounting equation must remain in balance. If the equation isn't balanced, this indicates that the analysis is incomplete or incorrect.

Equation Law:

The accounting equation states that the total value of a business's assets must always equal the combined value of its liabilities and its owners' equity

Hence:

Assets = Liabilities + Equity

Conclusion:

If a transaction changes the total value on one side of the equation, the other side must change by an equal amount. The rules for financial accounting ensure that the equation will remain in balance.

Types of Transaction and its effect on accounting equation:

Assets Only Transaction:

Some transactions only affect one side of the transaction. as long as it doesn't affect the equation it's correct.

For Example, if you buy inventory with cash, then cash decrease and inventory increase but assets remain unchanged.

Liabilities Only Transaction:

Same as Assets Only transaction, this is liabilities only transaction, which affects only liabilities side of the transaction. For Example When Debentures converted as a loan. Debentures decrease loan increase.

Asset & Liabilities Transaction:

Some transactions will affect both assets and liabilities transaction but in this transaction, if assets increase liabilities also increase, but if assets decrease liabilities should decrease to maintain the accounting equation.

This accounting equation method will help you to analysis the business transaction.