Understanding the Accounting Equation
To fully understand how accounting transaction analysis affects the basic accounting equation, you must first understand what the accounting equation is and how it works. The basic accounting equation is: Assets = Liabilities + Equity.
Every economic transaction your business makes must be classified into its proper categories, which include assets, liabilities and net worth.
- Assets are anything your business owns, which includes cash, equipment, buildings, land, inventory and accounts receivable.
- Liabilities are any debts that your business owes, which includes mortgages, loans, long-term debts, notes payable and other accounts payable.
- Net worth is basically net assets or what you would have left over if you paid off everything your business owed and is usually referred to as equity in the accounting equation.
- Equity is listed as Owner’s Equity for a sole proprietorship or Partner’s Equity for a partnership and Stockholders’ Equity or Shareholders’ Equity for corporations. In the expanded accounting equation, Equity is broken into two components: Revenues and Expenses. Revenue is what the business earns by providing goods or services, and expenses are the costs involved in generating revenue, such as rent, utilities, payroll and taxes.
To be effective, your company should always have a balance between what it owns and what it owes. When you analyze an accounting transaction, you’re determining how that transaction affects the basic accounting equation. Both sides of this equation must always balance, which is reflected on your company’s balance sheet.
Example of how the accounting equation works:
Your company has $15,000 in Owner’s Equity. The owner buys a new vehicle for the company for $20,000, but he pays $5,000 in cash and carries a note on the remaining $15,000 balance to be paid by a set time. This transaction affects the accounting equation like this:
|Assets = ||Liabilities + ||Owner’s Equity |
|+$15,000 (Cash) || ||$15,000 (Owner’s Capital) |
| || || |
|-$5,000 (Cash) ||+$15,000 (Notes Payable) || |
|+$20,000 (Vehicles) || || |
| || || |
|$30,000 = ||$15,000 + ||$15,000 |
Most companies typically have numerous transactions to record and track, which requires a more sophisticated system than this simple table. Bookkeepers usually use a bookkeeping software program with a double‐entry bookkeeping system to record transactions while keeping the accounting equation in balance and double‐checking the accuracy of the transaction entries.
How Double-Entry Bookkeeping Works
Double-entry bookkeeping is the accounting method you use to track where your company’s money comes from and where its money goes. As the name implies, there are two entries involved in this process, which involves a debit and a credit.
- Debits increase your company’s assets, decrease revenue accounts, decrease liability or equity accounts and increase expense accounts.
- Credits decrease your company’s assets, increase revenue accounts, increase liability or equity accounts and decrease expense accounts.
As you can see, debits and credits do the opposite of each other. Therefore, when you use the double-entry method, for every debit you have, there will be a corresponding credit equal to the same amount, and vice versa. This keeps your accounting equation in balance, so you know that if it’s not balanced, then you’ve made a mistake in your bookkeeping. Ultimately, you’ll use the information generated from these entries to generate your financial statements. These statements tell you how profitable your business is and how you should spend your money going forward.
Steps to Accounting Transaction Analysis
Your company purchases or sells items, it borrows on credit or extends credit to others or it earns income or takes on expenses. These are all transactions, which are a result of doing business. Each of these transactions changes the three parts of the basic accounting equation, but only if it has a financial impact on your company. Not all events qualify as transactions, so they must be thoroughly analyzed before you can record them. There are several steps to this process, including:
Step 1: Determine whether an event qualifies as an accounting transaction. Does it involve a monetary amount? For example, if you sign a lease on a new building, there isn’t an accounting transaction, because no money changed hands. However, if you paid a deposit at the time you signed this lease, then the deposit counts as an accounting transaction because there’s been an exchange of funds that must be recorded.
Step 2: Identify which accounts are affected by the transaction. Debits increase asset accounts, while credits decrease asset accounts. Credits increase a liability account, while debits decrease liability accounts. For example, your company purchases some new inventory valued at $10,000 on credit. The inventory is listed under assets, while the balance due is listed under liabilities as an account payable. Some commonly used accounts include:
- Asset Accounts: Cash, accounts receivable, notes receivable, inventory and prepaid expenses, land, buildings, equipment
- Liability Accounts: Accounts payable, notes payable, accrued liabilities
- Owner’s/Stockholders’ Equity Accounts: Common stock, retained earnings, dividends, revenue, expenses
Step 3: Determine how each account is impacted by the transaction by applying the rules of debits and credits to these accounts. Each transaction must have two or more related but opposite accounts to keep the accounting equation in balance. This means you must debit at least one account and credit at least one account in equal amounts for each transaction.
Using the example from Step 2:
- Under Assets: Inventory Account increases by $10,000, because your company acquired new inventory.
- Under Liabilities: Accounts Payable Account increases by $10,000, because your company’s debts increased.
- Assets are debited and Liabilities are credited, which means they balance for this transaction.
Always double-check receipts and invoices to ensure you have the correct transaction amount to enter on each account. Otherwise, your entries may be correct, but your bank statement won’t match your financial reports.
Once you’ve successfully analyzed your accounting transactions, you record them in a journal in chronological order. Journal entries are simply the written account of the transaction analysis you just completed. Debits are entered on the left margin of the journal entry and credits on the right. For each journal entry you will:
- Identify each account affected by the transaction.
- Classify each account by type: asset, liability, owner’s equity (revenue or expenses).
- Note the amount each account increased or decreased (debits on the left/credits on the right).
- Include a brief explanation if needed.
Accounting Transaction Analysis Recap
- If a business event or activity involves a monetary amount, it is an accounting transaction that must be recorded.
- It’s an asset if it increases what your company owns and a liability if it increases what your company owes.
- The asset and/or liability accounts relating to the transaction go up or down based on whether your company now has more or less of something than it previously had.
- Record the appropriate debit and credit as a journal entry to capture the transaction, ensuring the amount is correct and the accounting equation remains in balance.
Reliable Outsourced Bookkeeping Solutions
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Our virtual bookkeeping services cover as much or as little of your accounting processes as you need. This includes analyzing your accounting transactions and recording purchases, sales, payments and receipts into journals using cash basis or accrual accounting methods. Outsourcing your bookkeeping maximizes your resources and increases accuracy. We also offer interim CFO services to help you with financial analysis and planning. Contact us at 978-809-3282 to learn how our financial professionals can help you keep your financials on track.