Understanding how different transactions impact the accounting equation is critical for keeping the accounting books neat and tidy.
This post explains everything you need to know about the effects of different types of business transactions on the accounting equation using examples and quizzes.
How Transactions Affect the Accounting Equation
How a transaction impacts the accounting equation depends on the type of the two or more accounts involved (assets, liabilities, or equity). Some transactions don’t affect the accounting equation because they increase and decrease multiple accounts of the same type (e.g., assets).
Whenever a transaction is recorded in the accounting books, it has an equal effect on both sides of the accounting equation.
What that means is that if one side of the accounting equation changes because of a transaction, then the other side of the accounting equation has to change by the same amount so that the totals on both sides of the accounting equation always match.
For example, let’s say a business has assets worth $50,000. equity of $50,000 as well, and no liabilities. As you can tell, the accounting equation will show $50,000 on both sides.
Now, if a business gets a $10,000 loan from the bank, it will increase both sides of the accounting equation by increasing:
- The cash at bank account on the left side of the equation (assets) by $10,000;
- The bank loan liability account on the right side of the equation (liabilities + equity) by $10,000.
So the accounting equation after this transaction will be $10,000 higher on both sides.
Transactions that Affect Assets and Liabilities
| Type of Transaction | Effects on Accounting Equation |
|---|---|
Purchase of inventory on credit | Increase Assets, Increase Liabilities |
Getting a loan from the bank | Increase Assets, Increase Liabilities |
Repayment of a liability | Decrease Assets, Decrease Liabilities |
Transactions that Affect Assets and owner's Equity
| Type of Transaction | Effects on Accounting Equation |
|---|---|
Capital contribution by the owners | Increase Assets, Increase Equity |
Payment of dividends to shareholders | Decrease Assets, Decrease Equity |
Owner drawings | Decrease Assets, Decrease Equity |
Depreciation of assets | Decrease Assets, Decrease Equity |
Write-off a bad debt | Decrease Assets, Decrease Equity |
Sales revenue | Increase Assets, Increase Equity |
Transactions that Affect Liabilities and owner's Equity
| Type of Transaction | Effects on Accounting Equation |
|---|---|
Interest payable on a loan | Increase Liabilities. Decrease Equity |
Converting a loan liability into equity | Decrease Liabilities, Increase Equity |
Accrued expenses | Increase Liabilities, Decrease Equity |
These transactions only impact the right side of the accounting equation so the total assets will remain unchanged.
Unlike transactions listed in previous sections, the effects of these transactions work in opposite directions because the same side of the accounting equation is involved.
Transactions that don't affect Accounting Equation
| Type of Transaction | Effects on Accounting Equation |
|---|---|
Purchase of a fixed asset for cash | None |
Transferring funds from one bank account to another one owned by the same business | None |
Transferring the balance of retained earnings account to another equity reserve | None |
Quiz
How much do you know about The Effects of Transactions on the Accounting Equation?
Question 1
If a transaction decreases the total assets of a business, then the sum of its total liabilities and owner’s equity may or may not decrease depending on the nature of the transaction.
True
Incorrect.
False
Spot on!
If a transaction decreases the total assets of a business, then the right side of the accounting equation MUST reduce as well.
Question 2
A business owner buys a car on credit for his car rental business for $10,000.
If the sum of liabilities and owner’s equity in the business is equal to $100,000 after the purchase, what is the value of total assets?
$90,000
Incorrect.
$100,000
You're right!
Purchasing the car on credit will increase the total assets and total liabilities by $10,000 each.
Total assets in the business will equal the sum of liabilities and equity after the transaction (i.e., $100,000). The addition of the new car is already included in this value.
$110,000
Wrong answer.
Question 3
Which of the following transactions do not affect the accounting equation of a farmer?
A
Not correct.
Depreciation of the farm tractor will reduce the value of total assets and owner's equity.
B
Incorrect.
Although unpaid wages don't affect the total assets, it does impact the right side of the accounting equation by increasing liabilities and lowering the owner's equity.
C
Correct!
This transaction only replaces one asset (cash) with another asset (farm) which means that the total assets, liabilities, and equity should all remain unchanged.
Question 4
Which of the following transactions will increase both the total assets and the total liabilities of a library?
A
Incorrect.
Preordering books will lower the amount of cash and increase the value of receivables. The total assets and liabilities remain the same as before.
B
Not correct.
Depreciation lowers the value of assets and has no effect on liabilities.
C
You're right!
Receiving advance subscription from customers increases the total assets of the library because of the inflow of cash, while at the same time increases the amount of its liabilities because of unearned revenue.
How many questions did you answer correctly?
Score Grade
4 Master
3 Pass
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