The three primary elements of any business transaction are- assets, liabilities and capital. This relation between them in Accounting Equation remains unchanged no matter how worse or good the situation of a company is. It has even been justified by mathematical data.
Inter-relationship of these three accounting terminologies- assets, liabilities and capital, results into nine transactions. These transactions depict that a change in one element will automatically lead to a corresponding change in all other elements. These nine business transactions are as follows-
Each of these transactions can be further explained as-
Various creditors of goods at times draw a bill of exchange in the company. This is based on the arrangement of payment. Once this bill is accepted, this payment becomes due for payment after a specific period’s expiry. The acceptance of this bill diminishes a creditor’s liability and creates another liability. The bill on which this payment needs to be made is known as bills payable.
For example, if a business is started with an amount of $20,000, it will not only increase the assets, but even the capital of a firm will also be affected.
The financial position of a business will be affected by this transaction. This can be further explained as-
If a payment of $30,000 is made to the creditors, it will decrease creditors, liabilities of that company and even the value of assets will decrease. This decrease in assets and liabilities together at a time with the same amount will prove the Accounting equation to be true.
When a loan is converted into capital, on the one hand, it lowers the liability of a business and on the other hand; it increases the business capital.
There are some business transactions which involve capital like transfer of company’s share from one shareholder to another. During such a time, a company’s capital will increase and even decrease with the same amount and this will be left unchanged. With the amount of interest allowed, the owner’s capital will increase.
For instance, if goods are purchased on credit for an amount of $ 7,000, it will lead to an increase in the stock of goods with $7000. Further, it will even increase the liabilities of creditors. The financial position of this company will be affected as-
The amount withdrawn by an owner for his personal use will automatically lead to a decrease in cash and capital.
There are times when capital can be easily converted into a loan in the form of a liability. Such transactions occur when associate retires from a company and the capital which was refundable to him get transferred to his loan account. In such cases, instead of his capital, the company will show its partner’s loan as a liability. This leads to an increase in liabilities and an automatic decrease in capital.
A purchase of furniture involves both the assets- cash and furniture. This will lead to a transaction where furniture will increase as an asset and then get decreased as cash. Even an increase in an asset with the same value will not affect the accounting equation.