Effect of Transactions on the Accounting Equation of Perabot Sri Mawar

Introduction to Accounting

Skill: Analyse

Stimulus

Question

(a) For each transaction 1 to 5, analyse its effect on the three elements of the accounting equation (Assets, Liabilities, Owner's Equity), stating whether each increases, decreases or is unaffected, together with the amount.

(b) Calculate the closing values of Assets, Liabilities and Owner's Equity at month-end and show that the accounting equation still balances.

(c) Explain why transaction 3 must NOT be recorded as a business expense, referring to one relevant accounting concept.

Thinking steps

1. Recall the basic equation: Assets = Liabilities + Owner's Equity. Every transaction must keep this in balance by affecting at least two elements, or two items within the same element.
2. First identify the accounts involved in each transaction: is it cash, stock, creditor, loan, capital or drawings? This decides which element changes.
3. Transaction 1: capital brought in as cash, so Assets up and Equity up. Transaction 2: stock up (Asset) and creditor up (Liability). Transaction 4: bank up (Asset) and loan up (Liability).
4. Transaction 3 is a private drawing (child's school fees), not a business expense: Assets (cash) down and Owner's Equity down. Transaction 5 pays a creditor: Assets (cash) down and Liabilities down.
5. Total each element: Assets = 50000 + 12000 - 3000 + 20000 - 12000; Liabilities = 12000 + 20000 - 12000; Equity = 50000 - 3000.
6. Check the balance: Assets must equal Liabilities plus Equity. If equal, your analysis is correct.
7. For part (c), link the school fees to the separate entity concept: the business and the owner are two separate entities, so the owner's private spending is treated as drawings, not a business expense.

Model answer

(a) Effect analysis:

1. Capital cash RM50,000: Assets +RM50,000 (Cash), Liabilities no effect, Equity +RM50,000 (Capital).

2. Stock on credit RM12,000: Assets +RM12,000 (Stock), Liabilities +RM12,000 (Creditor), Equity no effect.

3. Child's school fees RM3,000 (drawings): Assets -RM3,000 (Cash), Liabilities no effect, Equity -RM3,000 (Drawings).

4. Bank loan RM20,000: Assets +RM20,000 (Bank), Liabilities +RM20,000 (Loan), Equity no effect.

5. Pay creditor RM12,000: Assets -RM12,000 (Cash), Liabilities -RM12,000 (Creditor), Equity no effect.

(b) Closing balances:

Assets = 50,000 + 12,000 - 3,000 + 20,000 - 12,000 = RM67,000.

Liabilities = 12,000 + 20,000 - 12,000 = RM20,000.

Owner's Equity = 50,000 - 3,000 = RM47,000.

Check: Liabilities + Equity = 20,000 + 47,000 = RM67,000 = Assets. The equation balances.

(c) Transaction 3 is Puan Halimah's private expenditure, not an expense that earns business income. Under the separate entity concept, the business and its owner are treated as two distinct entities; therefore money taken for personal use is recorded as drawings that reduce owner's equity, not as a business expense. If it were recorded as an expense, the business's net profit would be understated and the financial information would be inaccurate.