How to show the effect of transactions on the Accounting Equation

Classification of Accounts and the Accounting Equation

What you need

• Understand the meaning of assets, liabilities and owner's equity.
• Know the formula: Assets = Liabilities + Equity, and Equity = Capital + Revenue − Expenses − Drawings.
• A list of the business's transactions together with their amounts in RM.
• A blank accounting-equation table with a column for each account.

Step by step

1. 1

   Understand the accounting equation formula

   Begin with the basic formula Assets = Liabilities + Equity. Owner's equity can be expanded to Capital + Revenue − Expenses − Drawings. The key principle is that every transaction must keep both sides of the equation balanced. Throughout these steps we use Perniagaan Setia, owned by Encik Rahman, as the running example.

2. 2

   Prepare the equation table

   Draw a table with a column for each asset account (Cash, Equipment, Inventory), a liability column (Creditor), and an equity column (Capital, plus space for Revenue, Expenses and Drawings). Provide one row per transaction and a balance row at the bottom. This table lets you track the plus (+) and minus (−) effects neatly.

3. 3

   Analyse each transaction (dual effect)

   For each transaction, identify the two accounts involved and decide whether each one increases or decreases, and whether it is an asset, a liability or equity. First transaction: Encik Rahman starts the business with RM50,000 cash. Cash (asset) increases by RM50,000 and Capital (equity) increases by RM50,000, so Assets RM50,000 = Equity RM50,000.

4. 4

   Record capital and asset purchases

   Record the first three transactions. (1) Opening capital: Cash +RM50,000, Capital +RM50,000. (2) Buy equipment for cash RM12,000: Equipment +RM12,000 and Cash −RM12,000. This is an asset swap, so total assets stay at RM50,000. (3) Buy inventory on credit RM8,000: Inventory +RM8,000 and Creditor (liability) +RM8,000. Now Assets RM58,000 = Liabilities RM8,000 + Equity RM50,000.

5. 5

   Record a revenue transaction

   Record a transaction that earns income. (4) The business receives commission of RM3,000 in cash. Cash +RM3,000 and Equity +RM3,000 because revenue increases owner's equity. The equivalent double entry is: Debit Cash RM3,000; Credit Commission Received RM3,000. Assets are now RM61,000 = Liabilities RM8,000 + Equity RM53,000.

6. 6

   Record expense and drawings transactions

   Record the transactions that decrease equity. (5) Pay rent RM1,500 in cash: Cash −RM1,500 and Equity −RM1,500 because an expense reduces equity. (6) Encik Rahman withdraws RM1,000 cash for personal use (drawings): Cash −RM1,000 and Equity −RM1,000. Assets are now RM58,500 = Liabilities RM8,000 + Equity RM50,500.

7. 7

   Record payment to the creditor

   (7) Record a cash payment of RM4,000 to the creditor. Cash (asset) −RM4,000 and Creditor (liability) −RM4,000. The equivalent double entry is: Debit Creditor RM4,000; Credit Cash RM4,000. Both sides of the equation fall by RM4,000, so Assets are now RM54,500 = Liabilities RM4,000 + Equity RM50,500.

8. 8

   Check the equation balances

   Total each column to get the closing balances: Cash RM34,500, Equipment RM12,000, Inventory RM8,000, total Assets RM54,500. Liabilities (Creditor) RM4,000 and Equity RM50,500 (Capital RM50,000 + Revenue RM3,000 − Expenses RM1,500 − Drawings RM1,000). Confirm that Assets RM54,500 = Liabilities RM4,000 + Equity RM50,500. If the two sides are not equal, re-check the dual effect of each transaction.

Second example

Consider Kedai Harmoni, owned by Puan Aminah. The shop receives a bank loan of RM20,000 paid into its bank account. The effect: Bank (asset) +RM20,000 and Bank Loan (liability) +RM20,000. Both sides of the equation rise by RM20,000 and equity is not affected. This shows that not every inflow of assets comes from the owner or from revenue.

Next, Kedai Harmoni provides repair services on credit worth RM2,500 to a customer. The effect: Accounts Receivable (asset) +RM2,500 and Equity +RM2,500 because the revenue has been earned even though the cash has not yet been received. This reinforces the principle that revenue increases equity when it is earned, not when cash is received. After these two transactions, total assets rise by RM22,500, liabilities rise by RM20,000 and equity rises by RM2,500, so the equation stays balanced.

Common mistakes

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