1.3 Accounting transactions and the accounting equation

From the previous section, we learned that all accounting transactions are recorded in the accounting information system. But how do we go about recording these transactions in the accounting system? The best way to understand how transactions are recorded is by beginning with the accounting equation (first introduced in Accounting and Accountability – refer to Chapter 2):

Assets = Liabilities + Owner’s Equity

The equation asserts that a business’ assets must equal the sum of its liabilities and equity. This means to keep the accounting equation in balance, any change to the left side of the equation must be accompanied by a change to the right side. A business must make at least two changes in its assets, liabilities or equity when it records an accounting transaction, known as the dual nature of accounting. For example, when an owner invests $30,000 in a business, assets (cash) are increased by $30,000 and equity (owner’s capital) is increased by $30,000. This accounting transaction affects at least two accounts: one in the asset section of the business’ balance sheet, and one in the owner’s equity section of its balance sheet. Because both the left side and the right side both increase by the same amount, the accounting equation (Assets = Liabilities + Owner’s Equity) stays in balance.

It is important to note that this dual effect of accounting transactions does not necessarily mean that every transaction will affect both sides of the equation or even two elements of the equation. A transaction may only affect one side, for example by increasing one asset and decreasing another asset by the same amount. For instance, when a business buys a computer for $2000 cash, asset (Computer equipment) increases by $2000 and asset (cash) decreases by $2000. The accounting equation still balances after the business records this transaction as the net effect of the total for assets on the left side of the equation remains unchanged and the transaction does not affect the right side of the equation. For every accounting transaction, there is a source (money comes from somewhere) and a use (money goes somewhere).

To revisit how accounting transactions affect the accounting equation, please refer to what you learnt in Accounting and Accountability Topic 2 and Section 2.7 (p.38-41) of the AAA textbook. It is essential to return and visit the section on Analysing and recording business transactions so that when you are introduced to debits and credits in the next chapter, you will be able to better follow how T-accounts and debits and credits are used in a dual-entry accounting system.

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