How Transactions Affect the Balance Sheet
   

The following balance sheet illustrates how certain financial events affect it. Each event recorded in the accounting records is called a transaction. All these events occur in December.

The first event is the formation of a new entity. Assume that the owners of Art Supplies Ltd. invest €10,000 cash. As a result, Art Supplies Ltd. now has an asset of €10,000. You record this €10,000 as the item, Cash, on the assets side of the balance sheet. The owners have furnished this resource of €10,000, and you record this fact on the liabilities side of the balance sheet; the accounting term is Paid-in Capital. After you record this transaction, the balance sheet looks like the following:



Second, assume that the company uses €2,000 of its cash to buy equipment. You record the €2,000 decrease in cash by making the Cash item €8,000, and you record the new asset - Equipment - in the amount of $2,000. After you record the transaction, the balance sheet looks like that shown below.



This transaction increases one asset and decreases another asset by the same amount, so the total of the assets is unchanged.

The next transaction is for office furniture that the company bought. The total cost was €5,000, and Art Supplies Ltd. paid €1,000 cash and agreed to pay €4,000 to the supplier in two instalments. By providing the asset - Furniture - to Art Supplies Ltd. without receiving the full amount of cash in return, the supplier in effect furnished funds to the company. Put another way, the supplier has a claim against the assets of €4,000. An outside party (other than an owner) who has a claim against the entity is called a creditor. The amount of a creditor's claim is called a liability. The name of the liabilities arising from a supplier's claim is termed Creditors. Many companies are now using the U.S. term - Accounts Payable - to describe this class of liability.

This transaction decreases Cash by €1,000, making it €7,000. Next, record the new asset, Furniture, €5,000. Finally, you increase the new liabilities item, Creditors, by €4,000. The balance sheet now looks like the following:



This transaction increases both assets and liabilities, but total assets still equal total liabilities.

The fourth transaction involves the company paying €3,000 in cash later to the supplier who had the claim of €4,000. Record the €3,000 decrease in cash by reducing Cash from €7,000 to €4,000. Record the fact that the liability to the supplier is reduced by €3,000 by decreasing Creditors, from €4,000 to €1,000. After you record this transaction, the balance sheet looks like that shown below.



Note:   The total assets remain equal to the total liabilities.

The four previous transactions illustrate the main types of transactions affecting the balance sheet:

1.The first increases assets and liabilities by the same amount.  
2.The second increases one asset and decreases another asset by the same amount, leaving total assets unchanged.  
3.The third increases one asset, decreases another asset, and increases a liability, but the total of the two sides of the balance sheet remain equal.  
4.The fourth decreases both an asset and a liability by the same amount, so the total of the two sides remained equal.  

Keep in mind the following principles:

·Each transaction affects at least two items. The third transaction affects more than two items.  
·After a transaction is recorded, the total of the assets side of the balance sheet always equals (or "balances") the total of the liabilities side. This is why the statement is called a balance sheet.  
·The double entry principle is based on each accounting transaction affecting at least two items, and after it is recorded, the total of the assets side of the balance sheet equals the total of the liabilities side. This principle is often called the fundamental accounting equation:  
 
Assets = Liabilities

The reasoning behind this principle depends on how you view the balance sheet. Either of the following two explanations is correct.

·If liabilities are claims against assets, then the total amount claimed by all parties cannot be greater that the amount of assets available. In addition, the total claim cannot be less than the amount available because whatever is not claimed by other parties is claimed by the owners. Therefore, the amounts to be claimed (assets) equal the amounts of the claims (liabilities).  
·If liabilities are the source of funds and assets are the form in which these funds are invested, then the amount invested cannot be greater than the funds supplied for investment. In addition, the total invested cannot be less than the amount supplied because all funds are invested. Therefore, the funds invested in various resources (assets) equal the funds supplied (liabilities).  

Certain rules determine how the balance sheet items are listed but, this can differ from one country to another. On the assets side, Cash is usually listed first. (Cash includes all the money owned by the entity, whether in a cash drawer or in a bank account.) The other assets are listed in the order of their nearness to cash, that is, how soon they are likely to be turned into cash. Stock, for example, is likely to be sold sooner than the entity's furniture. As you add asset items, keep this rule in mind.

The right-hand side is divided into two main sections. One is called Liabilities and the other Equity. From here on, the name used for the heading of these two sections is Liabilities and Owner's Equity.



Liabilities are claims of parties other than the owners against assets. The order in which liabilities are listed corresponds to how soon each must be paid.

In a profit-oriented entity, the owner's equity section shows the claims of the owners. These are the shareholders in a company, the partners in a partnership, and the proprietor of a one-owner entity. In a non-profit entity, the owner's equity section is the interest of the entity itself: the residual amount after the liabilities have been satisfied. Since the owners cannot claim assets until after the claims of outside parties have been satisfied, the owner's equity section is listed below the liabilities.



Rather than listing the two sides of the balance sheet side by side, computerised accounting programs often list the assets section before the liabilities and equity section. This is done because the names of some items are too long to fit in a side-by-side format. Thus, the computer would print the balance sheet you developed in the preceding section as follows:

Art Supplies Ltd.
Balance Sheet as of 31/12/2007
Assets


Cash
4,000

Equipment
2,000

Furniture
5,000

Total Assets

11,000
=====
Liabilities


Creditors
1,000

Total Liabilities

1,000
Owner's Equity


Paid in Capital
10,000

Total Owner's Equity

10,000
Total Liabilities & Equity

11,000
=====


Because the right-hand side of the balance sheet is divided into two main sections, the fundamental accounting equation can now be restated as:

Assets = Liabilities + Owner's Equity



11,000 = 11,000