Transaction Analysis

08/01/2022 0 By indiafreenotes

The accounting transaction analysis is the process of translating the business activities and events that have a measurable effect on the accounting equation into the accounting language and writing it in the accounting books. This is the first stage in the accounting cycle, which is the foundation of accounting, regardless of the accounting type you are interested in. Businesses analyze to ensure that the balance sheet equation stays in balance after each transaction is completed.

Understanding the Accounting Equation

To fully understand how accounting transaction analysis affects the basic accounting equation, you must first understand what the accounting equation is and how it works.

The basic accounting equation is:

Assets = Liabilities + Equity

Every economic transaction your business makes must be classified into its proper categories, which include assets, liabilities and net worth.

  • Assets are anything your business owns, which includes cash, equipment, buildings, land, inventory and accounts receivable.
  • Liabilities are any debts that your business owes, which includes mortgages, loans, long-term debts, notes payable and other accounts payable.
  • Net worth is basically net assets or what you would have left over if you paid off everything your business owed and is usually referred to as equity in the accounting equation.
  • Equity is listed as Owner’s Equity for a sole proprietorship or Partner’s Equity for a partnership and Stockholders’ Equity or Shareholders’ Equity for corporations. In the expanded accounting equation, Equity is broken into two components: Revenues and Expenses. Revenue is what the business earns by providing goods or services, and expenses are the costs involved in generating revenue, such as rent, utilities, payroll and taxes.

Accounting transaction analysis can be broken down into six steps:

  1. Is the transaction an accounting transaction?

In order to be identified as an accounting transaction, the transaction must relate to the business and involve a monetary amount. For example, the signing of a rental agreement is not in itself an accounting transaction as there is no monetary amount involved. However, the payment of a deposit under the rental agreement is an accounting transaction, it relates to the business, and there is a monetary amount involved.

  1. Which ledger accounts does the transaction affect?

Identify which accounts the transaction if going to affect. For example, the cash payment of rent for the accounting period, is clearly going to affect the cash account and the rent expense account.

  1. What account type does each of the accounts involved belong to?

Each account can identify with an account type, either assets, liabilities, equity, revenue or expenses. Using the rent example, the cash account would be identified as an asset account, and the rent expense account is identified as an expense account.

  1. Is the balance on each account going to increase or decrease as a result of the transaction?

In the example used above, cash is going to leave the business when the rent is paid, so the cash account should decrease. The amount of rent paid is going to increase, so the rent expense account should increase as a result of the transaction.

  1. Will this increase or decrease lead to each account being debited or credited?

The purpose of identifying the type of account in step 3. above, is to make it easier to decide whether an increase or decrease requires the account to be debited or credited.

Remember, the extended accounting equation is:

Assets + Expenses = Liabilities + Equity + Revenue

Items on the left hand side of the equation are increased by a debit and decreased by a credit, items on the right of the equation are increased by a credit and decreased by a debit.

  1. What is the amount to be entered into each account?

Identify from the source documents the monetary amount to be entered for each account.

Accounting Transaction Analysis Table

The accounting transaction analysis described in the six steps above, is best set out in table format to ensure that important considerations about the transaction are not overlooked.

In the above example, suppose the cash payment for the rent was the amount of 4,000, using the six step process we have the following analysis of the transaction.

  • This is an accounting transaction as it relates to the business and involves a monetary amount.
  • The accounts involved are the cash account and the rent expense account.
  • The two accounts types are an asset account (cash) and an expense account (rent).
  • Cash is decreased and rent is increased by the transaction.
  • A decrease to an asset account is a credit, an increase to an expense account is a debit.
  • For each account the monetary amount is 4,000