Effects of Transactions on a Balance Sheet

As you have studied already that a Balance Sheet is true only at the time it is prepared. This is so because each and every transaction made by a business affects the Balance Sheet in some way or another. While the Balance Sheet Equation always remains true, i.e. the two sides of the Balance Sheet will always give the same total; the values of individual items listed in the Balance Sheet are changed as a result of transactions. To clearly understand this statement and the impact that various transactions may have on a Balance Sheet, let us take a few examples.

Example

Let us assume that Harry, a retailer, had the following assets and liabilities on 30 April 2019.

Effect of Transactions on a Balance Sheet

1. Transaction A

On 1 May, Harry bought a pair of chairs for $2,500 and paid for them by cheque. The effects of this transaction are:


(a) His furniture increased by $2,500 and
(b) His cash at bank decreased by $2,500

The net impact of this transaction is that an increase in one asset (furniture) has been off-set by a decrease in another asset (cash at bank). The total of assets, therefore, remains unchanged and the Balance Sheet stays balanced. The revised Balance Sheet will appear as follows..

Harry - Balance Sheet

2. Transaction B

On 2 May, Harry bought, on credit, some goods for resale for $4,800. The effects of this transaction are:

(a) The value of his stock increased by $4,800 and
(b) His liability towards creditors also increased by $4,800.


The net impact of this transaction is that an increase in an asset (stock) is balanced by an equal increase in a liability (creditors). As the amount of capital remains unaffected, the Balance Sheet stays in balance. It will now appear as follows:

Transaction 2

3. Transaction C

On 3 May, Harry paid $4,200 in cash to a creditor. The effects of this transaction are:

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(a). His cash in hand decreased by $4,200, and
(b). His liability towards creditors also decreased by $4,200.

The net impact of this transaction is that a decrease in an asset (cash in hand) is balanced by an equal decrease in a liability (creditors). As the amount of capital remains unaffected, the Balance Sheet stays in balance. It will now appear as follows:

Transaction C

4. Transaction D

On 4 May, Harry borrowed an additional $10,000 from SME BANK, asking SME BANK to pay direct to one his creditors. The effects of this transaction on Balance Sheet are:

(a) His liability towards SME BANK has increased by $10,000 and
(b) His liability towards his creditors has decreased by $10,000.

The net impact of this transaction is that an increase in one liability (SME BANK) is off-set by decrease in another liability (creditors). The amounts of assets, and liabilities remain unaffected and hence the Balance Sheet stays in balance. It will now appear as follows:

Transaction D

5. Transaction E

On 5 May, Harry introduced additional capital into his business by depositing $5,000 into the business bank account out of his personal cash held at his house. The effects of this transaction are..

(a) His capital increased by $5,000 and
(b) Cash at Bank also increased by $5,000.

The net impact of this transaction is that an increase in capital is balanced by an equal increase in an asset (cash at bank). As liabilities remain unaffected, the Balance Sheet equation stays in balance, as follows:

Effect of Transactions on a Balance Sheet E

6. Transaction F

On 6 May, Harry took some goods costing $800 out of the shop stock to his house for his family’s consumption. The effects of this transaction are:

(a) His capital decreased by $800 and
(b) His stock also decreased by $800

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The net impact of this transaction is that a decrease in the capital is balanced by an equal decrease in an asset (stock). As the liabilities are unaffected, the Balance Sheet stays in balance. It will now appear as follows:

Transaction F - effect of Transaction on a Balance Sheet

A Summary of Effects of Transaction on a Balance Sheet

Did you notice how the Balance Sheet remained in balance, i.e. the total of assets remained equal to the total of capital and liabilities, after each and all transactions? This is a very important fact to remember: Balance Sheet always balances. The reason why a Balance Sheet always balances is not difficult to understand. If you go over all the above transactions again- you will notice that each and every transaction has two effects on the Balance Sheet. These two effects are opposite in nature to each other and sort of neutralize each other. Study the following chart that summarises the impact of various transactions seen so far:

Impact of Transaction on a Balance Sheet

Effect of Compound Transactions on a Balance Sheet

Some transactions may affect not two but three or more items in a Balance Sheet. While the net effect of these transactions is the same as those that affect only two items, it will be helpful to study them a bit more carefully.

7. Transaction G

On 7 May, Harry sold some of the stock that had cost him $6,000 (and is included in his Balance Sheet at this value) to a credit customer for $7,500. The effects of this transaction are:

(a) His stock will decrease by $6,000 (the value at which it was included in his balance sheet), while
(b) His debtors will increase by $7,500 (the value at which it has been sold and the amount that will eventually be received from the debtor).
(c) The difference between the two, i.e. $1,500 represents Harry’s profit on the deal. This profit, or any other profit made by a business, belongs to its owner and should, therefore, be added to the amount of the owner’s capital.

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The net impact of this compound transaction is that the assets side is increased by a net amount of $1,500 ($7,500 increase in debtors less $6,000 decrease in stock) and at the same time capital is increased by an equal amount of $1,500. The Balance Sheet will, therefore, remain in balance. It will now appear as follows:

Compound Transaction Effect on a Balance Sheet

8. Transaction H

On 8 May, Harry sold all of his furniture for $1 1,200 receiving the proceeds by cheque, which he immediately deposited in his business bank account. The effects of this transaction are:

(a) His furniture will decrease by $12,500 (the value at which it was included in Balance Sheet)
(b) His cash at bank will increase by $11,200 (the amount actually received)
(c) The difference between the two represents a loss to the business. This has the effect of reducing business unit’s net worth, or in other words its owner’s capital. This should, therefore, be deducted from capital.

The net impact of this compound transaction is that the assets side is decreased by net amount of $1,300 ($12.500 decrease in Furniture less $11,200 increase in cash at bank) and at the same time capital is reduced by $1,300. The Balance Sheet, therefore, remains in balance. It will now appear as:

Transaction H

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