Basic Accounting - Ep. 6 - Transaction Analysis - Example
The process of translating a business's economic events into the accounting language and writing
it in their books is called "transaction analysis." Here is an example of using transaction analysis:
This is Jim. Jim has $10.
Jim wants to turn his $10 into much more money. Jim decides to start a business.
His business will be a lawn mowing business. Jim contributed his $10 to his business.
Jim then goes to the bank and borrows $100. Jim then goes to the hardware store and buys
a lawn mower for $100. Jim then buys gasoline needed to mow a lawn
with his mower. Next, Jim earns $20 by mowing a lawn.
At this point in time, what does Jim have? Jim has $20.
Also, Jim has a lawn mower that cost him $100. This business's story would be told in the
following way: The first transaction was Jim contributing
$10.
By analyzing this transaction, we determine that the cash account needs to be increased
by 10. Correspondingly, the equity account will be
increased by 10. This is reflected on the books by increasing
the balance sheet accounts as determined. Equity account, plus 10.
Cash, plus 10.
Transaction #2: Jim borrows $100 from the bank.
The amount of cash in the business just increased by 100.
Also, a liability of 100 was created. Now, to apply to the books,
Liabilities are increased by 100, and cash is increased by 100.
Transaction #3: Jim Buys Equipment. Cash left the business, so there is a decrease
in cash of 100. The cash was used to buy machinery, so there
was an increase in machinery of 100. On the books, an account called Mower is created,
and it is increased by 100 to show the purchase of assets.
The cash account is then decreased by 100. Notice that no liability or equity accounts
were changed. This transaction was trading one asset for
another. There was no increase or decrease in the total
amount of assets on the balance sheet, so there is no need for the other side of the
balance sheet to change.
Transaction #4: Jim Pays $10 for gas. The amount of cash in the business decreased
by 10. The money was used to pay an expense of operating
the business. Therefore, the expenses of the business increases.
To reflect this on the books, the cash account is decreased by 10.
Then, to show the corresponding decrease in equity, we will show an increase in the expense
account of the income statement. When expenses increase, the income decreases.
The decrease in income on the income statement is then reflected on the balance sheet in
the equity section. Remember, the equity section shows the net
income from the income statement. They are linked together.
Transaction #5: Jim Earns $20. The amount of cash in the business increases
by 20. The money was a result of earning activities
of the business, so there is an increase in the business's Revenue account by 20.
This is shown on the books by increasing the Revenue account on the income statement by
20. The net income is updated to reflect the change
in the Revenue account on the income statement. Correspondingly, the income account of the
equity section of the balance sheet is updated to reflect the income on the income statement.
Then, the cash account is increased by 20 to reflect the increase in cash.
If we add up all of the changes on the balance sheet, the two sides should still balance.
We see that they do balance. If we add up all of the changes in each account,
we can see that there is a total of $20 in cash, and there is Equipment with a cost of
$100. Looking at the liabilities section of the
balance sheet, we can see that there is debt of $100.
Then, we can see that there is a total of $20 in equity.
The Equity is comprised of two components. There is the $10 of original contribution,
and then there is $10 of income.
As we see on our income statement, there was a total of $20 of revenue, and $10 of expenses.
The net of these two numbers is $10, which represents our net income.
As we see, the amount of income on our income statement, matches the amount of income shown
on the equity section of the balance sheet.
This example shows that by analyzing each transaction, and determining its effects on
the accounts in the balance sheet and the income statement, we are able to tell the
story of the business through the language of accounting.