Recording of Transactions — Source Documents and the Accounting Equation
Business Transactions and Source Documents
Recording begins with a business transaction — an economic activity that changes the financial position of the business and can be measured in money (a purchase, a sale, a payment). Transactions are of two kinds: cash transactions (cash paid/received at once) and credit transactions (payment postponed). An event that does not change financial position (e.g. merely placing an order) is not a transaction.
Every entry in the books must be backed by a written proof called a source document (or supporting voucher). This satisfies the objectivity concept — records rest on verifiable evidence, not memory. The common source documents are:
| Document | Prepared / used when… |
|---|---|
| Cash memo | goods are sold/bought for cash (lists items, price, total). |
| Invoice / Bill | goods are sold/bought on credit; the seller's invoice = buyer's bill. |
| Receipt | cash/cheque is received; acknowledges payment. |
| Debit note | we return goods to a supplier / overcharge — we debit his account. |
| Credit note | a customer returns goods to us — we credit his account. |
| Cheque | payment is made through the bank. |
| Pay-in slip | cash/cheque is deposited into the bank. |
From these documents an accountant prepares a voucher — a written document, prepared on the basis of evidence, that analyses a transaction and shows the accounts to be debited and credited. Vouchers are of three kinds: cash vouchers (debit & credit), and non-cash (transfer) vouchers for credit transactions. The chain is therefore: transaction → source document → voucher → books of account.
Cash sale.
- A cash sale is supported by a cash memo.
We reduce his debt.
- When a customer returns goods, the seller credits the customer's account.
- The document sent is a credit note.
The analysing document.
- A voucher is a written document prepared from a source document.
- It analyses a transaction and shows which accounts are to be debited and credited.
Key Points
- Transaction = money-measurable event changing financial position; cash or credit.
- Source documents: cash memo (cash sale), invoice/bill (credit), receipt, debit note (we return), credit note (customer returns), cheque, pay-in slip.
- Chain: transaction → source document → voucher → books; supports the objectivity concept.
Assets, Liabilities, Capital and the Accounting Equation
Everything a business records can be sorted into three boxes: what it owns, what it owes to outsiders, and what it owes to the owner.
- Assets — resources owned by the business that give future benefit: cash, bank, building, machinery, furniture, stock, and debtors.
- Liabilities — amounts owed to outsiders: creditors, bank loans, bills payable, outstanding expenses.
- Capital — the owner's claim on the business (what the firm owes the owner). Capital increases with profit and fresh investment, and decreases with losses and drawings.
Because of the dual aspect concept, the total of what the business owns must always equal the total of the claims against it. This gives the accounting equation:
Assets = Liabilities + Capital
Rearranged, Capital = Assets − Liabilities (the owner's claim is what is left after paying outsiders). This equation always stays balanced: every transaction affects at least two items in a way that keeps both sides equal. For example, buying furniture for cash decreases one asset (cash) and increases another (furniture) — the totals do not change. Taking a loan increases an asset (cash) and a liability (loan) by the same amount. Earning revenue increases an asset and increases capital (profit); paying an expense decreases an asset and decreases capital.
Capital = Assets − Liabilities.
- Capital = 8,00,000 − 3,00,000 = Rs 5,00,000.
One asset replaces another.
- Furniture (asset) increases by Rs 20,000; cash (asset) decreases by Rs 20,000.
- Total assets unchanged → the equation still balances.
Asset and liability rise together.
- Cash (asset) increases by Rs 1,00,000.
- Bank loan (liability) increases by Rs 1,00,000.
Key Points
- Assets = owned (cash, stock, debtors, building). Liabilities = owed to outsiders. Capital = owed to owner.
- Assets = Liabilities + Capital, so Capital = Assets − Liabilities.
- Every transaction keeps the equation balanced (dual aspect). Profit/fresh capital raise capital; loss/drawings reduce it.
Solving Accounting Equation Problems
The exam tests whether you can take a series of transactions and show that the equation stays balanced after each one. The trick is to ask, for every transaction, "which two items change, and in which direction?" Then update a running table.
Worked problem. Start a business and record these transactions:
- Started business with cash Rs 1,00,000.
- Bought goods (stock) for cash Rs 30,000.
- Bought goods on credit from Ram Rs 20,000.
- Sold goods costing Rs 25,000 for Rs 35,000 cash (profit Rs 10,000).
- Paid rent Rs 5,000.
| Transaction | Cash | Stock | = Creditors | + Capital |
|---|---|---|---|---|
| 1. Capital introduced | +1,00,000 | — | — | +1,00,000 |
| 2. Goods for cash | −30,000 | +30,000 | — | — |
| Balance | 70,000 | 30,000 | 0 | 1,00,000 |
| 3. Goods on credit | — | +20,000 | +20,000 | — |
| Balance | 70,000 | 50,000 | 20,000 | 1,00,000 |
| 4. Sale (cost 25,000 for 35,000) | +35,000 | −25,000 | — | +10,000 |
| Balance | 1,05,000 | 25,000 | 20,000 | 1,10,000 |
| 5. Paid rent | −5,000 | — | — | −5,000 |
| Final | 1,00,000 | 25,000 | 20,000 | 1,05,000 |
Check: Assets = Cash 1,00,000 + Stock 25,000 = 1,25,000. Liabilities + Capital = 20,000 + 1,05,000 = 1,25,000. The two sides are equal — the equation balances. Notice that profit (Rs 10,000) increased capital and rent (an expense) reduced capital; that is how profit and expenses enter the equation.
Capital = total assets brought in.
- Assets = cash 50,000 + stock 20,000 = 70,000; no liabilities.
- Capital = 70,000.
Profit raises capital.
- Cash +18,000; stock −15,000; capital +3,000 (the profit).
Drawings reduce capital.
- Cash (asset) −4,000; capital −4,000 (drawings).
Key Points
- For each transaction, identify the two items that change and their direction; update a running table.
- Profit and fresh capital raise capital; expenses, losses and drawings reduce capital.
- After every transaction, check Assets = Liabilities + Capital.