Balance sheets are only true at the time they are prepared. This is because every transaction that a business makes affects the balance sheet.

Although the balance sheet equation is always true (i.e., that the two sides of the balance sheet will always have the same total), the values of individual items listed in the balance sheet change due to transactions.

To clearly understand this statement and the impact that various transactions may have on a balance sheet, let’s consider some examples.

Example

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

1. Transaction A

On 1 May, Harry purchased a pair of chairs for \$2,500, paying for them by check. The effects of this transaction were:

• Furniture increased by \$2,500
• Cash at bank decreased by \$2,500

The net impact of this transaction is that an increase in one asset (furniture) has been offset by a decrease in another asset (cash at bank). The value of total assets, therefore, remains unchanged, leaving the balance sheet in balance.

The revised balance appears as follows:

2. Transaction B

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

• Value of Harry’s stock increased by \$4,800
• Liability toward creditors 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:

3. Transaction C

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

• Cash in hand decreased by \$4,200
• Liability toward creditors 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:

4. Transaction D

On 4 May, Harry borrowed an additional \$10,000 from SME BANK, asking SME BANK to make the payment directly to one his creditors. The effects of this transaction on the balance sheet are:

• Liability toward SME BANK increased by \$10,000
• Liability toward creditors decreased by \$10,000

The net impact of this transaction is that an increase in one liability (SME BANK) is offset by a decrease in another liability (creditors). The amount of assets and liabilities remains unaffected and, hence, the balance sheet stays in balance.

After transaction D, the status of Harry’s balance sheet is as follows:

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:

• Capital increased by \$5,000
• Cash at bank 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 shown below.

6. Transaction F

On 6 May, Harry withdrew goods costing \$800 from stock for personal use. The effects of this transaction are:

• Capital decreased by \$800
• Stock decreased by \$800

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:

Summary of Effects of Transaction on a Balance Sheet

Did you notice how the balance sheet remained in balance after every transaction? That’s to say, the total assets always stayed equal to the total of capital and liabilities.

This is an essential fact to remember: Balance sheets always balance.

The reason why a balance sheet always balances is easy to understand. If you check all of the above transactions, you’ll notice that each one has two effects on the balance sheet.

These two effects have the opposite nature and, as such, neutralize each other.

The table below summarizes the impact of the various transactions seen so far.

Effect of Compound Transactions on a Balance Sheet

Some transactions may influence not just 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 is useful to study them a bit more carefully.

7. Transaction G

On 7 May, Harry sold stock costing \$6,000 (and included in his balance sheet at this value) to a credit customer for \$7,500. The effects of this transaction are:

• Stock will decrease by \$6,000 (the value at which it was included in his balance sheet)
• Debtors will increase by \$7,500 (the value at which it was sold and the amount that will eventually be received from the debtor)
• The difference between the two (i.e., \$1,500), representing 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.

The net impact of this compound transaction is that the assets side increases by a net amount of \$1,500 (i.e., a \$7,500 increase in debtors less a \$6,000 decrease in stock). In addition, capital increases by an equal amount of \$1,500.

The balance sheet will, therefore, remain in balance. It will now appear as follows:

8. Transaction H

On 8 May, Harry sold all of his furniture for \$11,200, receiving the proceeds by check. The check was immediately deposited in Harry’s business bank account. The effects of this transaction are:

• Furniture will decrease by \$12,500 (the value at which it was included in the balance sheet)
• Cash at bank will increase by \$11,200 (the amount actually received)
• The difference between the two represents a loss to the business. This has the effect of reducing the business unit’s net worth (i.e., the owner’s capital). This should, therefore, be deducted from capital.

The net impact of this compound transaction is that the assets side decreases by a net amount of \$1,300 (i.e., a \$12,500 decrease in furniture less an \$11,200 increase in cash at bank). Also, capital is reduced by \$1,300.

The balance sheet, therefore, remains in balance, as shown below.

What is the impact of a transaction on a balance sheet?

Each transaction has two effects on a balance sheet - one that increases an asset and one that decreases a liability. These two effects cancel each other out, so the balance sheet always remains in balance.

Why do balance sheets always balance?

The reason why balance sheets always balance is easy to understand. If you check all of the above transactions, you'll notice each one has two effects on the balance sheet. These two effects have the opposite nature and, as such, neutralize each other.

What is a net impact?

The net impact of a compound transaction is simply calculated by subtracting its negative effect from its positive effect. In other words, the net impact is the difference between increases and decreases. The term "net" means that you have to consider whether a transaction increases or decreases both assets and liabilities.

What happens when there is a gain on a transaction?

When there's a gain, this belongs to the business unit's owner. Thus, it's added to the business's capital. In this case, assets increase by a greater amount than liabilities and equity decreases by a smaller amount.

What happens when there's a loss on a transaction?

When there's a loss, this belongs to the business unit's owner. So, it gets deducted from capital. In this case, assets decrease by a greater amount than liabilities and equity decreases by a smaller amount.

True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website, view his author profile on Amazon, his interview on CBS, or check out his speaker profile on the CFA Institute website.