Accounting Equation Double Entry Framework Accounting Equation 1

Accounting Equation Double Entry Framework & Accounting Equation 1

Accounting Equation MEANING OF AN ACCOUNTING EQUATION An Accounting Equation is a mathematical expression which shows that the assets and liabilities of a firm are equal. An Accounting Equation is based on the dual aspect concept of accounting i. e. , every transaction has two aspects-debit and credit. It holds that for every debit there is a credit of equal amount and vice versa. 2

Accounting Equation MEANING OF AN ACCOUNTING EQUATION Total Claims (i. e. Capital and Liabilities) are always equal to the total Assets and is known as Accounting Equation. The claims, also known as equities. are of two types: 1. Owner's equity or capital, and 2. Outsiders Equity (Liabilities or amounts due to outsiders). We can express Accounting Equation as follows: a) Assets = Liabilities + Capital or b) Liabilities = Assets – Capital or c) Capital = Assets - Liabilities 3

Accounting Equation INTRODUTION The whole financial accounting is based on the accounting equation. The recourses possessed by the firm are known as assets and the amount supplied by him is known as capital. If he is was the only who had supplied the assets then capital must be equal to assets. • The indebtness of the firm for the recourses provided by other then the owner is known as liabilities. • To sides of equation are, therefore, equal. On the side are the recourses possessed and on the other side are the sources from which theses recourses were obtained. The equity of the two sides will always be true, no matter how many transactions into. The actual assets, capital and liabilities may change but the equality of the assets with that of the capital and liabilities will always hold true.

Accounting Equation Accounting equation American accounts have derived the rules of debit and credit through accounting equation which is given below: Assets = Equities The equation is based on the principal that accounting deals with property and rights to property and the sum of the properties owned is equal to the sum of the rights to the properties. The properties owned by a business are called assets and the rights to properties are known as liabilities or equities of the business.

Accounting Equation Equities may be divided into two categories • First one is equities of creditors which is representing the debt of the business known as liabilities. • Second is equities of the owner known as liabilities. • Keeping in view the two types of equities the equation given above can be stated as below: Assets = Liabilities + capital or Capital = Assets – Liabilities or Liabilities = Assets – Capital

RULES OFEquation ACCOUNTING Accounting EQUATION 1. Regarding assets : Increases in assets are debits and deceases 2. 3. 4. 5. in assets are credits. Regarding liabilities : Increases in liabilities are credits and decreases in liabilities are debits. Regarding capital : Increases in capital are credits and decreases in capital are debits. Regarding expenses : Increases in expenses are debits and decreases in expenses are credits. Regarding incomes or profits : Increases in incomes or profits are credits and decreases in incomes or profits are debits.

Accounting Equation ILLUSTRATION 1 You are required to complete the gapes in the following table : Assets (Rs. ) Liabilities (Rs. ) Capital (Rs. ) a) 25, 000 3, 600 ? b) 56, 000 9, 800 ? c) 33, 600 ? 25, 000 d) 39, 200 ? 32, 900 e) ? 12, 600 38, 400 f) ? 23, 300 79, 500 SOLUTION : With the help of accounting equation i. e. Capital + Liabilities = Assets The table in the illustration is completed as follows : Assets (Rs. ) = liabilities (Rs. ) + Capital (Rs. ) a) 25, 000 3, 600 21, 400 b) 56, 000 9, 800 46, 200 c) 33, 600 8, 600 25, 000 d) 39, 200 6, 300 32, 900 e) 51, 000 12, 600 38, 400 f) 1, 02, 800 23, 300 79, 500

Accounting Equation Effects of business transaction on accounting equation and balance sheet The accounting equation is expressed in a financial position called the Balance Sheet. It is not accounting record to be made, but it is convenient place to start. Introduction of Capital On April 1, 2012 Rajesh started a business and deposited Rs. 50, 000 in Bank Account. The first Accounting Equation will be as follows : Capital = Assets Rajesh’s Capital Rs. 50, 000 = Cash at Bank Rs. 50, 000 The initial Balance Sheet of the business would appear as under : BALANCE SHEET OF MR. RAJESH as on April 1, 2012 Liabilities Amount Assets Amount Rajesh’s Capital 50, 000 Cash in Bank 50, 000

Accounting Equation Purchase of an asset by Cheques On 3 rd April, 2012 Rajesh buys a building for Rs. 30, 000. The effect of this transaction is that Cash at Bank is decreased and a new asset building appears. The Accounting Equation will be as follows: Liabilities + Capital = Assets Rajesh’s Capital Rs. 50, 000=Cash at Bank Rs. 20, 000 +Building Rs. 30, 000 After the transaction the Balance Sheet will appear as follows : BALANCE SHEET OF RAJESH as on 3 rd April, 2012 Liabilities Amount Assets Amount Rajesh’s Capital 50, 000 Cash at Bank 20, 000 Building 30, 000 50, 000

Accounting Equation Purchase of an asset and incurring of a liability On 6 th April, 2012, Rajesh buys some goods for Rs. 5, 000 from Ram and agrees to pay them something within next two months. The effect of this is that a new asset, stock of goods is acquired and a liability for the goods is created. The Accounting Equation : Liabilities + Capital = Assets. Creditors + Rajesh’s Capital = Cash at Bank + Building + Stock of Goods Rs. 5, 000 + Rs. 50, 000 = Rs. 20, 000 + Rs. 30, 000 + Rs. 5, 000 After this transaction, the Balance Sheet will be as under : BLANCE SHEET OF MR. RAJESH as on 6 th April, 2012 Liabilities Amount Assets Amount Creditors 5, ooo Stock of goods 5, 000 Rajesh’s Capital 50, 000 Cash at Bank 20, 000 Building 30, 000 55, 000

Accounting Equation SALE OF AN ASSET ON CREDIT On 10 th April, 2012 goods which had cost Rs. 1, 000 were sold to Hitesh for the same amount; the money to be paid later. The effect is a reduction in the stock of goods and the creation of a new asset. The Accounting Equation : Liabilities + Capital =Assets. Creditors ( 5, 000)+Rajesh’s Capital (50, 000) = Cash at Bank(20, 000) + Building(30, 000) + Stock of Goods(4, 000) + Debtors(1, 000) After this transaction, the Balance Sheet will be as follows : BALANCE SHEET OF MR. RAJESH as on April 10 th , 2012 Liabilities Creditors Rajesh’s Capital Amount 5, 000 50, 000 55, 000 Assets Cash at Bank Stock of Goods Debtors Building Amount 20, 000 4, 000 1, 000 30, 000 55, 000

Accounting Sale of an asset for. Equation immediate payment On 13 th April, 2012 goods which had cost Rs. 500 were sold to Mohan for the same amount; Mohan paying for them immediate by cheque. The Accounting Equation : Liabilities + Capital = Assets Creditors(5, 000) + Rajesh’s Capital (50, 000)= Cash at Bank(20, 500) + Stock of Goods(3, 500) + Buildings (30, 000)+ Debtors(1, 000) BALANCE SHEET OF MR. RAJESH as on 13 th April, 2012 Liabilities Creditors Rajesh’s Capital Amount Assets 5, 000 Cash at Bank 50, 000 Stock of Goods Debtors Building 55, o 00 Amount 20, 500 3, 500 1, 000 30, 000 55, 000

Accounting Equation Payment of a liability On 15 th April, 2012 Rajesh gave a cheque for Rs. 2, 000 to Ram in part payment of the amount owing. The asset of Bank is, therefore, reduced and liability of the creditor is also reduced. Accounting Equation : Liabilities + Capital = Assets Creditors(3, 000) + Rajesh’s Capital(50, 000) = Cash at Bank(18, 500) +Stock of Goods(3, 500) + Debtors (1, 000) + Building (30, 000) BALANCE SHEET OF MR. RAJESH as on 15 th April, 2012 Liabilities Creditors Rajesh’s Capital Amount 3, 000 50, 000 Assets Cash at Bank Stock of Goods Debtors Building 53, 000 Amount 18, 500 3, 500 1, 000 30, 000 53, 000

Accounting Equation Collection of an assets Hitesh who owed Rajesh Rs. 1, 000 makes a part payment of Rs. 750 by cheque on 30 th April, 2012. The effect is to reduce one asset, debtors, and to increase another asset, Cash at bank. Accounting Equation : Liabilities + Capital = Assets Creditors(3, 000) + Rajesh’s Capital = Cash at Bank(19, 500) + Stock of Goods(3, 500) + Debtors(250) + Building(30, 000) After this transaction, the Balance sheet will be as follows: BALANCE SHEET OF MR. RAJESH as on 30 th April, 2012 Liabilities Amount Assets Amount Creditors 3, 000 Cash at Bank 19, 250 Rajesh’s Capital 50, 000 Stock of Goods 3, 500 Debtors 250 Building 30, 000

Accounting Equation Illustration Ram started a business on 1 -4 -2011 with capital of Rs. I, oo, 000 and a loan of Rs. 50, 000 borrowed from Sham. On 31 -32012 his assets were Rs 4, 000. Find out his Capital as on 31 -3 -2012 and profits made or loss incurred during the year 2011 – 2012. Solution : Closing Capital = Closing Assets – Closing External Liabilities = Rs 4, 000 – Rs. 50, 000( loan from Sham)= Rs 3, 50, 000 Profit = Closing Capital – Opening Capital = Rs. 3, 50, 000 – Rs. 1, 00 o = 2, 50, 000

Accounting Equation MEANING OF AN ACCOUNTING EQUATION Overview of the Balance Sheet that shows the Accounting Equation discussed above. Balance Sheet Liabilities Capital Secured Loan From Bank Current Liabilities Creditors Expenses Outstanding Rs. Assets 4, 000 Fixed Assets Land Building 2, 25, 000 Machinery Computer 75, 000 Current Assets 25, 000 Stock Debtors Cash and Bank Balances 7, 25, 000 Rs. 3, 000 2, 000 50, 000 1, 000 25, 000 7, 25, 000 17

Accounting Equation MEANING OF AN ACCOUNTING EQUATION An Accounting Equation always holds true with every change that occurs due to a transaction entered into. It is because of this reason that it is based on the dual aspect concept of accounting. A transaction may affect either both sides of the equation by the same amount or one side of the equation only. by both increasing or decreasing it by equal amounts. 18

Accounting Equation MEANING OF AN ACCOUNTING EQUATION Transactions from the Accounting viewpoint, can be divided into two, i. e. , Equation 1. Transactions Affecting Two Items and 2. Transactions Affecting More Than Two Items. 19

Accounting Equation Transactions Affecting Two Items Transactions affecting opposite sides are: (i) Increase in Asset, Increase in Liability: Transaction such as credit purchases increase asset (stock) and also increase liability (creditor). Similarly, loans from bank increase asset (cash) and also increase liability (loan). (ii) Decrease in Liability, Decrease in Asset: Transaction of payment to a creditor decreases liability (creditor) and also reduces asset (cash or bank). 20

Accounting Equation Transactions Affecting Two Items (iii) Increase in Asset, Increase in Owner's Equity: Introduction of capital by the proprietor increases asset (cash or bank) and also liability (capital). (iv) Decrease in Owner's Capital, Decrease in Asset: Drawings by the proprietor decreases liability (capital) and also asset (cash or bank). 21

Accounting Equation Transactions Affecting Two Items Transactions affecting same side but in opposite direction are: (i) Increase in Asset, Decrease in Another Asset: Transactions such as cash purchases or receipt from debtors increase one asset (goods and cash or bank, respectively) and decrease another asset (cash or bank and debtors). (ii) Decrease in Liability, Increase in Another Liability: Settlement of creditor by issue of Bill of Exchange decreases a liability (creditor) and increases another liability (Bill of Exchange). 22

Accounting Equation Transactions Affecting More Than Two Items Some transactions affect more than two items of the accounting equation or a Balance Sheet. For example, when a sale is made in cash for Rs. 30, 000, it is made at cost (Rs. 25, 000) plus profit (Rs. 5, 000). Cost of goods (Rs. 25, 000) reduces asset (stock of goods), cash increases by Rs. 30, 000 and the owner's capital increases by the profit Rs. 5, 000). It should be noted that profit increases the owner's capital and loss decreases it. 23

Accounting Equation Effect of Transactions on Accounting Equation The procedure to workout an Accounting Equation is: 1. Analyse the transaction in terms of such variables as assets, liabilities, capital. revenues and expenses. 2. Decide the effect of the transactions in terms of increase or decrease on variables mentioned in 1. 3. Record the effect on the relevant side of the equation. Let us take a few transactions to understand the accounting equation. 24

Accounting Equation Effect of Transactions on Accounting Equation Suppose, Rakesh starts business and the following successive transactions are entered into: (1) He commences his business with Rs. 20, 000 as Capital. Effect: It means that the firm has assets totalling Rs. 20, 000 in the form of cash and claims against the firm are also Rs. 20. 000 in the form of capital. The equation stands as follows: Assets = Liabilities + Capital Cash Capital Introduced 20, 000 = 0 + 20, 000 25

Accounting Equation Effect of Transactions on Accounting Equation (2) Purchases furniture for Rs. 500 in cash. Effect: It means cash in hand is reduced by Rs. 500 but a new asset (furniture) of the same amount has been purchased. Thus, total of assets remains unchanged. The equation will now appear as follows: Assets = Liabilities + Cash + Furniture Old Balance New Transaction New Balance Capital Rakesh's 20, 000 + 0 = 0 - 500 + 500 = 0 19, 500 + 500 = 0 + + + 20, 000 0 20, 000 26

Accounting Equation Effect of Transactions on Accounting Equation (3) Purchases goods for Rs. 1, 000 in cash. Effect: It means cash in hand is reduced by Rs. 1, 000 and another asset, i. e. , stock has come into existence but the total of assets remains unchanged. The equation now will be as follows: Assets Cash + Furniture = + Liabilities + Capital Rakesh's Stock Old Balance 19, 500 + 0 New Transaction -1, 000 + 1, 000 New Balance 18, 500 + 1, 000 = = = 0+ 20, 000 0 + 0 0+ 20, 600 27

Accounting Equation Effect of Transactions on Accounting Equation (4) Purchases goods for Rs. 2, 000 on credit. Effect: It means the stock has increased by Rs. 2, 000 making the total assets Rs. 22, 000. A liability of Rs. 2. 000 to the supplier of the goods (creditor) has arisen. The equation now will be as follows: Assets Old Balance New Transaction New Balance = Cash + Furniture + Stock 18, 500 + 500 0 + 1, 000 + 2, 000 = = 18, 500 + 3, 000 = Liabilities +Capital Creditors + Rakesh's 0 2, 000 + + 20, 000 0 2, 000 + 20, 000 28

Accounting Equation Effect of Transactions on Accounting Equation (5) Sold goods costing Rs. 2, 500 on credit for Rs. 4, 000. Effect: It means a debtor has come into existence to the extent of Rs. 4, 000. The stock will be reduced only by Rs. 2. 500, being the cost of goods sold. The net increase in assets. Rs. 1, 500. i. e. Rs. 4, 000 - Rs. 2, 500 (profit) will be added to the capital. The position now will be shown as Assets Cash = Liabilities + Capital + Furniture + Stock + Debtors = Creditors + 2, 000 + 21, 500 - 6, 000 2, 000 + 15, 500 Old Balance 18, 500 + New Transaction - 6, 000 + 0 + 4, 000 = New Balance 12, 500 + 4, 000 = 0 Rakesh's 29

Accounting Equation Effect of Transactions on Accounting Equation (7) Rakesh withdraws Rs. 2, 000 for personal use. Effect: Cash in hand is reduced by Rs. 2. 000 and capital will also reduced by the same amount. The new Accounting Equation will be as follows: Cash 12, 500 -2, 000 Old Balance New Transaction New Balance 10, 500 + Furniture + 5, 00 + + + Assets Stock 500 0 + 500 = + Debtors = + 4, 000 Liabilities Creditors 2, 000 0 = 2, 000 + + + - Capital Rakesh’s 15, 500 2, 000 + 13, 500 30

Accounting Equation Effect of Transactions on Accounting Equation It will be observed from above that the total of assets will always be equal to the total of liabilities and the capital. The last equation stated above can also be presented in the form of a statement i. e. Balance Sheet Liabilities Rs. Creditors 2, 000 Cash Capital Less: Drawings Assets Furniture 15, 500 2, 000 13, 500 Stock Debtors 15, 500 Rs. 10. 500 500 4, 000 15, 500 31

Accounting Equation Effect of Transactions on Accounting Equation A conclusion apparent from the transactions given above is that every transaction has a double sided effect. In other words, the Dual Aspect Concept will always hold good. A reduction or increase in an asset will have a corresponding effect on liabilities or capital. This is because of the rule that every receiver is a giver and every giver is a receiver. 32

Accounting Equation RULES FOR ACCOUNTING EQUATIONS 1. Capital: When capital is increased, it is credited (+) and when a part of the capital is withdrawn, i. e. drawings are made, it is debited (-). Interest on Capital is an expense for the business, and thus, profit is reduced by the amount and since interest on capital is an income for the proprietor, it is added to capital. Interest on Drawings is a profit for the business therefore added to profit and thus, capital. Since it is a loss/expense for the owner it is deducted from capital. Assets and Liabilities will not be affected by interest on capital and interest on drawings. 33

Accounting Equation RULES FOR ACCOUNTING EQUATIONS 2. Revenue: Owner's equity (Capital) is increased by the amount of revenue. 3. Expenses: Owner's equity (Capital) is decreased by the amount of expenses. Income = Revenue - Expense Income is the profit earned during an accounting period. Profit increases the owner's equity (Capital) and loss decreases the owner's equity (Capital). 34

Accounting Equation RULES FOR ACCOUNTING EQUATIONS 4. Outsiders' Equity: When liabilities are increased, outsiders' equities are credited (+) and when liabilities are decreased, outsiders' liabilities are debited (-). 5. Assets: If there is an increase in Assets, the increase is debited (+) in the Asset Account. If there is decrease in Assets, the decrease is credited (-) in the Asset Account. 6. It is possible that when one asset increases, the other asset decreases, e. g. , purchase of furniture for cash. Thus, furniture increases and cash decreases. 35

Accounting Equation RULES FOR ACCOUNTING EQUATIONS 7. It is possible that one asset decreases, the other asset increases, e. g. , sale of furniture for cash. Thus. cash increases and furniture decreases. 8. It is possible that when one liability increases, the other liability decreases, e. g. , on dishonour of bills payable. the Bills Payable Account is debited and the Creditor's Account is credited. Thus, creditor increases and the amount of bills payable decreases. 36

Accounting Equation RULES FOR ACCOUNTING EQUATIONS 9. It is possible that one liability decreases and the other liability increases, e. g. , creditors were made payment by accepting bills payable. Thus, creditor decreases and bills payable increases. 10. It is possible that when an asset increases, liability also increases, e. g. , furniture is purchased on credit. Thus, furniture increases and the amount of creditors also increases. 11. It is possible that when an asset decreases, liability also decreases. e. g. , cash paid to creditors. Thus, cash decreases and the amount of creditors also decreases. 37

Accounting Equation RULES FOR ACCOUNTING EQUATIONS 12. Effect of Outstanding Expenses (e. g. , Outstanding Salary): Increase in liabilities and decrease in capital. 13. Accrued Income: Increase in asset and increase in capital. 14. Income Received in Advance: Increase in asset (as cash) and increase in liabilities. 38

Accounting Equation RULES FOR ACCOUNTING EQUATIONS 15. An increase in an asset, without a corresponding increase in liability or a corresponding decrease in another asset, means an increase in capital. Conversely, an increase in liability without a corresponding increase in asset, or a corresponding decrease in another liability, indicates decrease in capital. 39

Accounting Equation ACCOUNTING EQUATION S. NO Transaction Assets 1. ) Mukesh started business with Rs. 80000 Cash 80000 2. ) Purchased goods for cash Rs. 28000 3. ) Purchased goods on credit Rs. 20000 4. ) Purchased furniture for cash for Rs. 6000 5. ) Paid rent Rs. 2000 6. ) Received commission Rs. 500 = Liabilities + Capital Creditors 0 80000 0 0 20000 0 Cash -6000 0 -6000 Cash +500 0 +500 Cash + stock -28000 + 28000 stock 20000 Cash + Furniture -6000 + 6000

Accounting Equation ACCOUNTING EQUATIONS S. no Transaction Assets = 10. ) Received dividend 5000 Cash +5000 0 +5000 11. ) Fresh capital invested Rs. 50000 Cash +50000 0 +50000 12. ) Purchased goods from Rohan Rs. 55000 Stock 55000 13. ) Paid cash to Rohan in full settlement of Rs. 53000 Cash -53000 14. ) Paid rent in advance RS. 3000 Cash + p. exp -3000 + 3000 15. ) Rent outstanding Rs. 3000 16. ) Deposited into Bank Rs. 8000 0 Cash + Bank -8000+ 8000 Liabilities Creditors - 55000 0 O/S exp. + 3000 0 + Capital 0 + 2000 0 Capital - 3000 0