2. LEARNING OBJECTIVES
This Chapter would enable you to understand:
Meaning of an Accounting Equation
Effect of Transactions on an Accounting Equation
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3. 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 at least two effects.
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4. MEANING OF AN ACCOUNTING EQUATION
Total of Capital and Liabilities are always equal to the total
Assets and it is known as Accounting Equation.
Equation as follows:
a) Assets = Liabilities + Capital or
b) Liabilities = Assets – Capital or
c) Capital = Assets - Liabilities
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5. ELEMENTS IN THE ACCOUNTING EQUATION
Assets : resources owned by the business
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ASSET
S
FIXED
ASSETS
Assets that have a useful life > 1 year
Used in business operations
to generate profit
Example : Land and building,
Plant and Machinery, Vehicles
CURRENT
ASSETS
Assets that can be
converted into
Cash within 1 year
Example : stock, debtor,
cash in hand
6. ELEMENTS IN THE ACCOUNTING EQUATION
Liabilities : Amount owed by the business to
external parties (creditors, bank)
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Liabilities
Long term
liabilities
Debts which are not expected
to
be paid within a year
Example : Bank loans
Current
liabilities
Debts which are expected to be
Paid within a year
Example : Creditors, accrued
expenses
8. BALANCE SHEET
Definition: Balance Sheet is the financial
statement of any type of organization which
includes assets, liabilities, capital, total debt,
etc.
Balance sheet includes assets on one side,
and liabilities on the other. For the balance
sheet to reflect the true picture, both heads
(liabilities & assets) should tally
.
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9. BALANCE SHEET
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Liabilities Rs. Assets Rs.
Capital 4,00,000 Fixed Assets
From Bank 2,25,000 Land and Building 3,00,000
Current Liabilities Machinery 2,00,000
Creditors 75,000 Computer 50,000
Expenses Outstanding 25,000 Current Assets
Stock 50,000
Debtors 1,00,000
Cash and Bank Balances 25,000
7,25,000 7,25,000
10. RULES
Every transaction has at least two effects
Every expenses and losses will be deducted
from capital
Every income and profit will be added into
capita
Equation should always be matched
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12. 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:
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Assets = Liabilities + Capital
Cash
Capital Introduced 20,000 = 0 + 20,000
13. (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:
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Assets =
Liabilities
+
Capital
Cash + Furniture Rakesh's
Old Balance 20,000 + 0 = 0 + 20,000
New
Transaction
- 500 + 500 = 0 + 0
New Balance 19,500 + 500 = 0 + 20,000
14. (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:
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Assets = Liabilities
+
Capital
Cash + Furniture + Stock Rakesh's
Old Balance 19,500 + 500 + 0
= 0 + 20,000
New
Transaction
-1,000 + 0 + 1,000
= 0 + 0
New Balance 18,500 + 500 + 1,000
= 0 + 20,600
15. (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:
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Assets = Liabilities +Capital
Cash + Furniture + Stock Creditor
s
+ Rakesh's
Old Balance 18,500 + 500 + 1,000 = 0 + 20,000
New
Transaction
0 + 0 + 2,000 = 2,000 + 0
New Balance 18,500 + 500 + 3,000 = 2,000 + 20,000
16. (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
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Assets = Liabilities + Capital
Cash + Furnitur
e +
Stock + Debtor
s
= Creditors + Rakesh's
Old Balance 18,500 + 500 + 500 + 4,000 = 2,000 + 21,500
New Transaction - 6,000 + 0 + 0 + 0 = 0 - 6,000
New Balance 12,500 + 500 + 500 + 4,000 = 2,000 + 15,500
17. (6) 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:
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Assets = Liabilitie
s
+ Capital
Cash + Furnitur
e
+ Stock + Debtor
s
= Creditor
s
+ Rakesh’
s
Old Balance 12,500 + 5,00 + 500 + 4,000 = 2,000 + 15,500
New
Transaction
-2,000 + 0 + 0 + 0 = 0 - 2,000
New
Balance
10,500 + 500 + 500 + 4,000 = 2,000 + 13,500
18. 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.
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Liabilities Rs. Assets Rs.
Creditors 2,000 Cash 10.500
Capital 15,500 Furniture 500
Less: Drawings 2,000 13,500 Stock 500
Debtors 4,000
15,500 15,500
Balance Sheet
