6 ACCOUNTING EQUATION 6.1 INTRODUCTION You have already studied about Dual Aspect Concept and the various basic Accounting terms viz Assets, Liabilities, Capital, Expenses and Revenue. Accordiag to this concept, every transaction affects the business in two ways by the same amount. Suppose, a businessman starts his business with Rs.2,00,000. In the books of accounts, Rs.2,00,000 will be recorded as an asset (Cash) and an equivalent . amount will be shown as liability against the owner, In this example, you have noted that assets are equal to liabilities. We can present this in mathematical form Assets This mathematical, expression is Accounting Equation. Eyery transaction has its effect on the Accounting equation in such a manner that both sides remain equal. Now, we shall ‘take different business transactions and see their subsequent effect on the accounting equation. 6.2 OBJECTIVES After studying this lesson, you will be able to: © state the meaning of accounting equation; —Accounting Equation :: 65 SS = © appreciate the importance of accounting equation; © point out the effect of each aspect of a transaction on the accounting equation; : © establish that assets “are equal to liabilities and capital; © prepare accounting equation from given transactions. 6.3 ACCOUNTING EQUATION The recording of business transaction in books of accounts is based on a fundamental equation called Accounting Equation. Whatever business possesses in the form of assets is financed by proprietor or by outsiders. This equation expresses the equality of assets on one side and the claims of outsiders (liabilities) and ownérs or proprietors on the other side. In Mathematical form, Assets = Li s+ Cap Whenever an asset is introduced in the business, a corresponding liability also emerges. A business does not have any amount of its own. Hence, we can say that Business owns Nothing, And Owes Nothing, What it Owns, it owes Let us see the effect of business transactions on Accounting equation. ‘These transactions increase or decrease the assets, liabilities or capital. Every business has certain assets. For example, Sunita has started business by contributing Rs.2,00,000 as Capital. It can be said that asset in the form of Cash has been created for the business concern. - Hence, Cash = Capital Rs. 2,00,000 = Rs.2,00,000 Sunita later on purchases furniture for Rs.20,000 and machinery for Rs.60,000. Now the position of the assets is a follows: iCash + Furniture + Machinery 2,00,000 = —1,20,000 + 20,000 + 60,000 (2,00,000 - 80,000) From the above business transactions, we find that Capital = Assets or Assets = Capital Increase or decrease in capital will result in the corresponding increase or decrease in assets. For example, Sunita introduces Rs.50,000 as additional capital. Then Capital === — Cash + Furniture + Machinery 2,00,000 = 1,20,000 + 20,000 + 60,000 + 50,000 + 50,000 730,000 = 1,70,000 + 20,000 + 60,000 Every business concern, generally borrows money from outsiders in order to carry on its activities. In other words, every business concen ‘owes money to outsiders. These assets are financed by the funds supplied by proprietors and outsiders. Money borrowed from outsiders is called as liability, For example, Sunil started business by investing Rs.5,00,000 and borrowed from Ajay Rs.1,00,000. Hence the amount of asset (cash) is Rs.6,00,000. The accounting equation of these two transactions will be — ‘Asset (cash)= Capital © + —_Liability (Loan from ajay) 6,00,000 = 5,00,000 + —1,00,000 ‘The fact that business receives funds from proprietors and creditors and retains all of them in the form of various assets, can be presented in terms of an equation as Assets Liabilities or A= C + L Liabilities Capital or L = A-C Capital = = Capital or C = A-CAccounting Equation :: 67 Let us consider some more examples: Rahul started business by introducing Rs.3,00,000 as capital. He also invested Rs.2,00,000 which he borrowed from Shweta. Assets = Capital + Liabilities Cash Loan from Shewta 5,00,000 = 3,00,000 + 2,00,000 She purchases goods from cash Rs.50,000 Assets = Capital + — Liabilities Cash + goods Old equation 5,00,000 = 3,00,000 + —2,00,000 effect of 50,000 + 50,000 = 0 : transaction : New Equation —_4,50,000+50,000 = — 3,00,000 + —2,00,000 He paid Shewta Rs.50,000 Assets. = Capital: + Liabilities Cash + goods Old equation 4,50,000 + 50,000= —3,00,000 + 2,00,000 effect of 50,000 +0 0 - 50,000 transaction ‘New Equation 3,00,000 + = 1,50,000 In the above example, expenses and revenue have not been considered. They also affect the accounting equation. Their effect is always on the capital account. Every business concern has to meet certain expenses in its day-do-day operations such as payment of salaries, rent, insurance premium, postage, ‘wages, repairs of machines, etc. These expenses are paid regularly. All expenses teduce the cash balance as they. are paid in cash. These expenses reduce the net income of the business. As the net income is the income of*proprietor, which is represented by the capital account, so all expenses are deducted from the Capital account.Similarly, every business concern receives certain revenues during its ‘day to day operations, such as rent received, commission received, etc. Revenue is added to the cash balance as it is received in terms of cash. . Revenue increases the net income of the business and hence, it is added to the capital account. Now, the Accounting Equation is represented by . Assets Capital + liabilities + revenue (cash) + revenue — expenses (cash) ~ expenses or A=C4L ‘Accounting equation is thus affected by every business transaction. Any increase or decrease in assets, liabilities and capital can be identified by preparing accounting equation. It also shows that every business transaction satisfies the dual aspect concept of accounting. It also serves as a basis for preparing the Balance Sheet. INTEXT QUESTIONS 6.1 L Fill in the blanks with correct words: a. Accounting equation is also called as .... equation, b. Assets = + Liabilities ¢. Accounting equation satisfies the ... accounting. . concept of d. Capital = Assets — c. Accounting equation serves as a basis for preparing, 4 f. "Liabilities =Accounting Equation ::6) IL Multiple choice questions: Choose the correct alternative in the following questions: Ll In accounting equation, assets are equal to a. Capital only b. Capital + liabilities c. Capital — Liabilities d.__.. Liabilities — Capital 2. — Which of the following lists is a list of. assets only? a. Cash, Stock, debtors, Machinery b. Cash, creditors, loan c. Capital, furnitu?, bills payable. 4. Capital, prepaid expenses, outstanding expenses. 3. Which of the following lists is a list of liabilities only? a. Cash, Stock, debtors b. Cash, loan, creditors ©. Creditors, loan, bank overdraft, bills payable 4. Prepaid rent, salary outstanding, bills F ceivables. 64 EFFECT OF TRANSACTIONS ON ACCOUNTING EQUATION “You have learnt’ that assets, labile and capi*al are the three basic elements of every business transaction, and ther relationship is expressed in the form of accounting equation which always 1emams equal At any point of time, there can br a change sn the individual asset, liabilit or capital, but the two sides ef the accounting equanon always remain equal. Let us examine this fact by taking up some more transactions and see how these transactions affect try accounting equation,Suppose, Rajni starts her business and the following transactions take place: 1 She started business with cash Rs.5,00,000 introduced as capital. Assets = Liabilities + Capital cash Effect of the Rs.5,00,000 = 0 + — Rs. 5,00,000 transaction ‘This transaction means that Rs.5,00,000 have been introduced by Rajni ia terms of cash, which is the capital for the business concern. Hence on one hand, the asset (cash) has been created to the extent of Rs.5,00,000. 2. She purchased furniture for cash worth Rs.50,000 Assets = ‘Capital + Liabilities Cash + Furniture Old equation 5,00,000 + 0 = 5,00,000 + 0 effect — “50,000 + 50,000 = 0 - 0 transaction New equation 4,50,000 + 50,000 = 5,00,000 + 0 ee een ace This transaction has its effect only on the assets, as one asset has been purchased against the other. In this transaction, furniture is purchased against cash given. Furniture and cash both are assets. Hence furniture is introduced by Rs.50,000. 3. She purchased goods for cash Rs.10,000 Assets = Capital + Liabilities Cash + Furniture+ Goods = Capital + Liabilities Old eq. 4,50,000 + 50,000 +0 = " 5,00,000 + 0 Effect of -10,000 +0 + 10,000 = 0 +0 the transaction _ New 440,000 + 50,000 + 10,000 = 5,00,000 + 0 equation Goods purchased is an asset and in return cash paid is also an‘asset .. . Accounting Ej::ation ge 71 “Hence in this transaction, there is an increase in one asset (goods) and - decrease in the other asset (cash) by Rs.10,000 leaving the capital and abilities untouched. 4, She purchased goods from Rohit for Rs.40,000 Assets = Capital + Liabilities Cash + furniture + Goods = Creditors * Old Equation 4,40,000 + 50,000 + 10,000 = 5,00,000-+ 0 effect 0 +0 + 40,000 = 0 + 40,000 -New Equa- 4,40,000 + 50,000 + 50,000 = — 5,00,000 + 40,000 ‘tion In this transaction, goods have been purchased on credit from Rohit, hence there is an increase in the assets (goods) by Rs.40,000 and also an increase in the liabilities by Rs.40,000, as the business concern now owes money to Rohit. In any transaction, whenever cash payment is not mentioned and. the name of the seller is given, then the transaction is always a credit transaction. 3. She sold goods to Rahul for Rs.20,000: the cost of the goods is Rs.15,000. Assets = Capital + Liabilities Cash + Furniture + Goods + Debtors OF eg. 4,40,000 + 50,000, + 50,000+0 © = 5,00,000 + 40,000 . Effect of the 0 +0 ~ 15,000 + 20,000 = 5,05,000 + 40,000 Transaction _4,40,000 + 50,000 + 35,000 + 20,000 = 5,05,000 + 40,000 Ee _ New Equation 4,40,000 + 50,000 + 35,000 + 20,000 = 5,05,000 + 40,000 In this transaction, goods have been sold on credit to Rahul, so there is a decrease in the assets (goods) by Rs.15,000, and an increase in the assets (Rahul) by Rs.20,000 as money has to be collected from Rahul. In this process, the proprietor has a gain of Rs.5,000 which is added to the capital : Whenever goods are so'd and nothing about cash received is mentioned and-the name of the purchaser is given then that transaction is treated as credit wansaction. .6. She paid salaries to clerks for Rs.12,000 - 7 Assets, = Capital = +1. bilities Cash + Fumiture + Goods + Debtors Old eq. 4,40,000 +50,000 +35,000 +20,000 = 505,000 + 40,000 Effect of the 12,000 +0 | +0 +0 = = -12,000 +0 transaction ‘New Equation 4,28,000 +50,000 — +35,000 +20,000 = 4,93,000 + 40,000 In this transaction, salaries paid to clerks is an expense for the business concer. Since salaries is paid in terms of cash, hence cash as an asset is reduced by Rs.12,000 and.as. all expenses reduce the capital, so capital is also reduced by Rs.12,000. 7 Cash paid to Rohit Rs.20,000 _ As ets Capital +Liabilities Cash Furniture +Goods +Debots Old eq. 4,28,000 50,000 +35,000 +20,000 = 4,93,000 +40,000 Effect of the - 20,000 -0 . +0 = =20,000 transaction ‘New Equation 4,08,000 +50,000 - +35,000 +20,000 = 4,93,000 +20,000 In this transaction, cash has been paid to the creditors, Rohit Rs.20,000, hence cash as an asset is reduced by Rs.20,00 and also the liability _ Rohit) is reduced by Rs.20,000. From the above transactions, now you are clear as to how every transaction has its effect on the accounting equation without disturbing the equality of the two sides. 5 COMBINATIONS OF THE EQUATION The inter-relationship between assets, liabilities and capital can be expressed in various forms. Nine combinations can be created. Increase or decrease m one has a corresponding Increase or Decrease in Itself or the other.Accounting Egitation: et us study the nine combinations with examples.) i) _nerease in asset with corresponding increase in capital Example: Started business with cash. ii) Increase in asset with corresponding increase in liabilities. Example: Goods purchased on credit. iii) Decrease in asset with corresponding decrease in capital Example: Cash withdrawn from the business by th. proprietor for personal use. ‘ iv) Decrease in asset with corresponding decrease in liability Example: Cash paid to the creditor. v) Increase and decrease in assets Example: Furniture purchased for cash, Goods purchased for cash, etc. vi) Increase and decrease in liabilities. Exaniple: Payment made to creditors by taking loan from bsnk. vii) Increase and decrease in capital.- Example: Interest on Capital viii) Increase in liabilities and decrease in capital. Example: Wages due but not yet paid, outstanding salaries ix) Increase in capital and decrease in liabilities. Example: Conversion of loan into capital.Let us consider another Illustratio~: once again: Mlustration 1. Shashi started business with : Cash Goods Machine He purchased goods for cash He sold goods (costing Rs.20,000) He purchased goods from Ravi He paid cash to Ravi in full settlement He sold goods to Vikas (costing Rs.54,000) He received prompt payment from Vikas and discount allowed Rs.2,000 Salaries paid by him Rent outstanding Prepaid insurance Commission received by him Amount withdrawn by him for personal use Interest an capital es by him Depreciation chargéd on Machinery Purchased goods from Sandeep cd stud the ac-cunting .quation Rs. 2,00,606 1,20,000 80,000 50,°00, 25,000 70,000 69,000 60.000 58,000 40,0:0 4,000 1,000 3,000 30,000 2,000 8,000 1,70,000Accounting Eqis wopenby Mon 000°0L “SH wry wo spoo8 paseysitg + + 000°02T + 000°SL‘T " ° + © + & 2 3 ooo'so’ + 0” + 000°0L+ 0 +0 + 0004+ =.0 +0 +0 + 000°0L +0. o00'so'y, 000‘0s‘1 + 000'SL‘T 00°57, 5H 105 7 . (000'02 “Sy 3805) o's +0 +0 =o +0 +0 + 00002 - d00'sz+ -- spoof.piog . 000'00% + 0 +0 - = 0 +0 ++ 000°08 + 000‘0L'I + 000‘0S‘T woprenba oN, : 00'S “Fu 205 0 +0 +0 =0 +0 +0 + _000%0S + 000°0s- posuyaind spoon 'Z 000'08 amyUW 000°02"1 Spoon 000°0z'I + o00'00'2 000'00'2 useD 000‘00'r * : susdxa : Tarde) + Supurising + siompery = predig = + SHoNqeg + SUMPEWY + - SPoOH + —YSED sone; opo's9'e = + 000'r +0 = 000 +0 + 000°08 + 000'99°T + 000'E7'T ‘wonEnby Mon 000 “su o> +0 3: +0 = 001 +0 +0 +0 + 000I- souemsuy predarg “Q] 000°99'€ = + 000'F +0 = 0 +0 + 00008 + 000°99°T + 000°FZ'T ‘wonenba May . 000'r “a 000'% > 000° +0 = 0 +0 +0 +0 +0 Supuesino may “6 cove + 0 +0 =o +0 + 000°08 + 000°99'T +.000‘r2‘I wonenby MeN “ 000'0r “sa o00'or - 00 +0 =o +0 +0 +0 + 000°0r- pred souzjes “g ooo’ = + 0 +0 = 0 +0 + 000°08 + 000'99'T + 000'r9'T . 000°2 ‘sy mmoosip pre sexta wow paatooar qwowéed o00'e + 000°RS+ wonenbg Mon 000°09 “sy 103 000'rS “sy PICS spooH “9 onenbg-MoN 000'69 “sy sow “Tones ny ur aey 1 opeut qoueg *¢ ooovlb = + 0 en) = 0 + 00009 + 000°08 + 000°99'I + 000'90'L 000°9 +0 +0 = 0 + 0009 + 0 + 000s -0 000'90'r + 0 +0 = 0 +0 + 00008 + 000°07'Z + 000°90'r 000° 000‘0L- 0 + 000°69- + ° + u ° + 7 + ° +o00'TE'E ooo'le'e 000'r o00'so's ooo'rs't 000‘0L'T 000°0L'T+ 000'1 000°¢L 0 00'so's 000°S0'S 000'9E'E + 000'96 uonunbg MON ooo'ou't “su doapng woyy coorou't +0 poseyoind spoop °$] OO0'TE'E 000°8 000'r 0 000°: 000°%L 000°8 uonenby mon 000'8 “Su Asouryoey uo uonsisaideg “F 000°99't + 00096 0 +0 o00'6e'e 000°%- 000% 000" o00‘08. 0 000°99't + 000'96 uopenbg MON 000% “FY jeuded wo ysazauy “ey 0 +0 000'6E'. oo0'oe 000°69'E 000°¢ 000'r 000'r 000't 000° oo0'o8 00°08 woenbg #9y ooo'oe “su 0 + 000'0E~ .| umtp WE NOwY “ZI 000°99' + 000'96 uojsenbg MeN ooo'e SY 000°99'1 + 000°92'T 0 + 000'E+18.:: Accountancy Ot INTEXT QUESTION 6.2 1 Goods purchased from Ritu for Rs.60,000. What effect will the transaction have on the Accounting Equation? a Increase in assets and decrease in liability. b. Increase and decease in asset. c. Increase and decrease in fiability. d. Decrease in asset and decrease in liability. Rent outstanding Rs.2,000. What effect will this transaction have on the Accounting Equation? a. Increase and decrease in asset. b. Increase and decrease in liability. c. Increase in liability and increase in asset. d. Increase in liability and decrease in Capital. Interest on drawings amcunted to Rs.5,000, What effect will this transaction have on the Accounting Equation? a. Increase and decrease in asset. b. Increase and decrease in liability. c. Increase and decrease in Capital. d. Increase in asset and Increase in liability. 65 WHAT YOU HAVE LEARNT Business transaction means exchange of goods and/or services for value and any other financial activity undertaken in the course of the business. Every business transaction is recorded on the basis of Accounting Equation. en‘Accounting equation is a statement showing the equality of assets on one hand and the capital and liabilities on the other: ‘Assets = Capital + Liabilities (A = C +L) Every business transaction has its effect on the Accounting Equation. Business owns nothing and owes nothing. What it owns it owes. Under any circumstance, the equality of the Accounting Equation remains same. ‘The effect of expenses and revenue is always on the Capital Account, Expenses rediice’ the Capital and revenues increase it. 10. 6.6 eee Every business transaction satisfies the’ Dual Aspect Concept. ‘Any increase or decrease in dne element of Accounting Equation has a corresponding increase or decrease on the other element or itself. : TERMINAL QUESTIONS Answer the following questions in 1-10. words. a If a firm borrows a sum of money, what will be its effect on the Accounting Equation? b. Give two examples — one showing the effect only on + assets and the other on liabilities only. c. How will you show income received in advance in the accounting equation? 4. If goods costing Rs.8,000 are sold for Rs.8,500, how will the capital be affected? ‘Answer the following in (30-50 words) , a.” What is an Accounting Equation? =.” b. How are revenue and expense treated in Accounting Equation? .“Accounting Equation remains intact under all circumstances”. Justify this statement with the help of examples (100-150 words). Prepare Accounting Equation on the basis of the following: (@ Karan started business with cash Rs. 1,60,000. (i) He purchased furniture for cash Rs.16,000. (iii) He paid rent Rs.1,600. (iv) He purchased goods on credit Rs.24,000. (v)_ He sold goods (cost price Rs.16,000) for Rs.40,000 for cash. Akshay had the following transactions: Rs. () Commenced business with cash 2,50,000 (i) Purchased goods for cash 1,00,000 (iii) Salaries paid . 2,500 (iv) sold goods for cash Rs.2,00,000 costing 1,50,000 (v) Rent outstanding 500 (vi) Purchased goods on credit 1,50,000 (vii) Purchased Machinery on credit 25,000 (vini) Purchased Motorcycle for personal use 25,000 (ix) Purchased building for cash 1,00,000 Use Accounting Equation to show the effect of the above transactions on the assets, liabilities and capital. Show the Accounting Equation on the basis of the following transactions Rs. () — Shivam started business Cash . 5,00,000 Goods 2,00,000 (it) He purchased machinery for cash 2,50,000 ————_—_° Accounting Equation = 81 ere (iit) He purchased goods from Ramesh 1,00,000 (iv) He sold goods to Suresh (Cost Rs.25,000) 30,000 (%) Paid insurance premium 5,000 (vi) Salary outstanding 10,000 (vii) Depreciation of Machinery 25,000 (Vili) Interest on Capital 3,000 . (x) Amount withdrawn for personal use 18,000 (%) Interest on drawings ° , i 900 (xi) Rent received in advance 1,500 (xii) Cash paid to Ramesh 50,000 (xiii) Cash received from Suresh ; 15,000 6.7 ANSWERS TO INTEXT QUESTIONS . 61 1 a. balance sheet equation b. capital © dual aspect d. liabilites e balance sheet £ assets IL 1. b. Capital + Liabilites 2 a 3c 62 1 1 a