Accounting Equation
Chapter 5
Accounting Equation
1
Accounting Equation
Learning Objectives
This Chapter would enable you to understand:
 Meaning of an Accounting Equation
 Effect of Transactions on an Accounting Equation
2
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.
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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
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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
4,00,000 Fixed Assets
Land and Building
2,25,000 Machinery
Computer
75,000 Current Assets
25,000 Stock
Debtors
Cash and Bank Balances
7,25,000
Rs.
3,00,000
2,00,000
50,000
50,000
1,00,000
25,000
7,25,000
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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.
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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.
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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).
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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).
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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).
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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.
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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.
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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
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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
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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 +
500 +
0
New Transaction
-1,000 +
0 +
1,000
New Balance
18,500 +
500 +
1,000
=
=
=
0+
20,000
0 +
0
0+
20,600
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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 +
0 +
500
0
+ 1,000
+ 2,000
=
=
18,500 +
500
+ 3,000
=
Liabilities
+Capital
Creditors
+ Rakesh's
0
2,000
+
+
20,000
0
2,000
+
20,000
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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 + Rakesh's
Old Balance
18,500 +
500 +
500 +
New Transaction
- 6,000 +
0 +
New Balance
12,500 +
500 +
2,000 +
21,500
0 +
4,000 =
0 =
-
6,000
500 +
4,000 =
2,000 +
15,500
0
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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
+ 0
+
+
+
Assets
Stock
500
0
+ 500
+
500
=
+ Debtors =
+ 4,000
=
+ 0
=
+ 4,000
Liabilities
Creditors
2,000
0
= 2,000
+
+
+
-
Capital
Rakesh’s
15,500
2,000
+ 13,500
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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
500
4,000
15,500
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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.
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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.
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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).
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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.
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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.
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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.
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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.
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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.
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Basic Accounting Terms
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