## Wednesday, September 17, 2014

### Illustrations of Accounting Equation with Examples

The starting point for accounting process is accounting equation. We have seen before that accounting equation is based on dual aspect concept (debit and credit) that each transaction has Two effects, one on asset and another on claims on the assets (liability).
Total claims i.e. of the owners and outsiders are equal to the total assets of the firm. These claims on asset are also known as equities 1. Owner’s equity (capital) 2.Outsider’s equity (liability).
Assets = Capital + Liabilities (A = C+L)
where asset=equity

Now it is time to learn effect of transaction on accounting equation. If you started a business with Rs. 10,000 as capital and the firm received Rs. 10,000 in the form of cash, then transaction equation can be written as
Assets = Capital + Liabilities
Cash = Capital + Liabilities  Rs. 10,000 = Rs. 10,000 + 0

Now if you buy some basic furniture for Rs. 1000 then your “cash” asset decreases and “furniture” asset increases by same amount. Total asset remain same.

Assets = Capital + Liabilities
Cash + Furniture = Capital + Liabilities
First transaction 10,000 + 0 = 10,000 + 0
Second transaction (–) 1,000 + 1,000 = 0 + 0
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Equation 9,000 + 1,000 = 10,000 + 0

Now suppose you buy goods worth Rs. 1500, then cash will be utilized at the same time, leaving asset unchanged. The equation will look like as given

Cash + Furniture + Stock = Capital +Liabilities
1st and 2nd transaction 9000 + 1000 + 0 = 10,000 + 0
3rd (–) 1500 + 0 + 1500 = 0 + 0
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Equation 7500 + 1000 + 1500 = 10000 + 0

Now suppose you buy goods on credit for Rs. 500. This transaction will create liability with increase in assets.
Cash + Furniture + Stock = Capital +Creditors
Transaction 1-3 7500 + 1000 + 1500 = 10,000 + 500
Transaction 4 0 + 0 + 500 = 0 + 500
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Equation 7500 + 1000 + 2000 = 10,000 + 500

Next lets assume that you sold goods costing Rs.1500 for Rs. 2000 on credit then “Debtors” account will go up by Rs.2000 and “cost of goods sold” would come down by Rs.1500. The increase of Rs. 500 would be your “Revenue” which would be added to the capital.

Cash + Furniture + Stock + Debtors = Capital + Creditors+Revenue
Transaction 1-4 7500 + 1000 + 2000 + 0 = 10,000 + 500
Transaction 5 0 + 0 +(-)1500 + 2000 = 500 + 0
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Equation 7500 + 1000 + 500 + 2000 = 10500 + 500

Lets assume now that you paid wages to the pizza delivery boys of Rs. 1300. It is an expense (loss to the company) and reduces capital.
Cash + Furniture + Stock + Debtors = Capital + Creditors
Transaction 1-5 7500 + 1000 + 500 + 2000 = 10500 + 500
Transaction 6 – 1300 + 0 + 0 + 0 = –1300 + 0
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Equation 6200 + 1000 + 500 + 2000 = 9200 + 500

What is evident from above series of transactions? The accounting equation holds good in all cases. Thus one thing to note is that when one asset increases, other asset decreases or liability increases or capital increases. Similarly when asset decreases , another asset increases and liability or capital decreases.

Above transaction may be put in presentable format as given below.

LiabilitiesRs.AssetsRs.
Capital9200Cash200
Creditors500Stock500
Debtors2000
Furniture1000
97009700

Now we shall see for some sample transactions how accounts are affected.

S.NoBusiness TransactionWhich account and how it is effected
AssetsLiabilities
1Capital injection in businessCash increasesCapital creation
2Cash used to purchase stocksStock increases and cash decreasesNo effect
3Purchases on creditStock increasesCreditors increases
4Any expense (e.g. rent,salaries)Cash decreasesCapital decreases
5Sale on cashstock decreases and cash increasesNo effect
6Payment to creditorsCash decreasesCapital decreases
7Credit saleStock decreases/Debtors increasesNo effect