Chapter: 06 Accounting Equation
The accounting equation is the fundamental principle of double-entry bookkeeping and forms the basis of the Balance Sheet. It shows the relationship between a business’s assets, liabilities, and owner’s equity or capital.
The most fundamental form of the accounting equation is:
Assets = Liabilities + Owner’s Equity (or Capital)
Assets: These are economic resources owned by the business that are expected to provide future economic benefits. They represent what the business owns.
- Examples: Cash, Bank Balance, Accounts Receivable, Inventory,Land, Buildings, Machinery, Furniture, Vehicles, Patents, Copyrights.
Liabilities: These are obligations or debts that the business owes to outside parties. They represent what the business owes.
- Examples: Accounts Payable,Loans, Bank Overdraft, Bills Payable, Outstanding Expenses.
Owner’s Equity (or Capital): This represents the owner’s claim on the assets of the business. It’s the residual interest in the assets after deducting all liabilities. It represents what the owners have invested in the business.
Accounting equation signifies that the assests of a business are always equal to the total of capital and liabilities.
If a business transcation results in the increase of assests, there will also be a corresponding increase in the amount of either capital or liabilities by the same amount.
Effect of Transcations on Accounting Equations:
1.) Gopal started business with Rs75,000 as capital.
Assets = Liabilities + Capital
Cash = Liabilities + Capital
75,000 = 0 + 75,000
2.) Gopal purchased furniture for Cash Rs5,000.
Assets = Liabilities + Capital
Cash + Furniture = Liabilities + Capital
75,000 + 0 = 0 + 75,000
(-) 5,000 + 5,000 = 0 + 0
70,000 + 5,000 = 0 + 75,000
3.) Gopal purchased goods for Cash Rs20,000.
Assets = Liabilities + Capital
Cash + Furniture+ Goods = Liabilities + Capital
70,000+5,000 + 0 = 0 + 75,000
(-) 20,000 + 0 + 20,000 = 0 + 0
50,000 + 5,000 + 20,000 = 0 + 75,000
(4) Gopal purchased goods on credit for Rs16,000.
Assets = Liabilities + Capital
Cash + Furniture + Goods = Creditors + Capital
50,000+ 5,000 + 20,000 = 0 + 75,000
0 + 0 + 16,000 = 16,000 + 0
50,000 + 5,000 + 36,000 = 16,000 + 75,000
(5) Goods costing Rs12,000 sold on credit for Rs15,000.
Assets = Liabilities + Capital
Cash + Furniture + Goods + Debtors = Creditors + Capital
50,000 + 5,000 + 36,000 + 0 = 16,000 + 75,000
0 + 0 – 12,000 + 15,000 = 0 + 3,000
50,000 + 5,000 + 24,000 + 15,000 = 16,000 + 78,000
(6) Paid Rs1,000 for rent.
Assets = Liabilities + Capital
Cash + Furniture + Goods + Debtors = Creditors + Capital
50,000 + 5,000 + 24,000 + 15,000 = 16,000 + 78,000
(-)1,000+ 0 + 0 + 0 = 0 (-) 1,000
49,000 + 5,000 + 24,000 + 15,000 = 16,000 + 77,000
(7) Received Commission Rs500.
Assets = Liabilities + Capital
Cash + Furniture + Goods + Debtors = Creditors + Capital
49,000 + 5,000 + 24,000 + 15,000 = 16,000 + 77,000
(-) 500 + 0 + 0 + 0 = 0 (-) 500
48,500 + 5,000 + 24,000 + 15,000 = 16,000 + 76,500
(8) Withdrew cash for private use Rs 3,000.
Assets = Liabilities + Capital
Cash + Furniture + Goods + Debtors = Creditors + Capital
48,500 + 5,000 + 24,000 + 15,000 = 16,000 + 76,500
(-)3,000 + 0 + 0 + 0 = 0 (-) 3,000
45,500 + 5,000 + 24,000 + 15,000 = 16,000 + 73,500
(9) Paid to Creditors Rs15,000.
Assets = Liabilities + Capital
Cash + Furniture + Goods + Debtors = Creditors + Capital
45,500 + 5,000 + 24,000 + 15,000 = 16,000 + 73,500
(-)15,000 + 0 + 0 + 0 = (15,000) + 0
30,500 + 5,000 + 24,000 + 15,000 = 1,000 + 73,500
(10) Deposited into bank Rs20,000.
Assets = Liabilities + Capital
Cash + Furniture + Goods + Debtors+ Bank = Creditors + Capital
30,500 + 5,000 + 24,000 + 15,000 + 0 = 1,000 + 73,500
(-)20,000 + 0 + 0 + 0 + 20,000 = 0 + 0
10500 + 5000 + 24,000 + 15,000 + 20,000 = 1,000 + 73,500
(11)Invested in Shares Rs50,000.
Assets = Liabilities + Capital
Cash +Furniture+ Goods + Debtors+ Bank+Shares = Creditors + Capital
10,500 + 5,000 + 24,000 + 15,000 + 20,000+ 0 = 1,000 + 73,500
(-) 50,000+ 0 + 0 + 0 + 0 + 50,000 = 0 + 0
(39,500) + 5,000 + 24,000 + 15,000 + 20,000 + 50,000 = 1,000 + 73,500
Meaning of Debit & Credit
In accounting, “debit” and “credit” are fundamental terms used in the double-entry bookkeeping system. This system ensures that every financial transaction has an equal and opposite effect in at least two different accounts, maintaining the balance of the accounting equation:
Assets = Liabilities +Capital.
- Debit (DR)
Recorded on the left side of an account often in what’s called a “T-account”.
Increases: Asset accounts
e.g., Cash, Accounts Receivable, Equipment, Inventory and
Expense accounts
e.g., Rent Expense, Salaries Expense, Utilities Expense.
Decreases: Liability accounts
e.g., Accounts Payable, Loans Payable
Equity accounts
e.g., Owner’s Capital, Retained Earnings
Revenue accounts
e.g., Sales Revenue, Service Revenue.
- Credit (CR)
Recorded on the right side of an account.
Increases: Liability accounts, Equity accounts, and Revenue accounts.
Decreases: Asset accounts and Expense accounts.
Rules of Debit and Credit
There are two approaches:
- AMERICAN OR MODERN APPROACH
- ENGLISH OR TRADITIONAL APPROACH
- American Approach
ASSET ACCOUNT
Dr. Cr.
| Increase in asset will be recorded on this side. | ₹ | Decrease in asset will be recorded on this side. | ₹ |
LIABILITY ACCOUNT
Dr. Cr.
| Decrease in Liability will be recorded on this side. | ₹ | Increase in Liability will be recorded on this side. | ₹ |
CAPITAL ACCOUNT
Dr. Cr.
| Decrease in Capital will be recorded on this side. | ₹ | Increased in Capital will be recorded on this side. | ₹ |
REVENUE OR INCOME ACCOUNT
Dr Cr.
| Decrease in gains and incomes will be recorded on this side. | ₹ | Increase in gains and incomes will be recorded on this side. | ₹ |
LOSES OR EXPENSES ACCOUNT
Dr. Cr.
| Increase in losses and expenses will be recorded on this side. | ₹ | Decrease in losses and expenses will be recorded on this side. | ₹ |
ASSETS AND EXPENSES ACCOUNT
Dr. Cr.
| Record increase in these accounts on this side. | ₹ | Record decrease in these accounts on this side. | ₹ |
LIABILITY, CAPITAL OR INCOME ACCOUNT
Dr. Cr.
| Record decrease in these accounts on this side. | ₹ | Record increase in these accounts on this side. | ₹ |