Accounting Equation:

Learning Objective:

1.     Define and explain accounting equation.

2.     Give an example of accounting equation.

Definition and Explanation of Accounting Equation:

Dual aspect may be stated as "for every debit, there is a credit." Every transaction should have twofold effect to the extent of the same amount. This concept has resulted in accounting equation which states that at any point of time the assets of any entity must be equal (in monetary terms) to the total of equities. In other words, for every business enterprise, the sum of the rights tithe properties is equal to the sum of the properties owned. The properties of the business are called "assets". The rights tithe properties are called "equities". Equities may be sub-divided into two principle types: The rights of the creditors and the rights of the owners. The equity of the creditors represents debts of the business and is called liabilities. The equity of the owner is called capital, or proprietorship or owner's equity.

The formula known as the accounting equation, thus arrived at is as follows:

Assets = Equities OR Assets = Liabilities + Proprietorship

Another method of demonstrating the mathematical relationship involves a simple variation in the form of equation. Again it begins with the position that every business owns or has interest in certain assets. It also owes certain amounts to its creditors. The difference between what it owns and what it owes represents the owner's capital or proprietorship. Thus the original equation is changed into:

Assets - Liabilities = Proprietorship

Effects of Transactions on the Accounting Equation:

Each and every business transaction affects the elements of accounting equation. The effect is shown by the use of (+) or (-) placed against the elements affected. Note particularly that the equation remains in balance after each transaction. The accounting equation can be understood with the help of the following example:

Example:

Transaction 1:

Mr. Ritz commences his business with cash £50,000. This is an example of investment of asset in the business by the owner. The effect of this transaction on the accounting equation is that cash asset is increased by £50,000 and the proprietorship (Ritz’s capital) is also increased by the same amount such as:

Assets	=	Liabilities	+	Proprietorship
Cash				Ritz, Capital
+ 50,000	=	----		+ 50,000

Note that assets and equities increased by equal amounts

Transaction 2:

Purchased furniture on cash £10,000. This transaction effected accounting equation as the increase in one new asset furniture and decreases in assets cash with the same amount. Thus

Assets		=	Liabilities	+	Proprietorship
Cash	Furniture				Ritz, Capital
+ 50,000		=	----		+ 50,000
- 10,000	+ 10,000
40,000	+ 10,000	=			50,000

Note that this transaction has affected assets side only and no change is made in equities side of the equation.

Transaction 3:

Purchased merchandise for cash £10,000. This transaction will introduce a new element (merchandise) on the assets side and decrease the cash by £10,000.

Assets			=	Liabilities	+	Proprietorship
Cash	Furniture	Merchandise				Ritz, Capital
+ 40,000	+ 10,000		=	----		+ 50,000
-10,000	--	+ 10,000
30,000		+ 10,000	=			50,000

Note that this transaction has affected assets side only and no change is made in equities side of the equation.

Transaction 4:

Purchased merchandise on account (on credit) £5,000.

Assets			=	Liabilities	+	Proprietorship
Cash	Furniture	Merchandise		Creditors		Ritz, Capital
+ 30,000	+ 10,000	+ 10,000	=			+ 50,000
		+ 5,000		+ 5,000
30,000	+10,000	+ 15,000	=	+ 5,000		+ 50,000

Note that this transaction has affected assets side  and liabilities. Both the sides of equation have increased with the same amount.

Transaction 5:

Sold merchandise for cash £2,000 cost of these merchandise were £1,500.

Assets			=	Liabilities	+	Proprietorship
Cash	Furniture	Merchandise		Creditors		Ritz, Capital
+ 30,000	+ 10,000	+ 15,000	=	+ 5,000		+ 50,000
+ 2,000		- 1,500				+ 500 (Profit)
+ 32,000	+10,000	+ 13,500	=	+ 5,000		+ 50,500

Note that this transaction has affected assets side  and also the proprietorship. Difference between sales price and cost price is treated as profit and has been added to capital.

Transaction 6:

Sold merchandise on credit for £4,000 costing £3,000.

Assets				=	Liabilities	+	Proprietorship
Cash	Furniture	Merchandise	Debtors		Creditors		Ritz, Capital
+ 32,000	+ 10,000	+ 13,500		=	+ 5,000		+ 50,500
		- 3,000	+ 4,000				+ 1,000
32,000	+10,000	+ 10,500	+ 4000	=	+ 5,000		+ 51,500

Note that this transaction has affected assets side  and also the proprietorship. Anew element "debtors" has been introduced. Difference between sales price and cost price is treated as profit and has been added to capital.

Transaction 7:

Paid £1,000 to creditors for merchandise purchased.

Assets				=	Liabilities	+	Proprietorship
Cash	Furniture	Merchandise	Debtors		Creditors		Ritz, Capital
+ 32,000	+ 10,000	+ 10,500	+ 4,000	=	+ 5,000		+ 51,500
- 1,000					- 1,000
31,000	+10,000	+ 10,500	+ 4000	=	+ 4,000		+ 51,500

Transaction 8:

Received cash from a debtor £ 1,000 whom a sale on credit was made earlier. This is an example of collection from debtors. This transaction is an exchange of one asset for another. the effect is on one side of the equation, i.e., asset side. Thus:

Assets				=	Liabilities	+	Proprietorship
Cash	Furniture	Merchandise	Debtors		Creditors		Ritz, Capital
+ 31,000	+ 10,000	+ 10,500	+ 4,000	=	+ 4,000		+ 51,500
+ 1,000			- 1,000
32,000	+10,000	+ 10,500	+ 3000	=	+ 4,000		+ 51,500

Transaction 9:

Paid salaries £1,000 in cash. This transaction affected the equation by decrease in a cash asset and decrease in proprietorship (i.e., capital). Thus:

Assets				=	Liabilities	+	Proprietorship
Cash	Furniture	Merchandise	Debtors		Creditors		Ritz, Capital
+ 32,000	+ 10,000	+ 10,500	+ 4,000	=	+ 4,000		+ 51,500
- 1,000							- 1,000
31,000	+10,000	+ 10,500	+ 3000	=	+ 4,000		+ 50,500

Effects of all the transactions explained above are presented in the following table:

Assets					=	Liabilities	+	Proprietorship
	Cash	+ Furniture	+ Merchandise	+ Debtors		Creditors		+ Ritz, Capital
1	+ 50,000							+50,000
	50,000				=		+	50,000
2	- 10,000	+ 10,000
	40,000	10,000			=		+	50,000
3	- 10,000		+ 10,000
	30,000	10,000	10,000		=		+	50,000
4			+ 5,000			+ 5,000
	30,000	10,000	15,000		=	5,000	+	50,000
5	+ 2,000		- 1,500					+ 500 (Profit)
	32,000	10,000	13,500		=	5,000	+	50,500
6			- 3,000	+ 4,000				+ 1,000 (Profit)
	32,000	10,000	10,500	4,000	=	5,000	+	51,500
7	- 1,000					- 1,000
	31,000	10,000	10,500	4,000	=	4,000	+	51,500
8	+1,000			1,000
	32,000	+ 10,000	+ 10,500	+ 3,000		4,000	+	51,500
9	1,000							1,000
	31,000	10,000	10,500	3,000	=	4,000	+	50,500

The elements of the equation of Mr. Ritz that is,

Cash	+	Furniture	+	Merchandise	+	Debtors	=	Creditors	+	Capital
31,000	+	10,000	+	10,500	+	3,000	=	4,000	+	50,500

This may also be stated in vertical form as shown below:

EQUITIES		ASSETS
Creditors	£4,000	Cash	£31,000
Capital	£50,500	Debtors	3,000
		Merchandise	10,500
		Furniture	10,000
	£54,500		£54,500

The presentation of the effects of transactions in tabular form is only a device which helps beginners to understand the analysis of different types of transactions. It is not practically feasible to record the effects of transactions in this form. The increases and decreases in the various elements are recorded in the journal in a special technical form.

JOURNAL

Definition and Explanation:

The word "journal" has been derived from the French word "jour". Jour means day. So journal means daily. Transactions are recorded daily in journal and hence it has been named so. It is a book of original entry to record chronologically (i.e. in order of date) and in detail the various transactions of a trader. It is also known Day Book because it contains the account of every day's transactions.

Characteristics of Journal:

Journal has the following features:

1. Journal is the first successful step of the double entry system. A transaction is recorded first of all in the journal. So the journal is called the book of original entry.
2. A transaction is recorded on the same day it takes place. So, journal is called Day Book.
3. Transactions are recorded chronologically, So, journal is called chronological book
4. For each transaction the names of the two concerned accounts indicating which is debited and which is credited, are clearly written in two consecutive lines. This makes ledger-posting easy. That is why journal is called "Assistant to Ledger" or "subsidiary book"
5. Narration is written below each entry.
6. The amount is written in the last two columns - debit amount in debit column and credit amount in credit column.

Advantages of Journal:

The following are the advantages of journal:

1. Each transaction is recorded as soon as it takes place. So there is no possibility of any transaction being omitted from the books of account.
2. Since the transactions are kept recorded in journal, chronologically with narration, it can be easily ascertained when and why a transaction has taken place.
3. For each and every transaction which of the two concerned accounts will be debited and which account credited, are clearly written in journal. So, there is no possibility of committing any mistake in writing the ledger.
4. Since all the debits of transaction are recorded in journal, it is not necessary to repeat them in ledger. As a result ledger is kept tidy and brief.
5. Journal shows the complete story of a transaction in one entry.
6. Any mistake in ledger can be easily detected with the help of journal.

Objective of an Entry:

While recording transactions in journal the following two objects must be aimed at:

1. That each entry in the journal should be so clear that at any future time we may, without the aid of memory, perceive the exact nature of the transactions.
2. That each transaction should be so classified that we may easily obtain the aggregate effect of such transactions at the end of a certain period.

Narration of an Entry:

It is the remark or explanation put below each entry in the journal. The journal is a book of original entry and all possible details have to record in connection with each and every transaction entered there. The details are laid out in the form of a remark at the end of each journal entry, which is called narration.

Form of Journal:

Date (1)	Particulars (2)	L.F. (3)	Dr. Amount	Cr. Amount

Column (1)	Is meant for writing the date of the transaction.
Column (2)	Is used for recording the names of the two accounts affected by transactions.
Column (3)	Is meant for noting the number of the page of the ledger on which the particular account appears in that book.
Column (4)	Shows the amount to be debited to the account named.
Column (5)	Shows the amount to be credited to the account stated.

Rules of Journalizing:

The act of recording transactions in journal is called journalizing. The rules may be summarized as follows:

1. Use two separate lines for writing the names of the two accounts concerned in each transaction.
2. write the name of the debtor or account to be debited in the first line and the name of the creditor or the account to be credited in the next line
3. Write the name of the account to be debited close to the line starting the particulars column and that of the account to be credited at a short distance from this line.
4. Use "Dr" after each debit item and "To" before each credit. The term "Cr." after a credit item is unnecessary, as if one account is debtor, the other must be creditor.
5. To separate one entry from another a line is drawn below every entry to cover particulars column only. The line does not extend to amount column.

Example 1:

On first January, 1991 a started business with capital of £20,000 and his transactions of the month were as follows:
 

Jan.2	Purchased building for cash	8,000
Jan.8	Purchased goods from C	1,000
Jan.15	Sold goods for cash	500
Jan.20	Goods returned to C	100
Jan.22	Sold goods to R	400
Jan.25	R returned goods	25
Jan.31	Salaries paid for the month	200
Jan.31	Rent paid for the month	150

Solution:

Journal of A
 

Date	Particulars	L.F	Debit	Credit
Jan. 1	Cash Account          ...Dr.		20,000
	To Capital Account			20,000
	(Capital introduced)
Jan 2.	Building Account       ...Dr.		8,000
	To Cash Account			8,000
	(Building purchased for cash)
Jan. 8	Purchases Account   ...Dr.		1,000
	To Sales Account			1,000
	(Goods purchased on credit form C)
Jan. 15	Cash Account          ...Dr.		500
	To Sales Account			500
	(Goods sold for cash)
Jan. 20	C                           ...Dr.		100
	To purchases Returns Account			100
	(Goods returned to C)
Jan. 22	R                           ...Dr.		400
	To Sales Account			400
	(Goods sold on credit)
Jan. 25	Sales returns Account..Dr.		25
	To R			25
	(Goods returned by him)
Jan. 31	Salaries Account        ...Dr.		200
	To Cash Account			200
	(Salaries paid)
Jan. 31	Rent Account            ...Dr.		150
	To Cash Account			150
	(Rent paid in cash)
	Total		30,375	30,375

Capital Account:

The proprietor's account in the business books is called "capital account". Whenever the proprietor invests money in the business, instead of giving credit to his name, capital account should be credited.

Drawings Account:

Any cash or goods taken away by the proprietor for his personal use are called his drawings and are debited to "Drawings Account". Drawings account like the capital account is personal account of the proprietor.

Casts and Carry Forwards:

In bookkeeping casting means totaling. The first page of the journal will be cast by drawing a line across the money column. The total of this page will be carried forward to the  top of second page. The total of the second page will be carried forward to the third page and so on until the last page gives the final total.

When carrying forward the total of the one page to another, the words "carried forward" or "carried over" should be written at the bottom of the first page and words "brought forward" the top of the next page. The abbreviations c/f or c/o and b/f can also be used.

Compound Journal Entries:

When two or more transactions of the same nature take place on the same date, a compound journal entry may be made instead of making separate entries for each transaction.

Trade Discount:

No entry is passed for trade discount. The purchases or sales should be recorded at net price i.e., after deducting the trade discount from the list price.

Goods Given Away:

Sometimes goods are (a) given away as charity (b) taken by the proprietor for his private use (c) distributed free as samples. Such goods are not sales. Therefore they are not credited to sales account but are credited to purchases account because they reduce the amount of goods purchased.

Example 2:

On first April 1991 a merchant started business with a capital of £15,000 and his transactions of the month were as follows:
 

April 2	Purchased machinery for £7,000.
April 3	Bought furniture from S £300.
April 7	Purchased goods for cash £2,500
April 8	Sold goods to R & Sons £1,500
April 10	Bought goods from B, £1,000 and from C £2,000
April 12	Received cash from R & Sons £1,450, allowed him discount of £50.
April 15	Paid B cash £975, discount received £25.
April 16	Returned goods to C £500
April 17	Sold goods to Din Mohammad £800
April 20	Goods returned by Din Mohammad £200
April 21	Purchased from K goods of the list price of £600 subject to a 10 percent trade discount.
April 22	Paid C cash £1,500
April 25	Gave away charity cash £50 and goods worth £30.
April 27	Distributed goods worth £200 as free samples and goods taken away by the proprietor for personal use £100
April 28	Amount withdrawn by the proprietor for private use £200
April 31	Salaries paid for the month £500

Record these transactions in the journal.

Solution:

Journal
 

Date	Particulars	L.F	Debit	Credit
April 1	Cash Account          ...Dr.		15,000
	To Capital Account			15,000
	(Capital introduced)
April 2	Machinery Account		7,000
	To Cash Account			7,000
	(Machinery purchased)
April 3	Furniture Account		2,500
	To Cash Account			2,500
	(Goods purchased for cash C)
April 7	Purchases Account		3,000
	To Cash Account			3,000
	(Goods purchased for cash)
April 8	R & Sons		1,500
	To Sales Account			1,500
	(Goods sold on credit)
April 10	Purchases Account		3,000
	To B			1,000
	To C			2,00
	(Goods purchased on credit)
April 12	Cash Account		1,450
	Discount		50
	To R & Sons			1,500
	(Cash received and discount allowed)
April 15	B		1,000
	To Cash Account			975
	To Discount account			25
	(Salaries paid)
April 16	C		500
	To Purchases Return Account			500
	(Goods returned to C)
April 17	Din Mohammad		800
	To Sales Account			800
	(Goods sold on credit)
April 20	Sales Returns Account		200
	To Din Mohammad			200
	(Goods returned by him)
April 21	Purchases Account		540
	To K			540
	(Goods purchased on credit)
April 22	C		1,500
	To Cash Account			1,500
	(Cash paid to C)
April 25	Charity Account		80
	To Cash Account			50
	To Purchases Account			30
	(Cash and goods given in charity)
April 27	Free samples Account		200
	Drawings Account		100
	To Purchases Account			300
	(Goods distributed free and taken by the proprietor for private use)
April 28	Drawings Account		200
	To Cash			200
	(Cash drawn by the proprietor)
April 31	Salaries Account		500
	To Cash Account			500
	(Salaries paid in cash)

Note:

(a) In actual practice even the word "Dr." is not written after the name of the account to be debited, because it is also implied.

(b) When writing the name of a personal account, it is not considered necessary to add the word "account" after the name of the person.