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Accounting Equation

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In accounting, every business transactions involve double effects of equal value. Such double effects of equal value create an equation, which is called accounting equation. Such accounting equation should always be in balance. The accounting equation shows the relationship between the economic resources belonging to the business and the claims against these resources. The next term of economic resources is assets and claims consist of creditor’s claim (liabilities) and owner’s claim (owner’s equity). It can be expressed as follows:

Assets= Liabilities + Owner’s Capital

.

Principles of Accounting Equation

The accounting equation is based on the principle that assets of a business should always be equal to the total outside liabilities and owner’s equity or capital. Assets are the resources owned by the business firm for future benefits while liabilities and capital are the claims over the assets. Hence, the accounting equation shows the relationship between the economic resources belonging to the business and the claims against those resources. It focuses on the concept of duality i.e. each transaction has a dual effect and affects two components of the balance sheet.

Every transaction of a business, regardless of its complexity, has its effect on the accounting equation. A business transaction may bring a change in all or any of the components of the equation. Whatever may be the change i.e. increase or decrease, the accounting equation remains in balance.

Items

Increase

Decrease

Assets

Capital increases or liability increases or other asset decreases.

Capital decreases or liability decreases or other asset increases.

Liabilities

Capital decreases or other liability decreases or asset increases.

Capital increases or other liability increases or asset decreases.

Capital

Asset increases.

Asset decreases.

Income and gain

Capital and asset increase.

Capital and asset decrease.

Expenses and loss

Capital and asset decrease.

Capital and asset increase.

The process of determining the effect of each transaction in each component of accounting equation i.e. on assets, liabilities and owner’s equity is known as the transaction analysis. This process shows the increase or decrease of each component by the effect of each financial transaction. With the help of such analysis, we can journalize the transactions in the books of original entries or directly post on the debit or credit side of relevant asset or liability on owner’s equity account.

Assets
Anything which is the possession of a business including the amounts due to it from others is called an asset. As asset may be changed from a transaction of a business.

Liabilities
Liabilities are the claims of others against the business. Like an asset, a liability may be changed from transactions of a business.

Capital
Capital refers to the amount invested by the proprietor in the business. It also includes the amount of profit or loss. It may also be changed from a transaction of a business.

.

Preparation of accounting equation

Accounting equation can be prepared by using the following rules:

  • First of all, a format is prepared.
  • Description of every transaction is made in the transaction column.
  • Each transaction of a business has a two-fold effect – an effect on its assets and another effect on its liabilities or the proprietor’s capital, or an effect on one asset and another effect on another asset, or an effect on a liability and another effect on another liability.
  • After showing the effect, the total of each transaction is made. The total of the first transaction is written as ‘Beginning or Starting equation’. After that, the totals of other transactions except final transaction are called ‘New equation’. But the total of the final transaction is called ‘Final or Ending equation’.
  • As it has been already stated above that the claim over the assets by the outsiders is first, liabilities appear before the owner’s capital in accounting equation.



  • The accounting equation is based on the principle that assets of a business should always be equal to the total outside liabilities and owner’s equity or capital.
  • Anything which is the possession of a business including the amounts due to it from others is called an asset. 
  • Liabilities are the claims of others against the business.
  • Capital refers to the amount invested by the proprietor in the business.  
.

Very Short Questions

Solution:

Accounting Equation

S.N.

Transactions

Assets

=

Capital

+

Liabilities

a)

Commenced business with goods

+ 50,000

+ 50,000

0

Beginning Equation

50,000

=

50,000

+

0

b)

Goods purchased on cash

+ 20,000

0

0

- 20,000

New Equation

50,000

=

50,000

+

0

c)

Goods purchased on credit

+ 30,000

0

+ 30,000 (Cr.)

New Equation

80,000

=

50,000

30,000

d)

Goods sold on cash

- 12,000

0

0

+ 12,000

New Equation

80,000

=

50,000

30,000

e)

Goods sold on credit

-20,000

0

0

+ 20,000

Final Equation

80,000

=

50,000

+

30,000

Solution:

Accounting Equation

S.N.

Transactions

Assets

=

Capital

+

Liabilities

a)

Started business with bank balance

+ 75,000

+ 75,000

0

Beginning Equation

75,000

=

75,000

+

0

b)

Goods purchased through cheque

+25,000

0

0

-25,000

New Equation

75,000

=

75,000

+

0

c)

Goods sold on profit

-18,000

+ 2,000 (profit)

0

+ 20,000

New Equation

77,000

=

77,000

+

0

d)

Salary paid

-5,000

-5,000

0

New Equation

72,000

=

72,000

+

0

e)

Commission received

+8,000

+8,000

0

Final Equation

80,000

=

80,000

+

0

Solution:

Accounting Equation

S.N.

Transactions

Assets

=

Capital

+

Liabilities

a)

Cash introduced as capital

+ 28,000

+ 28,000

0

Beginning Equation

28,000

=

28,000

+

0

b)

Purchased furniture

+ 7,000

0

0

-7,000

New Equation

28,000

=

28,000

+

0

c)

Goods purchased from Roshan

+ 8,400

0

+ 8,400

New Equation

36,400

=

28,000

+

8,400

d)

Goods sold to Sabita on credit

-5,600

+1,400

0

+ 7,000

New Equation

37,800

=

29,400

+

8,400

e)

Paid wages

-2,000

-2,000

0

Final Equation

+ 28,000

=

27,400

+

8,400

Solution:

Accounting Equation

S.N.

Transactions

Assets

=

Capital

+

Liabilities

a)

Commencement of business with cash and machinery

+4,000

50,000

0

+10,000

Beginning equation

50,000

=

50,000

+

0

b)

Loan taken from Surya

+12,000

0

+ 12,000

New Equation

62,000

=

50,000

+

12,000

c)

Goods lost by fire and compensation received from insurance company

-4,000

-1,000 (loss)

0

+3,000

New Equation

61,000

=

49,000

+

12,000

d)

Repayment of loan to Surya including interest on loan

-12,500

-500

-12,000

New Equation

48,500

=

48,500

+

0

e)

Commission received and still received

+4,000

+10,000

0

+6,000

Final Equation

58,500

=

58,500

+

0

Solution:

Accounting Equation

S.N.

Transactions

Assets

=

Capital

+

Liabilities

a)

Started business with cash

+ 40,000

+40,000

0

Beginning Equation

40,000

=

40,000

+

0

b)

Goods purchased

+10,000

0

+4,000 (Cr.)

-6,000

New Equation

44,000

=

40,000

+

4,000

c)

Salary paid with due amount

-10,000

-12,000

+2,000

New Equation

34,000

=

28,000

+

6,000

d)

Commission received including advance

+3,000

+2,000

+10,000 (Cr.)

New Equation

37,000

=

30,000

+

7,000

e)

Paid rent including advance for next month

+1,000

-3,000

0

-4,000

Final Equation

34,000

=

27,000

+

7,000

0%
  • Anything which is the possession of a business including the amounts due to it from others is called ______.

    a liability
    an asset
    a capital
    an income
  • ______ are the claims of others against the business.

    Losses
    Gains
    Assets
    Liabilities
  • The process of determining the effect of each transaction in each component of accounting equation i.e. on assets, liabilities and owner s equity is known as ______.

    the accounting analysis
    the transaction analysis
    the posting analysis
    the effect analysis
  • ______ refers to the amount invested by the proprietor in the business.

    Expense
    Liability
    Asset
    Capital
  • Which one of them is the first step for preparing accounting equation?

    Each transaction of a business has a two-fold effect.
    A format is prepared.
    Description of every transaction is made in the transaction column.
    After showing the effect, total of each transaction is made.
  • Which one of them is the correct formula of accounting equation?

    Assets + Liabilities = Owner s Capital
    Assets= Liabilities + Owner s Capital
    Assets= Liabilities - Owner s Capital
    Liabilities = Owner s Capital - Assets
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