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Accounting Equation


An Accounting equation signifies that the assets of a business are always equal to the total of its liabilities and capital (owner's equity).
The equation is as follows:
A = L + C
Where,
A = Assets
L = Liabilities
C = Capital

The above equation can also be presented in the following forms:
  1. A - L = C
  2. A - C = L
Since, the accounting equation depict the fundamental relationship among the components of the balance sheet, it is also called the Balance Sheet Equation. As the name depicts, the balance sheet is a statement of assets, liabilities and capital.

The resources of the business entity must always be equal to the claims of those who have financed these resources. The proprietors and (public) outsiders provide the resources of the business. The claim of the proprietors is called capital and that of the outsides is known as liabilities. Each element of the equation in the balance sheet states the financial position of the business on a particular date. On analyzing the transactions, we can know that how balance sheet of a business entity gets affected.

Asset side of the balance sheet is the list of assets, which the business entity owns. The liabilities side of the balance sheet is the list of owner's claims and outsider's claims, i.e., what the business entity owes. The equality of the assets side and the liabilities side of the balance sheet is an undeniable fact and this justifies the name of accounting equation as balance sheet equation also.

Example # 1
Sanjay started business with a capital of Rs. 10, 00,000. From the accounting point of view, the resources of this business entity are in the form of cash, i.e., Rs. 10, 00,000. Sources of this business entity are the contribution by Sanjay (Proprietor) Rs. 10, 00,000 as Capital.

(For the purpose of understanding we will refer this example as example 1, throughout the chapter).

If we put this information in the form of equality of resources and sources, the picture would emerge somewhat as follows:
Books of Rohit

Balance Sheet as at..........
Liabilities

Amount Rs.

Assets

Amount Rs.

Capital

5,00,000
________

5,00,000
________

Cash in hand

5,00,000
________

5,00,000
_________


In the above balance sheet, the total assets are equal to the liabilities of the business. Since, the business has not yet started its activities and has not earned any profits; the amount invested in business is still Rs. 10, 00,000. In case any profits are earned, it will increase the amount invested in the business.

On the other hand, if the business suffers any losses, it will decrease the amount invested in the business.

Now we can analyse the transactions listed in example 1 and its effect on different elements and you will observe that the accounting equation always remain balanced:
  1. Opened a bank account in State Bank of India with an amount of Rs.8, 40,000.
Analysis of transaction: This transaction increases the cash in hand (Assets) and decreases cash (asset) by Rs. 8, 40,000.
  1. Bought furniture for Rs. 1, 20,000 and cheque was issued on the same day.
Analysis of transaction: This transaction increases furniture (assets) and decreases bank (assets) by Rs.1, 20,000.
  1. Bought plant and machinery for the business for Rs. 2, 50,000 and an advance of Rs. 20,000 in cash is paid to M/s.Shyam & co
Analysis of transaction: This transaction increases plant and machinery (assets) by, Rs. 2, 50,000, decreases cash by Rs. 20,000 and increases liabilities (M/s Shyam &co as creditor) by Rs. 2, 30,000.
  1. Goods purchased from M/s Samy Traders for Rs. 1, 20,000.
Analysis of transaction: This transaction increases goods (assets) and increases liabilities (M/s Samy Traders as creditors) by Rs. 1, 20,000.
  1. Goods costing Rs. 50,000 sold to Ranjani Enterprises for Rs. 70,000.
Analysis of transaction: This transaction decreases stock of goods (assets) by Rs. 50,000 and increases assets (Rajani Enterprises as debtors Rs. 70,000) and capital (with the profit of Rs. 20,000).

The final equation as per the above analysis table can be summarised in the form of a balance sheet as under:

 

Liabilities

Amount

Rs.

Assets

Amount

Rs.

Outsider's claims (Creditors)

Capitall

1,70,000

5,10,000

 

 







__________

6,80,000
________

Cash

Bank

Debtors

Stock

Furniture

Plant and machinery

 

   10,000

4,20,000

   35,000

   30,000

   60,000

1,25,000
_______
6,80,000
___
____


In terms of accounting equation
A = L + C
Rs. 6,80,000 = Rs. 1,70,000 + Rs. 5,10,000




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