# 5. ACCOUNTING EQUATION – Financial Accounting

## Accounting Equation

##### MEANING OF ACCOUNTING EQUATION

An accounting equation is a statement of equality between the resources and the sources which finance the resources and is expressed as follows:

Resources = Sources of Finances

Resources mean the Assets. The Assets refer to the tangible objects (e.g., Land and Building, Plant and Machinery, Furniture, Investments, Stock, Debtors, Bank Balance, Cash Balance) or intangible rights (e.g., Patents, Trademark, Copyright) owned by an enterprise and carrying probable future benefits.

Sources of finance mean equities and includes Internal Sources (or Internal Equity) (i.e., capital) and External Sources (or External Equity) (i.e., liabilities). Capital refers to the amount invested in an enterprise by its owners. Liabilities are the financial obligations of an enterprise other than owners’ funds. Thus, the aforesaid accounting equation may be expressed as follows:

Total Assets = Total Equities
or
Assets = Internal Equity + External Equity
or
Assets = Capital + Liabilities

Since the liability holders have a definite and prior claim against the assets, the capital is also called a residual of assets over liabilities and may be expressed as follows:

Capital = Assets - Liabilities

This equation is fundamental in the sense that it gives foundation to the double entry book keeping. This equation holds goods for all transactions and events and at all periods of time since every transaction and event has two aspects.

##### PROCEDURE FOR DEVELOPING AN ACCOUNTING EQUATION

An accounting equation may be developed by taking the steps given below:

#### Steps Involved in Developing an Accounting Equation

Step 1 → Ascertain the variables (i.e., Assets, Liabilities or Capital) of an equation affected by a transaction.

Step 2 → Find out the effect (in terms of increase or decrease) of a transaction on the variables of an equation.

Step 3 → Show the effect on the appropriate side of an equation and ensure that the total of right hand side is equal to the total of left hand side.

Accounting Equation to Record Capital Brought-In

Illustration 1 Started business with Rs 1,00,000. Analyse the transaction and give Accounting Equation.

Solution

Accounting Equation to Record Loan Borrowed

Illustration 2 Borrowed Rs 10,000 from Sun. Analyse the transaction and give Accounting Equation.

Solution

Accounting Equation to Record Purchase of Fixed Assets

Illustration 3 Purchased furniture for Rs 10,000. Analyse the transaction and give Accounting Equation.

Solution

Accounting Equation to Record Cash Purchase of Goods

Illustration 4 Purchased Goods for cash 20,000. Analyse the transaction and give Accounting Equation.

Solution

Accounting Equation to Record Credit Purchases of Goods

Illustration 5 Purchased Goods from Moon on credit for Rs 30,000. Analyse the transaction and give Accounting Equation.

Solution

Accounting Equation to Record Cash Sales of Goods

Illustration 6 Sold Goods costing Rs 10,000 for cash Rs 12,000. Analyse the transaction and give Accounting Equation.

Solution

Accounting Equation to Record Credit Sales of Goods

Illustration 7 Sold Goods costing Rs 20,000 to Star on credit for Rs 25,000. Analyse the transaction and give Accounting Equation.

Solution:

Accounting Equation to Record Return of Goods to Supplier

Illustration 8 Returned Goods costing Rs 5,000 to supplier of Goods. Analyse the transaction and give Account Equation.

Solution

Accounting Equation to Record Receipt of Payment from a Customer

Illustration 9 Received cash from a customer Rs 20,000. Analyse the transaction and give Accounting Equation.

Solution

Accounting Equation to Record Payment to a Supplier of Goods

Illustration 10 Paid cash to a supplier of goods Rs 15,000. Analyse the transaction and give Accounting Equation.

Solution

Accounting Equation to Record Payment of Expenses

Illustration 11 Paid Salary Rs 1,000. Analyse the transaction and give Accounting Equation.

Solution

Accounting Equation to Record Withdrawal of Cash for Personal Use

Illustration 12 Withdrew cash Rs 2,000 for personal use. Analyse the transaction and give Accounting Equation.

Solution

Accounting Equation to Record withdrawal of Goods for personal use

Illustration 13 Withdrew goods costing Rs 3,000 for personal use. Analyse the transaction and give Accounting Equation.

Solution

Accounting Equation to Record Depreciation on Fixed Assets

Illustration 14 Furniture costing Rs 10,000 in valued at Rs 9,000. Analyse the transaction and give Accounting Equation.

Solution

Accounting Equation to Record Expense Due but not Paid

Illustration 15 Rent due but not paid Rs 2,000. Analyse the transaction and give Accounting Equation.

Solution

Accounting Equation to Record Repayment of Loan with Interest

Illustration 16 Repaid loan of Rs 10,000 alongwith interest of Rs 100. Analyse the transaction and give Accounting Equation.

Solution

Illustration 17 Show the Accounting Equation on the basis of the following transactions and prepare the Balance Sheet at last.

1. Shri Ram commenced business with Rs 50,000.
2. Paid rent in advance Rs 2,000.
3. Purchased a typewriter for Rs 7,000.
4. Bought furniture from M/s Mohan Furnitures on credit for Rs 3,000.
5. Purchased goods from Sohan for cash Rs 35,000.
6. Sold goods to Shyam for cash Rs 40,000 (costing Rs 30,000).
7. Bought goods from Ramesh for Rs 30,000.
8. Sold goods to Shyam costing Rs 30,000 for Rs 50,000.
9. Purchased household goods for Rs 15,000 giving Rs 5,000 in cash and the balance through a loan.
10. Goods destroyed by fire (Cost Rs 500, Sale Price Rs 600).
11. Paid half the amount owed to Mohan Furniture.
12. Paid cash Rs 500 for loan and Rs 300 for Interest.
13. Withdrew goods for personal use (cost Rs 500, sale price Rs 600).
14. Received Rs 49,500 from Shyam in full settlement.
15. Paid Rs 29,700 to Ramesh in full settlement.
16. Paid salary Rs 500 and salary outstanding Rs 100.
17. Charged depreciation of Rs 300 on furniture and Rs 100 on typewriter.

Solution

Accounting Equation: Assets = Liabilities + Capital

Balance Sheet of Shri Ram as at...

Working Note Calculation of Cash in hand and Stock in hand at the end

#### Multiple Choice Questions

1. Which of the following is correct?
1. Assets = Liabilities - Capital
2. Assets = Capital - Liabilities
3. Assets = Liabilities + Capital
4. Assets = External Equities.
2. Which of the following is correct?
1. Profit/Loss = Closing Capital + Additional Capital - Drawings made - Opening Capital
2. Profit/Loss = Closing Capital - Drawings made - Additional Capital - Opening Capital
3. Profit/Loss = Opening Capital + Drawings made - Additional Capital - Closing Capital
4. Profit/Loss = Closing Capital + Drawings made - Additional Capital - Opening Capital.
3. Which of the following is correct?
1. Opening Capital = Closing Capital + Additional Capital - Drawings - Profit
2. Opening Capital = Closing Capital + Drawings - Additional Capital - Loss
3. Opening Capital = Closing Capital + Drawings - Additional Capital - Profit.
4. Which of the following is correct?
1. Closing Capital = Opening Capital + Additional Capital - Profit - Drawings
2. Closing Capital = Opening Capital + Additional Capital - Drawings + Profit
3. Closing Capital = Opening Capital - Additional Capital - Drawings - Loss.
5. The liabilities of a firm are Rs 6,000 and the capital of the proprietor is Rs 4,000. The total assets are:
1. Rs 6,000
2. Rs 10,000
3. Rs 2,000.
6. The assets on 31.12.20X1 Rs 60,000 and capital is Rs 45,000. Its liabilities on that date shall be:
1. Rs 60,000
2. Rs 1,05,000
3. Rs 15,000.
7. Ram has assets of Rs 10,000 and liabilities of Rs 2,000. His capital would be:
1. Rs 10,000
2. Rs 12,000
3. Rs 8,000.
8. If a firm borrows a sum of money, there will be:
1. increase in capital
2. decrease in capital
3. no effect on capital.

[Answer: 1. (c), 2. (d), 3. (c), 4. (b), 5. (b), 6. (c), 7. (c), 8. (c)]

#### Very Short Answer Type Questions

1. What is accounting equation?
2. State whether earnings increase or decrease owner’s equity.
3. State whether drawings increase or decrease owner’s equity.
4. State whether additional capital increase or decrease owner’s equity.
5. Can liabilities be zero?
6. Can assets be zero?
7. Can Capital be zero?
8. Show the accounting equation if there are no liabilities.
9. Show the accounting equation if there are profits.
10. Show the accounting equation if there are losses.
11. Show the accounting equation if there are revenue and expenses.
12. Show the accounting equation if there are drawings, additional capital, revenue and expenses.
13. Give an equation for calculating owner's equity.

• 14. Give an equation for calculating external equity.
• 15. “Accounting equation holds goods under all circumstances”. Justify this statement with the help of five illustrations.
• 16. State a transaction in which there is increase in one liability and decrease in another.
• 17. State a transaction in which there is increase in one liability and decrease in owner’s capital.
• 18. State a transaction in which there is a decrease in liability and increase in owner’s capital.
• 19. How will you deal with the following items in accounting equation?
1. Outstanding Expenses
2. Prepaid Expenses
3. Accrued Income
4. Unaccrued Income.

#### Essay Type Questions

• 20. State the procedure for developing an accounting equation.
##### PRACTICAL QUESTIONS
1. Fill in the blanks:

[Answer: I. Rs 30,000, II. Rs 33,000, Rs 33,000, III. Rs 21,000, Rs 36,000,
IV. Rs 27,000, Rs 42,000, V. Rs 30,000, Rs 9,0001]

2. Fill in the blanks:

[Answer: I. Rs 8,400, II. Rs 12,000, III. Rs 1,800, IV. Rs 9,600, V. Nil]

3. If capital of a business is Rs 6,000 and outside liabilities are Rs 9,000, calculate total assets of the business.

4. If total assets of a business are Rs 78,000 and net worth is Rs 48,000. Calculate creditors.

5. Mr X commenced his cloth business on 1st January 20X1 with a capital of Rs 18,000. On 31 December 20X1, his assets were worth Rs 30,000 and liabilities of Rs 6,000. Find out his closing capital and profits earned during the year.

6. If the capital of a business is Rs 42,000 and liabilities are of Rs 24,000. Calculate total assets.

7. Calculate total equity if:
1. Owner’s equity in the beginning Rs 36,000.
2. Equity of creditors at the end Rs 30,000.
3. Revenue during the period is Rs 42,000.
4. Expenses during the same period are Rs 39,000.

Also calculate amount of owner’s equity at the end.

1. Ram started a business on 1.1.20X1 with a capital of Rs 6,000 and a loan of Rs 3,000 borrowed from Bharat. On 31 December 20X1, his assets were Rs 18,000. Find out his capital as on 31.12.20X1 and profits made or losses incurred during the year 20X1.
2. If in the above problem 8(a) during 20X1, the proprietor had introduced additional capital of Rs 3,000 and had withdrawn Rs 1,800 for personal purposes, find out the profit.
3. If in the above problem 8(a) on 31.12.20X1 apart from loan, Ram owes Rs 1,500 to a supplier of goods, find out his capital as on 31.12.20X1 and profit.

[Answer: (a) Rs 15,000, Rs 9,000, (b) Rs 7,800, (c) 13,500, Rs 7,500]

8. Calculate the amount of total capital and assets as on 31.12.20X1 in each of the following cases:
1. Shyam started a business on 1.1.20X1 with a capital of Rs 6,000 and a loan of Rs 3,000 borrowed from Charat. During the year, he made a profit of Rs 3,000.
2. If in the preceding case the proprietor had introduced additional capital of Rs 3,000 and had withdrawn Rs 1,800 for personal use.
3. If in the preceding case, apart form loan, Shyam owes 1,500 to a supplier of goods on 31.12.20X1.

[Answer: (a) Rs 9,000, Rs 12,000, (b) Rs 10,200, Rs 13,200, (c) Rs 10,200, Rs 14,700]

9. Calculate capital as on 1.1.20X1 in each of the following cases:
1. On 31.12.20X1 the total assets and external liabilities were Rs 30,000 and Rs 900 respectively. During 20X1 the proprietor earned Rs 3,000.
2. If, in the preceding case the proprietor had introduced additional capital Rs 3,000 and had withdrawn Rs 1,800 for personal purposes.

[Answer: (a) Rs 26,100, (b) Rs 24,900]

10. Calculate the amount of external equities as on 31.12.20X1 in each of the following alternatives cases:
1. On 31.12.20X1, total assets and capital were Rs 30,000 and Rs 21,000 respectively.
2. On 1.1.20X1, Ram started a business with a capital of Rs 6,000 and a loan of Rs 3,000 borrowed from a friend. During 20X1, he earned a profit of Rs 3,000. On 31.12.20X1, the total assets were Rs 30,000.
3. On 1.1.20X1, Shyam started a business with a capital of Rs 6,000 and a loan of Rs 3,000 borrowed from a friend. During 20X1, he earned a profit of Rs 3,000, introduced an additional capital of Rs 3,600 and had withdrawn Rs 1,800 for his personal use. On 31.12.20X1 the total assets were Rs 30,000.

[Answer: (a) Rs 9,000, (b) Rs 21,000, (c) Rs 19,200]

11. Give an example for each of the following types of transactions:
1. Increase in one asset, decrease in another asset.
2. Increase in assets, increase in liabilities.
3. Increase in assets, increase in owner’s capital.
4. Decrease in assets, decrease in liabilities.
5. Decrease in assets, decrease in owner’s capital.
6. Increase in one liabilities, decrease in another liability.
7. Increase in liabilities, decrease in owner’s capital.
8. Decrease in liabilities, increase in owner’s capital.
12. Prove that the accounting equation is satisfied in all the following transactions of Suresh:
1. Commenced business with cash Rs 36,000.
2. Paid rent in advance Rs 300.
3. Purchased goods for cash Rs 18,000 and credit Rs 12,000.
4. Sold goods for cash Rs 18,000 costing Rs 12,000.
5. Paid salary Rs 300 and salary outstanding Rs 60.

Bought motorcycle for personal use 3,000.

[Answer: Assets Rs 50,700 = Liabilities Rs 12,060 + Capital Rs 38,640]

13. Mr X had the following transactions:
1. Commenced business with cash Rs 30,000.
2. Purchased goods for cash Rs 12,000 and credit Rs 18,000.
3. Sold goods for cash Rs 24,000, costing Rs 18,000.
4. Rent paid Rs 300.
5. Rent outstanding Rs 60.
6. Bought furniture Rs 3,000 on credit.
7. Bought refrigerator for personal use Rs 3,000.
8. Purchased building for cash Rs 12,000.

Use accounting equation to show the effect of the above transactions on his assets, liabilities and capital and also show his balance sheet.

[Answer: Assets Rs 53,700 = Liabilities Rs 21,060 + Capital Rs 32,640]

14. Mr X had the following transactions. Use accounting equation to show the effect on his assets, liabilities and capital:
1. Invested Rs 9,000 in cash.
2. Purchased securities for Rs 4,500 in cash.
3. Purchased a home for staff Rs 9,000 giving Rs 3,000 in cash and the balance through a loan.
4. Sold securities costing Rs 600 for 900.
5. Purchased an old car for Rs 1,680 in cash.
6. Received cash as salary Rs 2,160.
7. Paid Rs 300 for loan and Rs 180 for interest.
8. Paid cash for household expenses Rs 180.
9. Received cash for dividend on securities Rs 120.

[Answer: Assets Rs 16,920 = Liabilities Rs 5,700 + Capital Rs 11,220]

15. Show the accounting equation on the basis of the following transactions:
 Rs a. Manu started business with cash 30,000 b. Purchased goods on credit 2,400 c. Purchased goods for cash 600 d. Purchased furniture for 300 e. Paid rent 120 f. Withdrew for private use 420 g. Received interest for 60 h. Sold goods on credit (cost Rs 300) for 420 i. Paid to creditors 240 j. Paid salaries for 120

[Answer: Assets Rs 31,680 = Liabilities Rs 2,160 + Capital Rs 29,520]

16. Show the accounting equation on the basis of the following transactions and present a balance sheet of the last new equation balance:
 Rs a. Mohan commenced business with 42,000 b. Purchased goods on credit 8,400 c. Withdrew for private use 1,020 d. Purchased goods for cash 6,000 e. Paid wages 180 f. Paid to creditors 6,000 g. Sold goods on credit at par 3,000 h. Sold goods for cash (cost price was Rs 1,800) 2,400 i. Purchased furniture for 300

[Answer: Assets Rs 43,800 = Liabilities Rs 2,400 + Capital Rs 41,400]

17. Mr X started a real estate agency business with a cash investment of Rs 21,000. The following business transactions have been recorded:
1. Paid three months advance rent for office accommodation Rs 1,260.
2. Bought car for office Rs 12,600.
3. Purchased office furniture Rs 4,200.
4. Bought office typewriter from Standard Supply Company Rs 1,800.
5. Sold extra office furniture at cost to Amar for Rs 600. Amar paid Rs 360 in cash and accepted a bill at three months for the balance.
6. Amar paid the amount of the bill at maturity and Mr X paid half the amount he owed to Standard Supply Company.
7. Collected Rs 3,600 as commission.
8. Paid telephone bill amounting to Rs 90.

Use the following headings in a tabular form and work out the effects of the foregoing transactions on the equity of Onkar Nath through the accounting equation.

Cash + B/R + Prepaid rent + Office Car + Office equipment = Standard Supply Co. + Owner equity.

[Answer: Rs 6,150 + 0 + Rs 1,260 + Rs 12,600 + Rs 5,400 = Rs 900 + Rs 24,510]

18. Show the Accounting Equation on the basis of the following transactions and prepare the Balance Sheet at last.
1. Shri Ram commenced business with Rs 30,000.
2. Paid rent in advance Rs 1,200.
3. Purchased a typewriter for Rs 4,200.
4. Bought furniture from M/s Mohan Furnitures on credit for Rs 1,800.
5. Purchased goods from Sohan for cash Rs 21,000.
6. Sold goods to Shyam for cash Rs 24,000 (costing Rs 18,000).
7. Bought goods from Ramesh for Rs 18,000.
8. Sold goods to Shyam costing Rs 18,000 for Rs 30,000.
9. Purchased household goods for Rs 9,000 giving Rs 3,000 in cash and the balance through a loan.
10. Goods destroyed by fire (Cost Rs 300, Sale Price Rs 360).
11. Paid half the amount owed to Mohan Furniture.
12. Paid cash Rs 300 for loan and Rs 180 for Interest.
13. Withdrew goods for personal use (cost Rs 300, sale price Rs 360).
14. Received Rs 29,700 from Shyam in full settlement.
15. Paid Rs 17,820 to Ramesh in full settlement.
16. Paid salary Rs 300 and salary outstanding Rs 60.
17. Charged depreciation of Rs 180 on furniture and Rs 60 on typewriter.

[Answer: Assets Rs 44,160 = Liabilities Rs 6,660 + Capital Rs 37,500]