Accountancy · Ch 3 — Recording of Transactions - I
Accounting Equation
Accounting Equation
The accounting equation is the foundation of double-entry bookkeeping. It states that the assets of a business are always equal to the total of its liabilities and the owner’s capital. This relationship is expressed as:
A = L + C
Where:
- A = Assets (everything the business owns)
- L = Liabilities (claims of outsiders, i.e., what the business owes to others)
- C = Capital (the owner’s claim, i.e., what the business owes to the proprietor)
This equation can be rearranged to find a missing figure:
- A – L = C (to find capital)
- A – C = L (to find liabilities)
Because it shows the fundamental relationship between the three components of a balance sheet, the accounting equation is also called the Balance Sheet Equation. At any point in time, the total resources of a business must equal the total claims against those resources. The resources are provided by two groups: the proprietor (whose claim is capital) and outsiders (whose claims are liabilities). The balance sheet is simply a statement of assets, liabilities, and capital on a particular date. Every transaction affects the balance sheet in some way, and the equation must always remain balanced.
Example 1: Rohit starts a business
Rohit starts a business with a capital of ₹5,00,000 in cash. The resources of the business are cash (₹5,00,000), and the source of that resource is the proprietor’s capital (₹5,00,000). The balance sheet at this point is:
| Liabilities | Amount (₹) | Assets | Amount (₹) |
|---|---|---|---|
| Capital | 5,00,000 | Cash in hand | 5,00,000 |
| Total | 5,00,000 | Total | 5,00,000 |
The equation holds: ₹5,00,000 (Assets) = ₹0 (Liabilities) + ₹5,00,000 (Capital). Since no profit or loss has been earned yet, the invested amount remains unchanged. Any profit will increase capital; any loss will decrease it.
Analysing transactions and their effect on the accounting equation
The textbook now analyses five transactions from Example 1, showing how each affects assets, liabilities, and capital while keeping the equation balanced.
Transaction 1: Opened a bank account in State Bank of India with ₹4,80,000.
- Effect: Cash at bank (asset) increases by ₹4,80,000; Cash in hand (asset) decreases by ₹4,80,000.
- Net effect on equation: Total assets unchanged (one asset replaces another). Liabilities and capital unchanged.
Transaction 2: Bought furniture for ₹60,000 and issued a cheque.
- Effect: Furniture (asset) increases by ₹60,000; Bank (asset) decreases by ₹60,000.
- Net effect on equation: Total assets unchanged. Liabilities and capital unchanged.
Transaction 3: Bought plant and machinery for ₹1,25,000; paid an advance of ₹10,000 in cash to M/s Ramjee Lal.
- Effect: Plant and machinery (asset) increases by ₹1,25,000; Cash (asset) decreases by ₹10,000; Liabilities (creditor — M/s Ramjee Lal) increase by ₹1,15,000 (the unpaid balance).
- Net effect on equation: Total assets increase by ₹1,15,000 (₹1,25,000 – ₹10,000). Total liabilities increase by ₹1,15,000. Capital unchanged. Equation remains balanced.
Transaction 4: Goods purchased from M/s Sumit Traders for ₹55,000.
- Effect: Goods/Stock (asset) increases by ₹55,000; Liabilities (creditor — M/s Sumit Traders) increase by ₹55,000.
- Net effect on equation: Total assets increase by ₹55,000; total liabilities increase by ₹55,000. Capital unchanged.
Transaction 5: Goods costing ₹25,000 sold to Rajani Enterprises for ₹35,000.
- Effect: Stock of goods (asset) decreases by ₹25,000; Debtors (asset — Rajani Enterprises) increase by ₹35,000; Capital increases by ₹10,000 (the profit on the sale).
- Net effect on equation: Total assets increase by ₹10,000 (₹35,000 – ₹25,000). Capital increases by ₹10,000. Liabilities unchanged.
Profit increases capital; loss decreases capital. In transaction 5, the sale at a profit of ₹10,000 directly increases the owner’s equity (capital).