(5) ACCOUNTING EQUATION

 

Accounting equation 

The assets and the ownership of those assets of a business are shown in accounting records of that business. All assets should belong to some party of the business. Therefore, assets of a business should be equal to the total ownership of those assets. To show this relationship, an equation is used, which is called as the Accounting Equation. 

Construction of accounting equation 

If all assets are financed by the owner of the business, the accounting equation can be presented as follows. 

 Assets = Equity 

Example :- 

Amal started a business investing Rs.500 000 in cash. Here, assets (cash) of the business is equal to Rs. 500 000 and this total amount belongs to the owner, Amal. Accordingly, 

 Assets = Equity 

 Rs. Cash 500 000 = Rs. Capital 500 000 

When a business expands, the resources invested by owners would not be adequate. Therefore, the business will have to obtain resources from external parties. When the business borrows money, liabilities arise. When there are liabilities in the business, a part of its assets belong to debt holders. Remaining of the assets belongs to owners. In such a situation, accounting equation can be built as follows. 

Assets = Equity + Liabilities 

Example :- 

With reference to the above example, if Amal had obtained a bank loan of Rs. 300 000, assets of Amal's business are increased by Rs. 300 000 (cash). On the other hand, it increases liabilities (bank loan) of the business by Rs. 300 000. 

Accordingly, the accounting equation including the second transaction is now depicted as, 

 Assets = Equity + Liabilities 
  Rs. Cash 800 000 = Rs. Capital 500 000 + Bank loan 300 000

How do business transactions affect the accounting equation 

The value of assets, liabilities and equity are changed due to business transactions. Accordingly, the accounting equation changes due to the business transactions. Let us understand these changes using the following examples.

Example :- Nehara started a business to repair computers. The following transactions are given to you for the first month of the business. 

• Invested Rs. 500 000 as the capital 
•  Obtained a bank loan of Rs. 200 000 
• Deposited Rs. 100 000 in a fixed deposit account 
• Earned a cash income Rs. 60 000 from computer repairs 
• Paid Rs. 10 000 as the monthly rent of the business 
•  Nehara withdrew Rs. 20 000 from the business for her private use 
•  Purchased equipment at Rs. 100 000 
•  Paid Rs. 5 000 of the telephone bill of the month 
•  Nehara invested an additional capital of Rs. 50 000 
•  Settled Rs. 20 000 of the bank loan 

The impacts of the above transactions to the accounting equation are shown below.

Example :- 

The following balances were extracted as at 01.08.20xx from Sandamini's business. 

Assets 

Furniture = 300 000 

Stocks = 200 000 

Debtors = 100 000 

Cash = 200 000 

Liabilities 

Bank loan = 300 000 

Creditors = 100 000 

The following transactions occurred in the first week of August 20xx 

• Purchased goods at Rs. 100 000 to sell 
• Sold goods which were purchased at Rs. 100 000 for Rs. 125 000 
• Settled Rs. 50 000 of the bank loan 
• Paid Rs. 10 000 as salaries 
• Sandamini withdrew goods at a cost of Rs. 20 000 for her private use. 
• Purchased furniture at Rs. 50 000 for the use of the business 
• Purchased goods at Rs. 200 000 on credit basis. 
• Sold goods at Rs. 100 000 on credit basis.These goods had been purchased at Rs. 60 000 
• Received Rs. 80 000 from debtors 
• Paid Rs. 50 000 to creditors 

The procedure of calculating the owner's equity as at 01.08.20xx and the affects of the above transaction on the accounting equation are as follows.

01. The equity as at 01.08.20xx 

Equity = Assets - Liabilities 

Equity = (200 000 + 100 000 + 200 000 + 300 000) – (300 000 +100 000) 

Equity = 800 000 - 400 000 

Equity = Rs. 400 000 

02. Impact of the transactions on the accounting equation 

Example :- 

The following balances were shown as at 01.07.20xx of Ruwanthi's business. 

• Motor vehicles Rs.500 000 
• Stocks Rs.200 000 
• Cash Rs.100 000 
• Bank loan Rs.200 000 
• Creditors Rs.100 000 
• Capital Rs.500 000 

The following transactions occurred in July 20xx. 

• Owner invested Rs. 200 000 as additional capital 
• Paid Rs. 20 000 bank loan installment including Rs. 2 000 as the interest. 
• Purchased goods at Rs. 100 000 on credit basis 
• Paid Rs. 50 000 to creditors 
• The owner gave Rs. 200 000 worth of his private motor bicycle to the business 
• Sold goods which cost Rs. 100 000 at Rs. 150 000 on credit basis 
• Paid Rs. 10 000 for insurance 
• Received Rs. 70 000 from debtors 
• Paid Rs. 5 000 from business for the electricity bill of owner's house 
• Received sales commission income of Rs. 10 000 

See below how the above transactions affect the accounting equation.

Impacts of transactions on the accounting equation as follows.

It is also important to identify the transactions which have been presented in the accounting equation. See the following example,

Example :- 

The following accounting equation of Aloka's business shows the impacts of transactions occurred in January. 

The owner has not made drawings in the month. 

Transactions assumed to be taken place in each day can be presented as follows. 

Jan 03 - Purchased goods at Rs. 100 000 on cash basis and at Rs. 100 000 on credit basis 

Jan 07 - Paid Rs. 20 000 of expense. 

Jan 10 - Paid Rs. 60 000 of bank loan installment including Rs. 10 000 as the interest. 

Jan 14 - Sold goods which cost Rs. 200 000 at Rs. 300 000 on credit basis. 

Jan 18 - Invested Rs. 300 000 as additional capital. 

Jan 21 - Paid Rs. 100 000 to creditors. 

Jan 25 - Received Rs. 400 000 from debtors.

Situations that change the equity 

By studying the above facts, you may have understood the transactions that affect to increase or decrease the owner's equity. The following transactions affect to change the equity of the business.

 

• Introduction of additional capital 
• Drawings 
• Income 
• Expenses 

The owner has to invest cash or other assets according to the needs of the business. It increases the owners equity. 

The owner may withdraw money or other assets from the business for his personal use. This is called drawings. It decreases the owner's equity. 

Equity is increased by income and decreased by expenses.

Example :-

THE END OF THE ACCOUNTING EQUATION 

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