A transaction is a two way process in which value is transferred from one party to another, in which either a party receives a value in terms of goods, services, etc. and in turn returns the value in terms of money or kind. For recording any transaction it is very important that it is supported by some substantial document like purchasing invoices, bills, pay-slips, memos, passbook, etc.
A transaction supported by valid documents are recorded in the books of accounts under the Double Entry system.
In a double entry system, 2 approaches are followed to record the transactions-
1) Accounting Equation Approach
2) Traditional Approach
We have already studied the traditional approach under the topic “Double Entry System” earlier. Let’s discuss in detail the “Accounting Equation” approach in this chapter.
The relationship of assets with that of liabilities and owners’ equity in the form of an equation is known as “Accounting Equation”.
A basic accounting equation shows that sum of liabilities (external liabilities) and capital (internal liabilities) equals total assets of the firm. i.e.
Equity + Liabilities = Assets
Under double entry system, every transaction affects changes in assets, liabilities and capital in such a way that an accounting equation is completed and equated.
This accounting equation holds true at all points of time and for any number of transactions.
Let us first break down the terms used in the equation:-
Equity/Capital: The contribution by the owner/ shareholders is known as capital. It is the capital that an owner (in case of a sole-proprietorship) or shareholders (in case of a company) invests in the business to earn profitable returns from it.
Capital is also a kind of borrowings for the business, the only difference is this is borrowed from the owners so it is an internal liability which comes after the company’s obligation to pay its external obligations.
Equity/ Owners’ equity comprises of “Capital invested by the stakeholders plus profit earned minus losses suffered”.
Liabilities: This means borrowing of the firm from an outside source, e.g. loan taken for a year or more, goods or services purchased on credit, etc.
This is the primary obligation for an enterprise and has to be paid first before any other internal liabilities of the business. If the loan or credit availed is for a period of a year or less than year, then those liabilities are short-term liabilities or current liabilities for the firm. If it is for a period of more than a year, then those liabilities are termed as long-term liabilities.
Assets are the investments a firm does through its borrowings from different sources. Assets are also of two categories – Long term and short term. Long term assets or fixed assets are huge investments which a business does and which has the potential to provide long-term utility to the business over the years. E.g. Land, Building, machine, furniture, etc. These assets give long term benefits to the business until they become obsolete or are written off by depreciation.
Short-term or current assets are the assets which are highly liquid in nature and are used in the day-to-day operations of the business. E.g. cash, inventory, debtors (receivables due for less than a year), etc.
Let’s get back to the equation we discussed earlier-
(Current Assets + Fixed assets) = (Capital Invested + Profit – Losses – withdrawals) + (Long term liabilities + Current liabilities)
Any transaction that takes place in an enterprise have an equalizing effect on the equation, i.e. it should affect assets, liabilities or capital in a way that they agree to this equation.
Given below are some examples which will help you understand the concept better-
|Transactions||Assets (in $)||= Liabilities(in $)||+ Capital (in $)|
|1. Started the business with cash $20,000||20,000||0||20,000|
|2. Purchased inventory worth $14,000 on credit||14,000||14,000||0|
|3. Loan repaid to the bank for $8,000||(8,000)||(8,000)||0|
|4. Withdrew cash from the business for personal use $3,000||(3,000)||0||(3,000)|
|5. Borrowed $5,500 from a moneylender||5,500||5,500||0|
Now the above table shows you the effect of any transaction on the assets, liabilities and capital using the “+” and “-“signs but this is not how transactions are recorded in the books of accounts.
All the transactions/events or items increases the asset of the company or decreases its obligations/liabilities is debited in the books of account. All the transactions which increase the liability/obligation (internal liability- owners’ capital and external liability- creditors) or decreases the assets is credited in the books of accounts.
Let’s discuss some of these transactions in details with the help of examples-
|Transactions||Assets (in $)||= Liabilities(in $)||+ Capital (in $)|
|1. Sale of inventory for $7,500 (cost $6,000)||1,500||0||1,500|
|2. Purchase of inventory with cash for $2,500||0||0||0|
|3. Sale of old machinery for $15,500 (Cost $17,500 after charging depreciation)||(2,000)||0||(2,000)|
|4. Payment received from a debtor in cash for $3,400||0||0||0|
|5. Administration expenses for the year $4,000 paid in cash||(4,000)||0||(4,000)|
|6. Outstanding expenses of $3,600 due for the year||0||3,600||(3,600)|
|7. Interest of $600 received from the bank||1,500||0||1,500|
|8. Withdrawal of cash $9,000 by the owner for personal use||(9.000)||0||(9,000)|
1. Sale of inventory implies reduction in stock by cost price and increase in cash/debtors by sale price. So, the net increase in assets will just be the excess of sale price over cost price. The capital will also increase with the same amount as it is the profit for the firm, and it increases the firm’s liability to pay to its owners.
Conclusion: Increase in assets is debited and decrease is credited. Profits increases the capital, hence credited and losses are debited.
2. Purchase of inventory implies increase in stock and decrease in cash for the same amount. So, these is no net change in the amount of assets.
Conclusion: These transactions are called compensating transactions. They don’t have an overall impact on assets or liabilities but significant to record in the books of accounts because it affects the individual accounts like cash, machinery, creditors, inventory, etc.
3. Sale of machinery implies the reduction in the value of machinery by book value (cost less depreciation) and increase in cash/debtors by sale price. As, this is a case of loss, so, the net decrease in assets will just be the excess of cost price over sale price. The capital will decrease with the same amount as it is the loss for the firm, and it decreases the firm’s liability to pay to its owners.
Conclusion: Same as 1.
4. Payment received implies increase in cash and decrease in debtors by the same amount. So, these is no net change in the amount of assets.
Conclusion: Same as 2.
Expenses always have either of the two effects on the Balance sheet-
5. Expenses paid decreases the profit of the entity. Profit increases the liability of the business to pay to its stakeholders. So, expenses are always debited in the Capital Account. As, in this case expenses are paid in cash, it will decrease assets by the same amount as capital. So, assets will be debited.
6. As discussed earlier, expenses are always debited in the Capital Account. In this case expenses are yet not paid and are due to, it will increase the amount of creditors and hence liabilities will be credited.
Conclusion: Expenses are debited in the Capital account because it decreases the profit of the firm. It also either decreases the assets or increases the liabilities to balance out the effect.
7. Income received always have an increasing effect on both the assets and the Capital. If income is received in cash it increases the cash, if not then it increases the value of debtors in the balance sheet. It also increases the capital as more income means higher profits of the firm, which in turn increases the firm’s liability to pay to its stakeholders/owners.
Conclusion: Income is credited in the Capital account and it increases the assets so the asset account is debited.
Analyse the following transactions of M/S Ananya & Co. for the month of January 2018 on the basis of double entry system by adopting the Accounting Equation approach.
1. Ananya introduced cash $8,000
2. Cash deposited in the City Bank $2,000
3. Salaries paid for the month of January 2018, $2,000 and $1,200 is still payable
4. Stationaries purchased for $600
5. Sales made for $4,300 on credit
|Transaction S.No.||Analysis||Accounts Involved||Rule||Entry|
|1.||Cash invested by the owner in the business||Cash – Asset|
Capital – Capital
|Increases in assets are credits; decreases in Owner’s Capital are credits||Debit Cash|
|2.||Bank balance increases|
Cash balance decreases
|Bank – Asset|
Cash – Asset
|Increases in assets are credits; decreases are credits||Debit Bank|
|3.||Salaries to be paid $3,200|
Cash balance decreases by $2,000
Obligation to pay $1,200
|Salary – Expense|
Cash – Asset
Salaries Outstanding – Liability
|Increases in expenses are debits;|
Decreases in assets are credits
Credit Salaries Outstanding
|4.||Increases in stationaries $600|
Decrease in cash $600
|Stationaries – Asset|
Cash – Asset
|Increases in assets are credits; decreases are credits||Debit Stationaries|
|5.||Sales increased by $4,300|
Receivables/ Debtors increased by $4,300
|Sales – Income |
Debtors – Asset
|Increases in assets are debits;|
Increases in incomes are credits