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Dear All, Welcome to the sessions in Financial Accounting. I have planned my sessions with an assumption that you will not become book-keepers or accountants. I assume that you will be using the financial accounting numbers for decision making. Following note explains the concept of accounting equation. I will make an effort to explain accounting using accounting equation only. I know that most of you may not be having any accounting background. In my view, that should not bother you much. Moreover, you should not get intimidated by the normal accounting books available in the libraries or book stalls. For those who have a strong accounting background I want to say that we will not be using debits and credits during the sessions. I suggest that you should read the note and try to understand the concept as clearly as possible. At the end to the note I have provided some questions. Make an effort to solve the questions. Compulsory Work

Prepare a list of 20 transaction and show the accounting equation. Collect the latest annual report of any company and read it.

Good Luck! N. D .Prasad Email: durgacsrem@gmail.com

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Accounting Equation: Basic Tool for Understanding Accounting Accounting equation is the basic tool for understanding and analysing the financial transactions. In fact, every transaction, irrespective of its size, nature, can be explained with the help of the accounting equation. Accounting equation is based on the basic principle of accounting: Dual Aspect Principle. According to the principle every business owns some property i.e. some economic resources. These resources in accounting are called Asset. We will understand the meaning of assets in details during our sessions. These assets (resources) can be in any form: Cash, stock, land, plant etc. However, these resources should have some source of financing. In other words, one needs funds to acquire these assets. So every asset should be supported by some funds. Accounting equation captures that relationship as follows: Total Sources = Total Assets Sources can be divided into following three categories Equity: Money contributed by the owners Loan: Money contributed by the outsiders (Banks and Creditors) Profit: Money generated by the business As mentioned in the previous paragraph assets can be in the form of investment in the business (fixed assets and current assets), investments outside the business. So accounting equation can be presented as follows: Capital + Profit+ Borrowings = Fixed assets + Current assets + Investments Business transactions affect the equation as follows: Change capital, or Change profit, or Change Borrowings, or Change in the investment in the business, or Change in the investment outside the business, or All or some of the above.

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Let us take some of the financial transactions and understand the accounting equation in greater detail. 1. A and B started AB ltd. each contributing Rs. 100000 as capital. Source of money is the owners money which known as Capital. Since on this date the money has not been used to acquire anything, the entire capital would be available in the business in the form of Cash. The necessary accounting equation will be as follows:

Accounting Equation Source = Use Capital = Cash 200000 200000

2. B transferred two computers worth of Rs. 50,000 to the business. They agreed to treat the computers as the capital contributed by B. The equation will be as follows:
Source Accounting Equation Use/Assets Cash 400000Computer 400000Total 200000 200000 400000

Increase in Assets , Increase in Capital Capital can be contributed in cash or kind

Capital Total

3. They took 10% loan from IDBI Rs.100 000.

Source Capital IDBI Loan Total Accounting Equation Use 400000Cash 100000Computer 500000Total 300000 200000 500000

Increase in Source , Increase in Cash or any other asset.

4. Purchased machinery costing Rs.20 000 for cash.

Source Capital IDBI Loan Total Accounting Equation Use 400000Cash Computer 100000Machinery 500000Total 280000 200000 20000 500000

Increase in one asset, Decrease in Cash or any other asset. No change in total sources

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5. Purchase furniture on credit from X ltd for Rs. 30 000.

Source Capital IDBI Loan X Ltd. Total Accounting Equation Use 400000Cash 100000Furniture 30000Computer Machinery 530000Total 280000 30000 200000 20000 530000

Increase in one asset, Increase in borrowings. No change in cash and capital

6. Purchased land for cash Rs. 50 000.

Source Capital IDBI Loan X Ltd. Accounting Equation Use 400000Cash 100000Furniture 30000Computer Machinery Land 530000Total 230000 30000 200000 20000 50000 530000

Increase in one asset, decrease in cash. No change in borrowings and capital

Total

7. Purchased goods worth of Rs. 50 000 for cash.

Source Capital IDBI Loan X Ltd. Accounting Equation Use 400000Cash Goods 100000Furniture 30000Computer Machinery Land 530000Total 180000 50000 30000 200000 20000 50000 530000

Increase in one asset, decrease in cash. No change in borrowings and capital

Total

8. Purchased goods worth of Rs. 70 000 on credit from Y Ltd.

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Accounting Equation Use 400000Cash Goods 100000Furniture 30000Computer 70000Machinery Land 600000Total 180000 120000 30000 200000 20000 50000 600000

Source Capital IDBI Loan X Ltd. Yltd Total

Increase in one asset, Increase in borrowings. No change in cash and capital

9. Sales: Let us understand the impact of sales on the accounting equation in the following cases: Sold all goods for Rs. 150 000 for cash Sold all goods for Rs. 175000 on credit to Mr. Z Sold 75% of the stock on credit at profit of 25% on cost Sold all goods for Rs. 150 000 for cash.
Source Capital Profit IDBI Loan X Ltd. Yltd Total Accounting Equation Use 400000Cash 30000Goods 100000Furniture 30000Computer 70000Machinery Land 630000Total 330000 0 30000 200000 20000 50000 630000

Profit is the balancing figure. If all transactions have been entered, and Use is more than Source, it will be treated as profit. In this case entire sales has been realized in the form of cash.

Source Capital Profit IDBI Loan X Ltd. Yltd Total

Sold all goods for Rs. 175000 on credit to Mr. Z

Accounting Equation Use 400000Cash 55000Goods Mr. Z 100000Furniture 30000Computer 70000Machinery Land 655000Total 180000 0 175000 30000 200000 20000 50000 655000

Profit is the balancing figure. If all transactions have been entered, and Use is more than Source, it will be treated as profit. In this case entire sales is on credit cash.. No change in cash. New item Mr. Z, a debtor has been created.

Sold 75% of the stock on credit at profit of 25% on cost

Accounting Equation

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Source Capital Profit IDBI Loan X Ltd. Yltd Total Use 400000Cash 22500Goods Mr Z 100000Furniture 30000Computer 70000Machinery Land 622500Total 180000 30000 112500 30000 200000 20000 50000 622500

Profit is the balancing figure. If all transactions have been entered, and Use is more than Source, it will be treated as profit. In this case entire sales is on credit cash.. No change in cash. New item Mr. Z, a debtor has been created. Since part of the goods have been sold, the unsold goods are shown as stock (goods) at cost price.

Sold all goods for Rs. 100000 on credit to Mr. Z

Source Capital Profit IDBI Loan X Ltd. Yltd Total

Accounting Equation Use 400000Cash -20000Goods Mr Z 100000Furniture 30000Computer 70000Machinery Land 580000Total 180000 0 100000 30000 200000 20000 50000 580000

Loss is the balancing figure. If all transactions have been entered, and Use is less than Source, it will be treated as loss. In this case entire sales is on credit cash.. No change in cash. New item Mr. Z, a debtor has been created.

Above transactions can be put in the form of an equation i.e. Accounting Equation

Transac tion Profit 1 2 3 4 5 6 7 8 9 30000 10 55000 11 22500 12 -20000

Sources Creditor Creditor s Loan

Application/Uses/Assets

70000 70000 70000 70000 70000

30000 30000 30000 30000 30000 30000 30000 30000

Capital Total Cash Computer Machinery Furniture Land Goods Debtors Total 200000 200000 200000 200000 400000 400000 200000 200000 400000 100000 400000 500000 300000 200000 500000 100000 400000 500000 280000 200000 20000 500000 100000 400000 530000 280000 200000 20000 30000 530000 100000 400000 530000 230000 200000 20000 30000 50000 530000 100000 400000 530000 180000 200000 20000 30000 50000 50000 530000 100000 400000 600000 180000 200000 20000 30000 50000 120000 600000 100000 400000 630000 330000 200000 20000 30000 50000 0 630000 100000 400000 655000 180000 200000 20000 30000 50000 0 175000 655000 100000 400000 622500 180000 200000 20000 30000 50000 30000 112500 622500 100000 400000 580000 180000 200000 20000 30000 50000 0 100000 580000

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Accounting Equation and some specific financial items Expenses and Payments

Expenses Expenses may be for cash or on credit. Let us start with an accounting equation for business started with cash o Rs 200,000.
Accounting Equation Source = Use Capital = Cash 200000 200000

Source Capital Loss Total

See the impact of salary paid: Rs. 3000

Accounting Equation Use 200000Cash -3000 197000Total 197000 197000 Decrease in cash without corresponding revenue or asset is generally treated as loss. In other words during the period there were no incomes, so the entire expense is loss. Observe the decrease in cash.

Source

Expense due but not paid: Outstanding Salary : Rs. 3000

Accounting Equation Use This is a credit transaction so no change in cash. However, due to the accrual concept of accounting, expenses without corresponding revenue is generally treated as loss. Money payable to the employees is shown as source/laibility

Capital 200000Cash 200000 Loss -3000 Outstanding Salary 3000 Total 200000Total 200000

Expense paid but not due: Salary for the next accounting period paid in the current period.
Accounting Equation Use/Asset 197000 3000 197000 Cash payment towards expenses of the subsequent period. According to the Accounting Period Principle the benefit of this will arise in the next time period. So in the current accounting period it will be treated as an asset. Asset is something which has the potential to generate income.

Source

Capital 200000Cash Advance Salary Total 200000Total

Show the Accounting Equation for: Salary paid for the previous time period
Payments:

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Payment is the outflow of money. However every outflow of money is not an expense. See the following: Payment, the benefit of which expires in one accounting period is called expense or Revenue Expenditure. Payment, the benefit of which expires over a long period of time is called Capital Expenditure Payment may take one of the following shapes: Incurring expense Acquiring asset Repayment of liability

Let take the following accounting to understand the impact of the above transactions
Accounting Equation Source = Use Capital + Loan = Cash 100000 +100000 200000

Incurring expense: Paid rent for the month at the end of the month: Rs.12000
Accounting Equation Source Use Capital Loss Total 200000Cash -15000 185000Total 185000

200000

Purchased furniture for Rs.50000 Sometimes payment result in some expenses whose benefits accrue for more than one year (for 25 years). Such payments are called Deferred Revenue Expense
Source Capital Loss Total Accounting Equation Use 200000Cash -20000Patent 180000Total 140000 40000 180000

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Acquiring asset: Purchased furniture and paid by cash: Rs.50000

Source Capital Accounting Equation Use 200000 Cash Furniture Total 175000 25000 200000

Total

200000

Sometimes payment results in decrease in liabilities. Accounting Period and Accounting Equation Suppose rent per month is Rs. 3000 and the firm has paid Rs. 12000. The impact on the accounting equation depends on the definition of accounting period. However, the impact on the cash is same independent of the accounting period.
Source Capital 200000 Use Cash 200000

Source Capital Loss 200000 -12000

Use Cash 188000

Source Use Capital Loss Cash Advance Rent 200000 -3000 188000 9000

Show the Accounting Equation if the accounting period is 12 month

Cash and Capital

Capital is a source and cash is form. Capital can be contributed in any form. There may be situation when a firm will have huge capital but no cash, or huge cash and very small amount of capital.
Source Capital 200000 Application Cash 200000 Source Application Capital Cash Stock 200000 50000 150000

Source Source Application Capital Profit Cash Stock 200000 100000 250000

Computer 0 50000

Source Application Capital Cash Stock Computer 200000 0 150000 50000

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Explain the change in capital and cash position in the above accounting equations.

Investment and Fixed Assets If money is investment outside the business ie in other businesses, it called investment. Whereas, if the investment is made in the same business, it is called Fixed Assets
Investment in the business (Fixed Asset)

Source Capital 200000

Application Cash 200000

Source Application Capital Plant Cash 200000 150000 50000

Investment in outside the business (Investment)

Source Application Capital Shares in B Cash 200000 150000 50000

Revenue Expenses and Capital Expenses Deferred Revenue Expenses Revenue expense: the benefits of which expire within one accounting period. Salary paid or outstanding. Capital expenses are those whose benefits extend over a very long period
Interest paid/Accrued/Due Source Application Capital + Loan Cash Plant 400000 100000 300000 200000

Interest paid: Expense and Cash outflow

Source Application Capital + Loss Loan Cash Plant 400000 -12000 100000 288000 200000

Interest due but not paid: Expense and liability Source Application Capital + Loss Interest Due Loan Cash Plant 400000 -12000 12000 100000 300000 200000

Show the Accounting Equation for Interest received/Interest due but not received Interest on borrowing accrued but not due.

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Bad debts Bad debt is loss due to the non-recovery of credit sales, which arises due to the insolvency of the customer (debtor). Suppose a customer Mr. Z becomes insolvent and the entire amount due to him becomes bad-debt. Impact on the accounting equation is shown below: reduction in debtors (Mr.Z), increase in loss (from profit to loss), and no change in the cash balance.
Source Capital Profit IDBI Loan X Ltd. Yltd Total Use 400000Cash 55000Goods Mr. Z 100000Furniture 30000Computer 70000Machinery Land 655000Total 180000 0 175000 30000 200000 20000 50000 655000 Source Capital Profit IDBI Loan X Ltd. Yltd Total Use 400000Cash -120000Goods Mr. Z 100000Furniture 30000Computer 70000Machinery Land 480000Total 180000 0 0 30000 200000 20000 50000 480000

Provision for doubtful debts As per the conservative principle a firm is required to provide for the future losses. This would reduce the profit of the period. Suppose the firm expects that 10% of money due from Mr. Z.
Source Capital Profit IDBI Loan X Ltd. Y ltd Total Accounting Equation Use 400000 55000 Cash Goods Mr. Z 100000 Furniture 30000 Computer 70000 Machinery Land 655000 Total 180000 0 175000 30000 200000 20000 50000 655000 Source Capital Profit Use 400000 Cash 37500 Goods Mr. Z IDBI Loan X Ltd. Y ltd Total Less Provision 100000 Furniture 30000 Computer 70000 Machinery Land 637500 Total 180000 0 175000 -17500 30000 200000 20000 50000 637500

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Discount Discount is the benefit given by the firm to the customers as an incentive for prompt payment. Suppose Mr. Z is given a discount of Rs. 25000. Impact on the accounting equation is shown below: reduction in debtors (Mr.Z), decrease in profit (from Rs.55000 to Rs. 30000) and increase in cash by Rs. 150000 (175000-25000).
Accounting Equation Use 400000 Cash 55000 Goods Mr. Z 100000 Furniture 30000 Computer 70000 Machinery Land 655000 Total 180000 0 175000 30000 200000 20000 50000 655000 Accounting Equation Use 400000 Cash 30000 Goods Mr. Z 100000 Furniture 30000 Computer 70000 Machinery Land 630000 Total 330000 0 0 30000 200000 20000 50000 630000

Source Capital Profit IDBI Loan X Ltd. Yltd Total

Source Capital Profit IDBI Loan X Ltd. Yltd Total

Depreciation Depreciation can be explained in one of the following ways: Loss due to the wear and tear of fixed asset. Cost apportioned over the life of the fixed asset. Provision for replacement of fixed asset Charge for using the fixed asset

Impact of depreciation on the accounting equation can be seen from the following transactions.
Purchase of plant Source Application Capital = Cash Plant 200000 50000 150000

Depreciation at 10% for the period

Application Cash Plant 50000 135000

Source Capital + Loss = 200000 -15000

Some times depreciation is not deducted from the cost of the plant. Plant is shown at the original cost and the depreciation is shown under a separate head called Accumulated Depreciation. The accounting equation will be as follows:
Source Capital Loss Accumulated Depreciation= 200000 -15000 15000 Application Cash Plant 50000 150000

The final profit or loss is not affected the presentation of depreciation in the accounting equation.

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Revaluation of Assets
Sources Application Capital Profit Loans Cash Other Assets 300000 30000 200000 330000 200000

Suppose the firm is interested in revaluing the assets to Rs. 300000. The impact on the accounting equation will be as follows: Increase in assets is matched with Revaluation Reserve.
Sources Application Capital Profit Revaluation Reserve Loans Cash Other Assets 200000 30000 100000 200000 330000 300000

Composite Items Owners Fund: Capital and accumulated profit/loss is called owners fund. Owners fund is also known as net worth or equity. See the following accounting equation:
Source Capital + Loss = 200000 -15000 Application Cash Plant 50000 135000

Source Application Capital Profit Cash 200000 100000 300000

Stock 0

Source Owners Fund 185000

Application Cash Plant 50000 135000

Source Owners Fund 300000

Application Cash 300000

Stock 0

Capital Employed: Capital employed is the sum of owners fund and long-term borrowing. See the following accounting equations:
Source Use Capital IDBI Loan Cash Computer 400000 100000 300000 200000 Source Capital Employed 500000 Use Cash Computer 300000 200000

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Dividend: Dividend is the part of the profit distributed among the shareholders. Generally it is given in the form of cash. It leads to reduction of cash and the accumulated profit. Dividend is given as percentage of capital..
Sources Application Capital Profit Loans Cash Other Assets 400000 30000 200000 330000 300000 Suppose 5% of capital is declared and distributed as dividend Sources Application Capital Profit Loans Cash Other Assets 400000 10000 200000 310000 300000

Show the accounting equation using the concepts of Owners fund and Capital Employed
Bonus Share: Sometimes dividend can be declared in the form of shares. So the declaration of bonus shares does not involve any outflow of cash. The impact of issue of bonus shares on the accounting equation is shown below:
Sources Application Capital Profit Loans Cash Other Assets 400000 30000 200000 330000 300000 Suppose 5% of capital is declared as bonus shares Sources Application Capital Profit Loans Cash Other Assets 420000 10000 200000 330000 300000

Right Shares Shares issued to the existing share holders at the time of subsequent issue of shares are called Right shares. Unlike the issue of bonus share, issue of right shares involves cash flows.
Sources Application Capital Profit Loans Cash Other Assets 400000 30000 200000 330000 300000

If Right Shares are issued to the tune of Rs. 50000. The equation will be as follows:
Sources Application Capital Profit Loans Cash Other Assets 450000 30000 200000 380000 300000

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Buyback of shares
Sources Application Capital Profit Loans Cash Other Assets 400000 30000 200000 330000 300000

If shares worth of Rs. 50000 are bought back. The equation will be as follows:
Sources Application Capital Profit Loans Cash Other Assets 400000 30000 200000 330000 300000 For details of buyback of share see chapter

Show the accounting equation Issue of Shares in consideration of other assets Conversion of shares to debentures

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Work to Do 1) Following are the transactions of Mr. R R started business with Rs. 10000 Purchased goods worth of Rs. 8000 Purchased furniture worth of Rs. 5000 (40% paid in cash) Sold all goods at a profit of 50% Required: Accounting Equation 2) Following are the transactions of Ms. Y Started business using her computer costing Rs. 25000 Received a business order from a school to develop a accounting software. Received advance from the school: Rs. 20000 Purchased AIS book for Rs. 15000 Paid salary to her assistant: Rs. 5000 Delivered the software to the school and received the balance: Rs.25000 Required: Accounting Equation 3) Following the transactions of Mr. Dalal Purchased shares of Infosys: Rs. 45000 Purchased shares of Dr. Reddys Lab.: Rs.20000 Purchased shares of SBI: Rs. 50000 Sold Infosys shares: Rs. 50000 Sold 50% of SBI shares: Rs. 35000 Required: Accounting Equation 4) Following are the financial items of A ltd.: Debtors = 50,000, Land = 100,000 Loan = 50,000, Payables = 20,000 Cash in hand = 10,000 Cash at Bank = 20,000, Stock of material = 50,000 Bonds = 50 000, Required: Find the missing item using the Accounting Equation 5) Show the impact of the following on the accounting equation S started a education business with Rs. 250000 cash She contributed furniture, black board etc. worth of Rs. 100000 A student joins the institute and deposits fee of Rs.1500 cash and deposits Rs. 15000 in the Institutes account in the bank (SBI). Five more students join the institute depositing only 1720 each as installment fee.

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Later a student wanted refund of Rs. 1720. Institute refunds after deducting Rs. 200 as cancellation charges. S had 20 employees with a monthly salary of Rs.2000 for two peon paid in cash and for the other 18 paid by cheque Rs.12750 per month.. Purchased books worth of Rs.75000 on credit from A Books Store. Availed loan of Rs.500000 from SBI to purchase a bus. Released an advertisement i n the local newspaper by paying to Rs.100000

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