Notes

Accounting Equation

1) Accounting Equation
→ An accounting equation is a formula of accounting that shows that the assets of a business are
always equal to the total capital and liabilities.

→ It is also known as Balance Sheet Equation.

→ This is an American method for presentation of accounting transactions. This is a modem approach.
While under traditional approach, rules of personal account, real account and nominal account are
used.

→ Accounting Equation approach reflects the direct impact of transactions on assets, capital, and
liabilities.

2) Traditional Method
► Steps to prepare final (annual) accounts:
1. Journal entry
2. Subsidiary books
3. Ledger Posting
4. Trial balance
5. Adjustments
6. Balance Sheet

► Three components of annual accounts:

1. Trading Account
2. Profit-Loss Account
3. Balance Sheet

► Double-entry system process:

1. Balance of the Trading Account is transferred to the Profit and Loss Account.
2. Balance of the Profit and Loss Account is transferred to the Capital Account in the Balance
Sheet.
3. The Balance Sheet discloses the financial status of the business.

3) Accounting equation method:

→ The equation approach also follows all accounting rules, but it directly prepares the Balance Sheet
from transactions.

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 → This method provides a simplified way to understand the impact of transactions on the financial
position.

4) Formula for Accounting Equation

Assets = Capital + Liabilities

In Brief, A = C + L

5) Always every transaction has dual effects, which is effected on A = C + L is in this manner:
→ Increase and decrease in A only
→ Increase/decrease in A and C
→ Increase/decrease in A and L
→ Increase/decrease in C and L

Transaction Type Example

Increase in Asset, Increase in ► Credit purchases increase stock and creditor liability.
Liability ► Loan from bank increases cash and liability.
Decrease in Liability, Decrease in ► Payment to a creditor decreases creditor liability and reduces
Asset cash/bank.
Increase in Asset, Increase in ► Introduction of capital by proprietor increases cash and owner’s
Owner’s Capital capital.
Decrease in Owner’s Capital, ► Drawings by proprietor decrease cash and owner’s capital.
Decrease in Asset
Increase in Asset, Decrease in ► Cash purchases or receipt from debtors increase goods and
Another Asset reduce cash/bank.
Decrease in Liability, Increase in ► Settlement of creditor by issuing debentures decreases creditor
Another Liability liability and increases debentures liability.

6) Transaction classification:
→ Goods-related transactions
→ Revenue-expense transactions
→ Asset purchase-sales transactions
→ Borrowing and lending transactions

7) Trasanctions having effects on accounting equation

Sr. Transactions Account Asset = Capital + Liability

Affected [A] [C] [L]
Capital & Withdrawal Related Trasanctions
1 Business Commenced Cash, Bank, Increase Increase
with Cash, Bank, Furniture
Furniture & Debtors Debtor

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 Sr. Transactions Account Asset = Capital + Liability
Affected [A] [C] [L]
2 Withdrawal from Cash Decrease Decrease
Business Capital
Purchase & Sales Related Transactions
3 Cash Purchase Stock One Increase
Cash/Bank Another decrease
4 Credit Purchase Stock Increase Increase
Creditor
5 Purchase Return Stock Decrease Decrease
Creditor
6 Paid to Creditors Creditor Decrease Decrease
Cash/Bank
7 Cash Sales Cash/Bank One Increase Increase
Stock Another decrease [Profit]
Capital
8 Credit Sales Debtor One Increase Increase
Stock Another decrease [Profit]
Capital
9 Sales Return Stock One Increase
Debtor Another decrease
10 Payment Received Cash/Bank One Increase
from Debtors Debtors Another decrease
Income/Expense related Transactions
11 Expense Paid in Capital Decrease Decrease
Cash/Bank Cash/Bank
12 Expense Outstanding Capital Decrease Increase
[Unpaid] Liability
(Salary/wages/Rent
Outstanding)
13 Income Received Cash/Bank Increase Increase
Capital
14 Income Outstanding Asset Increase Increase
[Unreceived] / Income Capital
Received in Advance
Asset Related Trasanctions
15 Purchase of Asset in Asset One Increase
Cash Cash/Bank Another decrease
16 Purchase of Asset in Asset Increase Increase
Credit Creditor
17 Sale of Asset in Cash Cash/Bank One Increase
Asset Another decrease
18 Sale of Asset on Credit Debtor One Increase
Asset Another decrease
Loan Related Trasanctions

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 Sr. Transactions Account Asset = Capital + Liability
Affected [A] [C] [L]
19 Loan Borrowed Bank Increase Increase
Loan
20 Loan Paid Loan Decrease Decrease
Bank
Outgoing Material
21 Goods destroyed by Loss Decrease Decrease
Fire Stock
Bank Transactions
22 Cash Deposited into Bank One Increase
Bank Cash Another decrease
23 Cash Withdrawal from Cash One Increase
Bank Bank Another decrease

8) Effect of Some Trasanctions:

Sr. Transaction Treatment in Accounting Equation

1 Outstanding Expenses - expenses - Deduct from Capital as it is an expense, reducing profit.

which have been incurred but not - Add new column in Liabilities as "Outstanding
paid during the current accounting Expenses."
period.
2 Prepaid Expenses - expenses which - Deduct from Cash due to payment.
are not yet due but paid in advance - Add new column in Assets as "Prepaid Expenses."
for the succeeding accounting period.
3 Accrued Income - incomes which - Add to Capital as income, increasing profit.
are earned but not received during - Add new column in Assets as "Accrued Income."
an accounting period.
4 Unearned Income/Income - Add to Cash as inflow.
Received in Advance - the incomes - Add new column in Liabilities as "Income Received in
which are received but not earned Advance"
during the current accounting period.

5 Interest on Capital - an expense for → Add to Capital as Income for the owner
business → Deduct from Capital as its Expense for business
Overall: No effect on Assets & Liabilities
6 Interest on Drawings - an income → Add to Capital as Income for the business
for business → Deduct from Capital as its Expense for owner
Overall: No effect on Assets & Liabilities

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9) Accounting Equation Format

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