Chapter 2

The Accounting Equation and Double entry

System

The accounting equation

In its simplest form, the accounting equation states that Total Assets equal Total Capital. Total
capital is made up all funds which finance all resources or assets of a business. Total assets of a
business are financed by the owner who injects capital. Often, the owner is unable to finance all
activities of a business single-handedly, particularly for large businesses. Some other parties who
do not have ownership interest also finance activities of a business by extending credit and loans.
These are known as liabilities. Total capital therefore, consists of liabilities and owner's equity.

Assets are resources of value the firm utilizes in conducting business. Two common distinctions
are made between Fixed assets and Current assets. Fixed assets are those resources acquired by
the business not for the intention of re-selling but are kept in the business. Usually they retain
their form, have long lives and cost substantial amounts of money. Examples of fixed assets are
Land, Buildings, Machinery, Motor Vehicles, Furniture and Equipment.

Current assets are those resources acquired by the business and which change from one form to
another within an accounting cycle as a result of business activities. Stocks in the stores are
converted into Debtors when they are sold on credit. Debtors are then converted into Cash when
outstanding amounts are settled. Cash can then be converted into Stocks again. Stocks, Debtors
and Cash are therefore, examples of current assets.

Liabilities are what other individuals and firms have temporarily contributed towards financing
assets of the firm and amounts that are owing to parties external to the firm. These are
distinguished between current and long term liabilities. Current liabilities are those obligations
which have to be repaid within one accounting cycle, usually 12 months. Long-term liabilities
are those obligations which do not have to be met within one accounting cycle. These extend
over twelve months. Examples of current liabilities are Trade Creditors, Unpaid electricity bills,
Bank overdrafts, etc. Examples of long term liabilities are Bank loans extending over one year,
long term lease financing obligations, etc.

The accounting equation can at this stage be expressed as:

Assets = Liabilities + Owner’s Equity

This equation may be proved with a number of simple examples.

12 Introductory Financial Accounting

Owner’s
Transaction Assets Liabilities
Equity
Owner puts shs. 50,000 cash to start business +50,000 cash +50,000
Firm buys lorry for cash shs. 10,000 - 10,000 cash
+10,000 lorry
Firm borrows shs. 30,000 from a bank +30,000 cash + 30,000 loan
Firm buys shs. 20,000 stock on credit from a +20,000 stock + 20,000 creditor
supplier
Total Assets, Liabilities and Capital +100,000 + 50,000 + 50,000

Note that up to this point no sales have been made.

Owner's Equity is increased by additional capital contributions and profits. Profits is the excess
of revenues over expenses. Owner's equity is decreased by capital withdrawals and losses. Losses
occur when revenues are unable to cover expenses.

The expanded accounting equation can be shown as follows:

Assets = Liabilities + Owner's Equity + (Revenues - Expenses)

The example may be extended to consider the following independent cases:

(a) All of the stock was sold for shs. 20,000 cash.
(b) All of the stock was sold on credit for shs. 20,000.
(c) All of the stock was sold for shs. 30,000 cash.

Before considering (a), (b) and (c) above a summary of assets, liabilities and owner’s equity is as
follows:

Assets Liabilities Capital

Cash 70,000 Loan 30,000
Stocks 20,000 Creditor 20,000 50,000
Lorry 10,000
100,000 50,000 50,000

Case (a)

In this case cash increases by shs. 20,000 while stocks decrease by a similar value. Since cash
and stocks are all assets by definition, this transaction does not affect the total assets figure.

Case (b)

This situation results in a decrease in stocks by a value of shs. 20,000. Although this is also a sale
as in situation (a), no cash is received. Instead the firm is promised to be paid at a later date. Such
a transaction results in creation of an asset in the form of a debt. Again there is no change in total
assets as this is also a swap between two forms of assets, which is stocks and a debtor.

Case (c)

In this case a difference is encountered because stock was sold at a profit, that is, at a price more
than it cost to the firm to acquire. Stocks decreased by a value of shs. 20,000 but cash increased
 The Accounting Equation and Double Entry System 13

by a larger value of shs. 30,000. The net change in total assets was an increase of shs. 10,000.
Since profits increase capital, the profit of shs. 10,000 increased owner's equity. Profits always
increase owner's equity, if not withdrawn.
The ending position of the equation would be as follows, assuming transaction (c) was effected:

Assets Amount Liabilities Amount Capital Amount

Cash 100,000 Loan 30,000 50,000
Lorry 10,000 Creditor 20,000 10,000
110,000 50,000 60,000

In addition to cost of stock, firms incur expenses in the course of conducting business; these must
also be deducted from Revenues.

Using the accounting equation, the dual aspects or compensating effects of every transaction in
the different categories of accounts may be summarized as follow:

(a) An increase in an asset will result in:

an increase in a liability or
an increase in owner's equity or
a decrease in another asset.

(b) a decrease in an asset will result in:

a decrease in a liability or
a decrease in owner's equity or
an increase in another asset

(c) An increase in liability will result in:

an increase in an asset or
a decrease in owner's equity or
a decrease in another liability

(d) a decrease in a liability will result in:

a decrease in an asset or
an increase in owner's equity or
an increase in another liability.

(e) an increase in owner's equity will result in:

an increase in an asset or
a decrease in a liability or
a decrease in another form of owner's equity

(f) a decrease in owner's equity will result in:

a decrease in an asset or
an increase in liability or
an increase in another form of owner's equity

It can be observed from the above summary that to maintain the equality of the accounting
equation: Assets = Liabilities + Owner's equity; an increase on one side of the equation will have
the corresponding effect of either:

(i) an increase on the other side or

(ii) a decrease on the same side.

In the same way a decrease on one side of the equation will have the corresponding effect of
either:
14 Introductory Financial Accounting

(i) a decrease on the other side or

(ii) an increase on the same side.

Transaction Analysis
A typical business engages in numerous activities and transactions each day. Some of these are
financial in nature and are eventually classified as accounting data. The main objective of the
accounting process is to sort out these accounting data by recording and classifying them.
Transaction analysis shows how a transaction affects the specific elements of the accounting
equation.

An accounting transaction is primarily an exchange in value. Therefore, it may be expected that

it will result in either an increase or decrease in the items affected. For example, when furniture
is bought for cash the two items affected are cash and furniture. Cash is given out which results
in a decrease in this asset and at the same time a piece of furniture is received which results in an
increase in this asset. Both cash and furniture are assets. Therefore, this particular transaction
shows that an increase in one class of asset (furniture) results in a corresponding decrease in
another class of asset (cash).

The account
The accounting equation, although useful in showing the effect of transactions cannot be
employed as a tool for recording business transactions. If there are numerous transactions, each
has to be recorded separately and if these were to be recorded through the accounting equation, it
would consume excessive paper and time. The probability of making arithmetic errors also
multiplies. The use of the "account" was consequently developed over time for the purpose of
recording the effects of transactions because it proved to be a better tool. It is the basic
component of the formal accounting system.

An account is a record which shows increases, decreases and net change (balance) in assets,
liabilities, capital, revenues or expenses. In a manually operated accounting system each account
is placed in a separate page or card of a bound or loose - leaf book called a ledger. A ledger could
also be maintained in computer files. An account in a ledger will be identified by a title and a
reference number.

A two-column account form is illustrated below. This format is often used in a manually
maintained record keeping system.

Cash Account Account no. 00

Date Details Fol. Debit Date Details Fol. Credit

Such an account has a left side and a right side. The left side is the debit side, abbreviated "Dr";
and the right side is the credit side, abbreviated "Cr".

A simplified form of an account is called 'T' account because it resembles the letter “T”. It is
often used to illustrate the dual effect of accounting transactions. The left side records all the
debit entries and the right side records all the credit entries.
 The Accounting Equation and Double Entry System 15

Cash Account

The conventional account as seen above has two sides which have identical contents (date,
details, folio and amount). With the advances in computerisation, it was observed that the
conventional format could be modified and the duplication avoided. This resulted in a leaner
account format which looks as follows:

Date Details Folio Debit Credit Balance

This format has now become popular even in manual accounting systems but will still be
conveniently referred to as the computer format. Advantages of this layout are that first, it can be
displayed easily on a standard 80-column Video Display Unit (VDU). Secondly, it can be printed
also quite easily on a standard 80-column printer.

The double entry system

Accounting entries are made on the left side and right hand sides of an account. When an
amount is entered on the left side, the account is said to be debited, and when an amount is
entered on the right side the account is said to be credited. The difference between the total
debits and total credits is the balance of the account. The balance may be either a debit balance if
the debit side exceeds the credit side; or a credit balance if the credit side exceeds the debit side.
When the total debits equal the total credits, the account is said to have nil or zero balance.

The words "debit" and "credit" should not be confused with "increase" or "decrease". Certain
accounts may increase when debited and other accounts may increase when credited depending
on the type of account involved.

In the accounting equation Assets = Liabilities + Owner's Equity, assets are on the left side of
the equation. Asset accounts also ordinarily have debit balances. Therefore, asset accounts are
increased when they are debited and the opposite is true; asset accounts are decreased when they
are credited.

Example

On 1st July a firm has cash balance shs. 200,000 and on 3rd July shs. 10,000 is used to buy
office furniture. Since both cash and office furniture are asset accounts, this transaction will be
recorded in the respective accounts as follows:
16 Introductory Financial Accounting

Cash Account
July Balance 200,000 July Office Furniture 10,000
1 3

Office Furniture Account

July Cash 10,000
3

The cash account shows the opening balance on July 1st shs. 200,000 on the debit side. The shs.
10,000 used to buy office furniture is a decrease in cash and entered on the credit side. After this
transaction cash will have a remaining debit balance of shs. 190,000.

On the other hand, this transaction resulted in an increase of shs. 10,000 in the office furniture
account, which had a nil balance on 1st July. This increase is shown on the debit side of the
office furniture account. The effects of this transaction are an increase in the asset office furniture
and a decrease in the asset cash.

The fundamental rule of double entry accounting requires that a debit entry should always have a
corresponding credit entry.

Again going back to the accounting equation; usually Liabilities and Owner's Equity are on the
right side of this equation. These categories of accounts ordinarily have credit balances.
Therefore increases in these accounts are entered on credit side; while decreases are entered on
the debit side. This may be seen in the following example.

Example

On July 5, merchandise costing shs. 20,000 were bought on credit.

Stock Account
July Trade Creditor 20,000
5

Trade Creditor Account

July Stock 20,000
5

This transaction resulted in an increase of shs. 20,000 in the asset stock which was debited.
Correspondingly, the liability to Trade Creditors is increased by the same amount, so this account
was credited.

Note: (i) The increase in the Asset (left side of the equation) equals the increase in the
liability (right side of the equation).
(ii) The debit to stock account has a corresponding credit in the Trade Creditor
 The Accounting Equation and Double Entry System 17

account.

When all transactions are recorded in this manner, the equality of the accounting equation is
always maintained.

The expanded accounting could now be depicted as:

Assets = Liabilities + Owner's Capital + (Revenues - Expenses) - Drawings

The equation could be re- arranged as follows:

Assets + Expenses + Drawings = Liabilities + Owner's Capital + Revenues

The rules for recording of transactions for items on the left of the equation are exactly the same.
For these items, increases are recorded as debits (which is incidentally the left side of the
account), and decreases are recorded as credits.

There are in principle similarities between assets, expenses and drawings. Assets are resources of
value available in the business for the purpose of generating profits. Expenses and drawings are
all expended resources, while expenses are resources expended in the interest of the business,
drawings are business resources consumed in the owner's personal interest. For items on the right
side of the equation the rule of recording transactions is, increases are recorded on the credit side
of the account and decreases are recorded on the left side of the account. In summary, the simple
rules for recording transactions under a double entry system are as follows:

Assets - Debit for increases and credit for decreases

Liabilities - Debit for decreases and credit for increases.

Owner's Equity - Debit for decreases and credit for increases.

Revenues - Credit for increases and debit for decreases.

Expenses - Debit for increases and credit for decreases.

Drawings - Debit for increases and credit for decreases.

18 Introductory Financial Accounting

Review questions
1. Define an asset, a liability, owner's equity, revenue and an expense giving three
examples of each.

2. What is the difference between Liabilities and Owner's equity?

3. What is an account? And what are the two sides of an account?

4. Why is a double - entry system so called?

5. Give the rules of debit and credit for asset accounts, liability accounts and owner's
equity.

6. Why is the rule of debit and credit the same for liability and owner's equity.

7. If the owner of a business withdrew cash for personal use, will owner's equity be
affected?

8. Do the terms 'debit' and 'credit' signify increase or decrease, or may they signify either?
Explain.

Exercises
1. The income statement of a sole trader for the month of June indicates a net income of
shs. 310,000. During the same period the owner withdrew shs. 400,000 in cash from the
business for personal use. Would it be correct to say that the owner suffered a net loss of
shs. 90,000 during the month? Explain.

2. Describe how the following business transactions affect the three elements of the
accounting equation.

(a) Owner invested cash in the business

(b) Purchased Office Supplies on credit
(c) Received cash for services rendered
(d) Paid for electricity consumed during the period.
 The Accounting Equation and Double Entry System 19

3. Using the accounting expression of 'debit' and 'credit', describe how an account is
increased and decreased, and state its normal balance by completing the following
schedule;

Type of Account Increase Decrease Normal balance

a. Assets
b. Liabilities
c. Capital
d. Revenues
e. Expenses

4. Analyse the following transactions and state the dual effect of each one on the
accounting equation: Assets = Liabilities + Owner's equity

(a) The owner invested an additional shs. 1,000,000 cash into the business.
(b) Merchandise costing shs. 600,000 was purchased on credit.
(c) Bought a typewriter for shs. 250,000 cash.
(d) Sold merchandise for cash shs. 100,000, these had cost shs. 80,000.
(e) A trade creditor was paid shs. 160,000 cash of the amount owing.
(f) Borrowed shs. 500,000 from the bank.
(g) Paid salaries of employees amounting to shs. 120,000.

5. Describe a transaction that will:

(a) Increase an asset and increase a liability

(b) Increase an asset and decrease another asset
(c) Decrease an asset and decrease owner equity
(d) Decrease an asset and decrease a liability
(e) Increase an asset and increase owner equity.

Problems
1. Record the following transactions completed during August of the current year using 'T'
accounts in the books of Joha.

Aug. 1 Obtained a Loan from NBC of shs. 500,000.

1 Paid rent for the month shs. 45,000.
2 Purchased desk calculator on credit from Bambi shs. 80,000.
8 Made cash purchases shs. 40,000.
10 Paid advertising expenses shs. 7,000.
12 Sold goods on credit to customers shs. 60,000.
14 Sold goods in cash shs. 30,000.
15 Paid Bambi shs. 80,000.
20 Withdrawal by Joha of shs. 7,000 cash for her personal use.
22 Received from credit customers shs. 40,000 cash.
24 Received and paid electricity bill for the month shs. 3,000.
26 Sold to credit customers items worth shs. 30,000.
28 Received from customers on account shs. 20,000.
30 Paid wages for office worker shs. 20,000.
20 Introductory Financial Accounting

2. Kopa started business as a seller of clay flowerpots on 1st September, 200X. He

transferred shs. 850,000 from his personal bank account to a newly opened business
bank account. Transactions from the first day of business were as follows:

Sept. 2 Paid by cheque, rent of shop premises for the month shs. 20,000.
4 Bought on credit from Fanicha Kwetu, fixtures and fittings for the shop,
amounting to shs. 100,000.
6 Bought on credit from Mfinyanzi Supplies 400 clay pots each shs. 160.
8 Bought by cheque, 200 clay pots at shs. 140 each. Also shs. 500 was
paid by cheque for carriage of the pots to the shop.
10 Sold on credit to Maua & Co. 20 clay pots at shs.200 each.
12 Sold on credit to Waridi, 10 clay pots at shs. 200 each.
14 Sold for cash, 100 clay pots for shs. 200 each.
16 Sold for cash 80 clay pots at shs. 190 each.
20 Kopa took shs. 10,000 from the cash box for own use.
22 Received from Maua & Co. the whole amount due.
24 Paid Mfinyanzi Supplies shs. 10,000 by cheque.
26 Paid Fanicha Kwetu shs. 80,000 by cheque.
27 Sold on credit 50 clay pots to Tegemea Gardeners at shs.180 each
28 Bought 100 clay pots from Mfinyanzi Supplies on credit at shs. 150
each.
29 Paid by cheque Fanicha Kwetu the balance owing in their account.
30 Paid sales attendant wages shs. 15,000 and miscellaneous expenses shs.
10,000. Issuing cheques for these amounts.

Required:

(a) Record these transactions in 'T' accounts

(b) Show that at the end of the month the accounting equation was in balance.