ACCOUNTING FOR DECISION MAKING

Unit – I
ACCOUNTING EQUATION
What is Accounting Equation
An Accounting Equation is a mathematical expression which shows
that the assets and liabilities of a firm are equal.

An Accounting Equation is based on the dual aspect concept of

accounting meaning, every transaction has two aspects-debit and
credit.

That further means in every business transaction for every debit

there is a credit of equal amount and Vice Versa.
It means total claims (those of outsiders and of the proprietors) will
always equal the total assets of the firm.

The claims, also known as equities, are of two types:

1.Owner's equity or capital and

2.Liabilities or amounts due to outsiders (i.e., Outsiders Equity).
The relationship known as the Accounting Equation can be
presented in equation form as given below in 4 ways:

And the Balance Sheet Equation can be presented in equation

form as given as below:
Nature of Accounting Equation
An Accounting Equation always holds true with every change
that occurs due to transaction entered into. It is because of
this reason that it is based on the dual aspect concept of
accounting.

A transaction may affect either both sides of the equation by

the same amount or one side of the equation only, by both
increasing or decreasing it by equal amounts.

Transactions from the Accounting Equation viewpoint, can be

divided into two, i.e.,
1.Transactions Affecting Two Items and
2.Transactions Affecting More Than Two Items.
Transactions Affecting Two items:
As the title suggests, these are those transactions that affect two
items of the accounting equation or Balance Sheet.

(a) Transactions affecting opposite sides are:

Increase in Asset, Increase in Liability.' Transaction such as credit
purchases increase asset (stock) and also increase liability (creditor).
Similarly, loans from bank increase asset (cash) and also increase
liability (Loan).

Decrease in Liability, Decrease in Asset: Transaction of payment to a

creditor decreases Liability (creditor) and also reduces asset (cash or
bank).
Increase in Asset, Increase in Owner's Equity: Introduction of capital
by the proprietor
increases asset (cash or bank) and also liability (capital).

Decrease in owner's Capital, Decrease in Asset: Drawings by the

proprietor decreases liability (capital) and also asset (cash or bank).
(b) Transactions affecting same side
but in opposite direction are:
Increase in one Asset, Decrease in Another Asset:
Transactions such as cash purchases or receipt from debtors
increase one asset (goods and cash or bank, respectively) and
decrease another asset (cash or bank and debtors).

Decrease in one Liability, Increase in Another Liability:

Settlement of creditor by issue of Bill of Exchange decreases a
liability (creditor) and increases another liability (BiII of
Exchange).
Transactions Affecting More Than Two items:

Some transactions affect more than two items of the accounting

equation or a Balance Sheet.

For example, when a sale is made in cash for Rs. 30,000, it is made
at cost (Rs. 25,000)
plus profit (Rs. 5,000).

• Cost of goods (Rs. 25,000) reduces asset (stock of goods);

• Cash increases by Rs. 30,000; and
• Owner's capital increases by the profit (Rs. 5,000).

It should be noted that profit increases the owner's capital and

loss decreases it.
Procedure to prepare Accounting Equations
The procedure to workout an Accounting Equation is:

Analyze the transaction in terms of such variables as assets,

liabilities, capital, revenues and expenses.

Decide the effect of the transactions in terms of increase or

decrease on variables assets, liabilities, capital, revenues and
expenses.

Record the effect on the relevant side of the equation.

Illustrations
Let us take a few transactions to understand the accounting
equation.

Transaction 1:
Mr. Riaz commences his business with cash Rs.50,000.

This is an example of investment of asset in the business by the

owner. The effect of this transaction on the accounting equation is
that cash asset is increased by Rs.50,000 and the proprietorship
(Riaz’s capital) is also increased by the same amount such as:

Assets = Liabilities + O.E/ Capital

Cash Riaz, Capital

+ 50,000 = —- +
50,000
Transaction 2:
Purchased furniture on cash Rs.10,000.
This transaction effected accounting equation as the increase in one
new asset furniture and decreases in assets cash with the same
amount. Thus
Assets = Liabilities + O.E / Capital

Cash Riaz, Capital

Furniture

+ 50,000 = —- +
50,000

- 10,000 + 10,000

40,000 + = 50,000
10,000
Transaction 3:
Purchased merchandise for cash Rs.10,000.

This transaction will introduce a new element (merchandise) on the assets

side and decrease the cash by Rs.10,000.

Assets = Liabilities + O.E / Capital

Cash Furniture Riaz, Capital

Merchandise

+ 40,000 + 10,000 = —- +
50,000

-10,000 – + 10,000

30,000 10,000 + 10,000 = 50,000

Note that this transaction has affected assets side only and no change is made in
equities side of the equation.
 Transaction 4:
Purchased merchandise on account (on credit) Rs.5,000.

Assets = Liabilities + O.E / Capital

Cash Furniture Creditors Riaz, Capital

Merchandise

+ 30,000 + 10,000 + 10,000 = + 50,000

+ 5,000 + 5,000

30,000 +10,000 + 15,000 = + 5,000 + 50,000

Note that this transaction has affected assets side and liabilities. Both the sides of
equation has increased with the same amount.
Transaction 5:
Sold merchandise for cash Rs.2,000 cost of these merchandise were Rs.1,500

Assets = Liabilities + O.E / Capital

Cash Furniture Creditors Riaz, Capital

Merchandise

+ 30,000 + 10,000 + 15,000 = + 5,000 + 50,000

+ 2,000 - 1,500 + 500 (Profit)

+ 32,000 +10,000 + 13,500 = + 5,000 + 50,500

Note that this transaction has affected assets side and also the proprietorship. Difference
between sales price and cost price is treated as profit and has been added to capital.
Transaction 6:
Sold merchandise on credit for Rs.4,000 costing Rs.3,000.

Assets = Liabilities + O.E / Capital

Cash Furniture Merchandise Creditors Riaz, Capital

Debtors

+ 32,000 + 10,000 + 13,500 = + 5,000 + 50,500

- 3,000 + 4,000 + 1,000

32,000 +10,000 + 10,500 + 4000 = + 5,000 + 51,500

Note that this transaction has affected assets side and also the proprietorship. Anew
element “debtors” has been introduced. Difference between sales price and cost price
is treated as profit and has been added to capital.
Transaction 7:
Paid Rs.1,000 to creditors for merchandise purchased.

Assets = Liabilities + O.E / Capital

Cash Furniture Merchandise Debtors Creditors Riaz, Capital

+ 32,000 + 10,000 + 10,500 + 4,000 = + 5,000 + 51,500

- 1,000 - 1,000

31,000 +10,000 + 10,500 + 4000 = + 4,000 + 51,500

Transaction 8:
Received cash from a debtor Rs 1,000 whom a sale on credit was made earlier.

This is an example of collection from debtors. This transaction is an exchange of one

asset for another. the effect is on one side of the equation, i.e., asset side. Thus:

Assets Liabilities + O.E / Capital

Cash Furniture Merchandise Debtors Creditors Riaz, Capital

+ 31,000 + 10,000 + 10,500 + 4,000 + 4,000 + 51,500

+ 1,000 - 1,000

32,000 +10,000 + 10,500 + 3000 = + 4,000 + 51,500

Prepare the Accounting Equation on the basis
of following:

1. Mr. Shiraz Khan started business and introduce

capital Rs. 1,00,000 in cash.
2. Purchased goods in cash Rs. 50,000.
3. Purchased from Bismillah Furnitures Rs.
20,000.
4. Sold goods costing Rs. 25,000 for Rs. 35,000.
5. Paid Bismillah Furnitures in cash.
 Asset Liabilities Capital
No. Transaction = +
Rs
Rs Rs

1 Shiraz Khan started business with cash 100000 = 0 + 100000

2 Purchased goods in cash Add 50000
Less 50000
New Equation 100000 = 0 + 100000
3 Purchased Goods from Bismillah Furnitures Add 20000 = 20000 + 0
New Equation 120000 = 20000 + 100000
4 Sold goods costing Rs 25000 Less -25000
for Rs 35000 (Note) Add 35000 = 0 + 10000
New Equation 130000 = 20000 + 110000
5 Paid Bismillah Furnitures Less -20000 = -20000 + 0
New Equation 110000 = 0 + 110000

Note: Profit should be added in Capital.

Prepare the Accounting Equation on the basis of the following

1. Ram started business with cash Rs. 2,00,000, stock Rs. 5,00,000,
Machine Rs. 8,00,000 and Furniture Rs. 4,00,000.

2. He sold Goods costing Rs. 2,00,000 at a profit of 20% on cost and

received half the payment in Cash and a Bill for Rs. 50,000 out of
the remaining balance.

3. He purchased goods for Rs. 50,000 from Ravi on credit.

4. He depreciate Machine @ 10% p.a. and Furniture @ 20% p.a.

5. He paid Salary Rs. 20,000 and Rent Rs. 25,000 but Rent Rs. 5,000
still remain unpaid
6. He paid Insurance Rs. 15,000 @ Rs. 1,000 p.m.

7. He withdrew Rs. 1,00,000 for purchasing Motor Cycle for his

personal use.

8. He paid to Ravi Rs. 19,000 in full settlement against the

payment of Rs. 20,000.

9. He received Rs. 50,000 as Security Deposit from his tenant.

10. He charge interest on Drawing @ 10% p.a.