Theoretical Framework of Accounting

Accounting Equation

An Accounting Equation is also called the Balance Sheet Equation. We all know that we record all the business transactions using the Dual Aspect concept. This means that each debit has an equal credit and vice-versa.

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There are two approaches to record the transactions in financial accounting. One is the Traditional approach or the British Approach and another is the Modern Approach or the American Approach. Under the Modern Approach, we do not debit and credit the accounts. Here, we use the Accounting Equation to debit or credit an account. Thus, it is also called the Accounting Equation Approach. Now let us study the Accounting Equation in detail.

Accounting Equation

An Accounting Equation is also called the Balance Sheet Equation. We all know that we record all the business transactions using the Dual Aspect concept. This means that each debit has an equal credit and vice-versa.

This approach classifies the accounts as follows:

  1. Assets Accounts: Assets are the properties, possessions or economic resources of a business which help in business operations and in earning revenues. These are measurable in terms of money. However, assets of a firm may be tangible or intangible. Also, we can classify the assets as Fixed Assets and Current Assets. For example, land, building, furniture and fixtures, plant and machinery, vehicles, debtors, bills receivable, bank balance, cash, stock, etc.
  2. Liabilities Accounts: Liabilities are the amounts that an entity owes to the outsiders or the obligations or the debts payable by the entity. We can also classify the liabilities as Long-term and Current. For example, debentures, bank loans, creditors, bills payable, rent outstanding, short-term loans, bank overdraft, etc.
  3. Capital Accounts: Capital or Owner’s Equity is the money that the owner brings into the business. The owner can bring Capital in the form of cash or assets. It is an obligation of the business and the business has to pay back this amount to the owner as business is a separate entity from its owner. Therefore, we show the Capital on the liabilities side of the Balance Sheet. Also, we show Capital account after deducting the Drawings by the owner. Drawings are the amount of cash, goods or assets that the owner takes for personal use from the business. Also, the profits increase the Capital and losses decrease it.

Accounting Equation

The Accounting Equation is:

Assets = Liabilities + Capital (Owner’s Equity)

Or

Capital = Assets – Liabilities

It is to be noted here that the Accounting Equation shall remain balanced every time. As we know that each transaction has a Dual aspect. Thus, each debit has an equal credit.

Solved Example on Accounting Equation

Analyze the following transactions under the Accounting Equation Approach.

  1. Commenced business with cash ₹500000
  2. Purchased goods ₹25000
  3. Paid salary ₹10000
  4. Sold goods costing ₹20000 at a profit of 25% on the cost
  5. Paid salary in advance ₹2000
  6. Introduced additional capital ₹10000
  7. Purchased computer ₹15000
  8. Deposited ₹50000 into the bank 
Ans.

Analysis of transactions:

  1. It increases the Cash thus, add to cash. Also, it increases the Capital, hence add to Capital.
  2. Goods are purchased thus, cash is decreasing. While, goods are coming in thus, they are increasing. Therefore, deduct cash and add goods.
  3. Salary is paid therefore cash is decreasing. While salary is an expense. Thus, deduct cash and also deduct from Capital.
  4. Goods are going out thus, deduct them. Thus cash is coming in, add it. Also, add the profit to Capital.
  5. Salary is paid in advance which is a current asset. Deduct Cash is and add salary paid in advance.
  6. Cash and Capital both are increasing. Hence, add Cash and Capital.
  7. Cash is decreasing while the computer is increasing. Therefore, deduct cash and add to the computer.
  8. Cash is decreasing and bank balance is increasing. Therefore, deduct cash and add to the bank.

                             Summary of transactions using the Accounting Equation

                                  ASSETS LIABILITIES + CAPITAL
  Cash Stock Computer Pre-paid Salary Bank

 

Total

 

Capital Total

 

1. 500000 500000 500000 500000
2. (25000) 475000 25000 25000    500000 500000  500000
3. (10000) 465000    25000       490000 (10000) 490000    490000
4. 25000 490000 (20000) 5000           495000 5000     495000  495000
5. (2000) 488000      5000  

 

2000  2000   495000  495000    495000
6. 10000 498000      5000  

 

          2000     505000  505000  505000
7. (15000) 483000      5000         15000           2000  

 

  505000  505000  505000
8. (50000) 433000      5000         15000           2000   50000         505000        505000  505000

 

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