THE ACCOUNTING EQUATION

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Financial Accounting (Mgt-101)

Lesson-12

THE ACCOUNTING EQUATION

Resources in the business = Resources supplied by the owner

In accounting, terms are used to describe things. The amount of resources supplied by the owner is called

capital. The actual resources which are in the business are called assets. This means that the accounting

equation above, when the owner has supplied all the resources, can be shown as:

Assets=Capital

Usually, people, other than the owner has supplied some of the assets. Liabilities are the name given to the

amounts owing to these people for these assets. The equation has now changed to:

Assets=Capital + Liabilities

It can be seen that two sides of the equation will have the same totals. This is because we are dealing with

the same thing with two different points of view. It is:

Resources in the business = Resources: who supplied them

Assets = Capital + Liabilities

It is a fact that total of each side will always equal one another, and this will always be true no matter how

many transactions there may be. The actual assets, capital and liabilities may change, but the total of the

assets will always equal to the total of capital and liabilities.

Assets consist of property of all kinds, such as buildings, machinery, stocks of goods and motor vehicles.

Also benefits such as debts owned by customers and the amount of money in the bank accounts are

included.

Liabilities consist of money owing for goods supplied to the business and for expenses. Also loans made to

the firm are included.

Capital is often called the owner's net worth.

Working capital

Working capital of the business is the net value of current assets & current liabilities.

Current assets are the resources of the business that are expected to be received within 12 months in an

accounting period.

Current liabilities are the amount owing to the business that is expected to be paid within one year in a

financial year.

So, working capital is the net of what is receivable in an accounting year & what is payable in that year or:

Working Capital = Current Assets Current Liabilities

For instance, current assets of the business worth Rs.100,000 & current liabilities of the business has the

value of Rs. 75,000. Then working capital is Rs. 25,000.

i.e., (100,000-75,000).

Financial Accounting (Mgt-101)

STOCK

Stock is termed as "value of goods available to the business that are ready for sale". For accounting

purposes, stock is of two types:

· Opening stock

· Closing stock

Opening stock is the value of goods available for sale in the beginning of an accounting year. For purpose

of financial reporting, opening stock is added to the purchases for the year to become a part of cost of

goods sold. As this is available in the beginning of the year, it is assumed that it will be consumed in the

accounting year. That is why; it becomes a part of cost of goods sold. Stock of previous year is the opening

stock in present year.

Closing stock is the value of goods unsold at the end of accounting year. For purposes of making financial

statements, it is deducted from cost of goods sold & is shown as an asset in the balance sheet. As this is the

value of goods that are yet to be sold, so it cannot be included in cost of goods sold. That is why it is

deducted from cost of good sold. On the other hand, its benefit will be received in the next accounting year,

so it is shown as an asset in the balance sheet.

Now, the contents of cost of goods sold are:

Opening stock

Plus: purchases

Plus: Freight/ carriage paid on purchases

Less: closing stock

For instance, opening stock of a business worth Rs. 15,000, business purchased goods of Rs. 12,000 for the

year & also paid Rs. 1,500 as carriage on purchases. The value of closing stock at the end of the year is Rs.

10,000. Then, value of closing stock is calculated as under:

Opening stock

15,000

Add: purchases

12,000

Add: carriage on purchase

1,500

Less: closing stock

(10,000)

Cost of goods sold

18,500

Ali Traders

Trial Balance As On January 31, 20--

Title of Account

Code

Dr. Rs.

Cr. Rs.

Cash Account

35,000

Bank Account

130,000

Capital Account

200,000

Furniture Account

15,000

Vehicle Account

50,000

Purchases Account

60,000

Mr. A (Creditor)

15,000

Sales

95,000

Mr. B (Debtor)

15,000

Salaries

5,000

Financial Accounting (Mgt-101)

Expenses

20,000

Expenses Payable

20,000

Total

330,000

The Accounting Equation.

Assets = Capital + Liabilities

Assets = 35,000+130,000+15,000+50,000+15,000= 245,000

Capital = 200,000

Liabilities = 15,000 + 20,000 = 35,000

Capital + Liabilities = 235,000

We ignore the Net Profit Rs.10000 (Net profit is added in capital account)

When we added Net profit in capital then;

Assets = Capital + Liabilities

245000 = 210000+35000

245000 = 245000

Account form Balance Sheet

Name of the Entity (Ali traders)

Balance Sheet As At (January 31, 20--)

Liabilities

Assets

Particulars

Amount Rs.

Particulars

Amount

Rs.

Capital

200.000 Fixed Assets

65,000

Profit and Loss Account

10,000

Furniture

15,000

50000

210,000 Vehicle

Current Liabilities

Current Assets

Mr. A

15,000

Mr. B

15,000

Exp. payable

20,000

35,000

Bank 130,000

180,000

Cash

35,000

Total

245,000 Total

245,000

Financial Accounting (Mgt-101)

Report form Balance Sheet

Ali traders

Balance Sheet As At January 31, 20--

Particulars

Amount Rs.

Assets

Fixed Assets

65,000

Current Assets

180,000

Total

245,000

Liabilities

Capital

200,000

Profit and Loss Account

10,000

210,000

Current Liabilities

35,000

Total

245,000

Treatment of closing stock

If closing stock is Rs.10000 then;

Name of the Entity (Ali Traders)

Profit and Loss Account for the Month Ending January 31, 20--

Particulars

Amount

Rs.

Income / Sales / Revenue

95,000

Less: Cost of Goods Sold ( 60,000 - 1,000 )

(59,000)

Gross Profit

36,000

Less: Administrative Expenses

(25,000)

Net Profit

11,000

Financial Accounting (Mgt-101)

Ali traders

Balance Sheet As At January 31, 20--

Particulars

Amount Rs.

Assets

Fixed Assets

65,000

Current Assets (180,000 + 1,000)

181,000

Total

246,000

Liabilities

Capital

200,000

Profit and Loss Account

11,000

210,000

Current Liabilities

35,000

Total

246,000

Treatment of Depreciation

In Profit and Loss Account it is considered as expense and in Balance Sheet it is deducted from the

concerned asset.

If useful life of an asset is 50 month and considered that there is no residual value then,

Dividing total cost by life of the asset.

Rs.65,000 / 50 months = Rs.1,300 monthly charge

Name of the Entity (Ali Traders)

Profit and Loss Account for the Month Ending January 31, 20--

Particulars

Amount

Rs.

Income / Sales / Revenue

95,000

Less: Cost of Goods Sold ( 60,000-1,000 )

59,000

(59,000)

Gross Profit

36,000

Less: Administrative Expenses

25,000

Depreciation

1,300

(26,300)

Net Profit

9,700

Financial Accounting (Mgt-101)

Ali traders

Balance Sheet As At January 31, 20--

Particulars

Amount Rs.

Assets

Fixed Assets (65,000 1,300)

63,700

Current Assets (180,000 + 1,000)

181,000

Total

244,700

Liabilities

Capital

200,000

Profit and Loss Account

9,700

209,700

Current Liabilities

35,000

Total

244,700

Distribution of Profits / Drawing

Ali traders

Balance Sheet As At January 31, 20--

Particulars

Amount Rs.

Assets

Fixed Assets (65,000 1300)

63,700

Current Assets (181,000 - 5,000)

176,000

Total

239,700

Liabilities

Capital

200,000

Profit and Loss Account

9,700

Drawing

(5,000)

204,700

Current Liabilities

35,000

Total

239,700

Financial Accounting (Mgt-101)

Illustration

Consider the trial balance given hereunder:

Saeed & co.

Trial Balance As On ( January 31, 2002)

Title of Account

Code

Dr. Rs.

Cr. Rs.

Cash Account

161,250

Capital Account

150,000

Furniture Account

2,000

Purchases Account

16,000

Carriage on purchase account

250

Salim& co. (Creditor)

Sales

37,000

Usman & co. (Debtor)

Salaries

2,500

sRent

3,000

Stationery

2,000

Utility billst

5,000

Accrued expenses

5,000

Total

192,000

Financial Accounting (Mgt-101)

(This trial balance is extracted from the solved illustration, in lecture 11)

Let's say, the value of closing stock at the end of the period is Rs. 2,000. Then profit & loss account will bear

the following change.

Saeed & Co.

Profit & Loss Account for the period ended January 31, 2002

Particulars

Amount

Rs.

37,000.

Income / Sales / Revenue (See Note

16,250 2,000

(14,250)

#1)

Less: Cost of Goods Sold Closing

stock

Gross Profit

22,750.

Less: Admin. Expenses

(12,500)

(See Note # 2)

Net Profit/ (Loss)

10,250

Its effect in the balance sheet is as follows:

Saeed & Co.

Balance Sheet As At January 31, 2002

Liabilities

Assets

Particulars

Amount

Particulars

Amount

Rs.

Capital

150,000 Fixed Assets

Profit and Loss Account

10,250 Furniture Account

2,000

160,250

Current Liabilities

Current Assets

Accrued Expenses

5,000 Cash

161,250

Closing Stock

2,000

Total

165,250 Total

165,250

This is a practical demonstration of the treatment of closing stock. But, we are not mentioning the journal

entry of closing stock at this stage. It will be discussed in detail, when we will study the topic of fixed assets.

DEPRECIATION

Depreciation is the method of charging cost of fixed assets to the profit & loss account as an expense.

Fixed Assets are those assets which are:

Financial Accounting (Mgt-101)

· Of long life

· To be used in the business

· Not bought with the main purpose of resale.

When an expense is incurred, it is charged to profit & loss account of the same accounting period in which it

has incurred. Fixed assets are used for longer period of time. Now, the question is how to charge a fixed

asset to profit & loss account. For this purpose, estimated life of the asset is determined. Estimated life is the

number of years in which a fixed asset is expected to be used. Then, total cost of the asset is divided by total

number of estimated years. The value, so determined, is called `depreciation for that year' and is charged to

profit & loss account. The same amount is deducted from total cost of fixed asset. The net amount (after

deducting depreciation) is called ``Written Down Value''.

For instance, an asset has a cost of Rs. 150,000. It is expected to be used for ten years. Depreciation to be

charged to profit & loss account is Rs. 15,000, i-e. cost of asset/estimated life. In this case, it will be

150,000/10 = 15,000.

That is why depreciation is called an accounting estimate.

To understand its accounting treatment, consider the above mentioned illustration

Let's suppose the useful life of furniture is five years. Then, depreciation for the year will be (2,000/5 = 400).

Now, the profit & loss account will show the following picture:

Saeed & Co.

Profit & Loss Account for the year ended January 31, 2002

Particulars

Amount

Rs.

37,000.

Income / Sales / Revenue (See Note #1)

Less: Cost of Goods Sold

(16,250)

Gross Profit

20,750.

Less: Admin. Expenses + Depreciation

12,500 + 400

(12,900)

Net Profit/ (Loss)

9,850

Balance sheet will look like this:

Financial Accounting (Mgt-101)

Saeed & Sons

Balance Sheet As At January 31, 2002

Liabilities

Assets

Particulars

Amount

Particulars

Amount

Rs.

Capital

150,000 Fixed Assets

Profit and Loss Account

9,850 Furniture Account

2,000

Less: depreciation

(400)

159,850

1,600

Current Liabilities

Current Assets

Accrued Expenses

5,000 Cash

161,250

Closing Stock

2,000

Total

164,850 Total

164,850

Treatment of depreciation is practically demonstrated at this point. Its journal entry will be discussed in

detail, when we cover the topic `Fixed Assets'.

DRAWING

Capital is the cash or kind invested by the owner of the business. Sometimes, the owner wants to take cash

or kind out of the business for personal use. This is known as drawing. Any money taken out as

drawings will reduce capital.

The capital account is very important account. To stop it getting full of small details, cash items of drawings

are not entered in the capital account. Instead, a drawing account is opened, and all transactions are entered

there.

Sometimes goods are also taken by the owner of the business. These are also known as drawings.

To understand the accounting treatment of drawings, look into the following trial balance:

Saeed & co.

Trial Balance As On ( January 31, 2002)

Title of Account

Code

Dr. Rs.

Cr. Rs.

Cash Account

161,250

Capital Account

160,000

Furniture Account

2,000

Drawings

10,000

Profit & loss account

8,250

Salim& co. (Creditor)

Usman & co. (Debtor)

Accrued expenses

5,000

Total

173,250

BALANCE SHEET

Financial Accounting (Mgt-101)

Saeed & Sons

Balance Sheet As At January 31, 2002

Liabilities

Assets

Particulars

Amount

Particulars

Amount

Rs.

Capital

160,000 Fixed Assets

Profit and Loss

8,250 Furniture

2,000

Account

(10,000) Account

Less: Drawings

158,250

Current

Liabilities

5,000 Assets

161,250

Accrued Expenses

Cash

Total

163,250 Total

163,250

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