Every transaction has two effects. For example, if someone transacts a
purchase of a drink from a local store, he pays cash to the shopkeeper and in
return, he gets a bottle of dink. This simple transaction has two effects from
the perspective of both, the buyer as well as the seller. The buyer's cash
balance would decrease by the amount of the cost of purchase while on the other
hand he will acquire a bottle of drink. Conversely, the seller will be one
drink short though his cash balance would increase by the price of the drink.
Accounting attempts to record both effects of a transaction or event on
the entity's financial statements. This is the application of double entry
concept. Without applying double entry concept, accounting records would only
reflect a partial view of the company's affairs. Imagine if an entity purchased
a machine during a year, but the accounting records do not show whether the
machine was purchased for cash or on credit. Perhaps the machine was bought in
exchange of another machine. Such information can only be gained from
accounting records if both effects of a transaction are accounted for.
Accounting Entries are
recorded in ledger accounts. Debit entries are made on the left side of the
ledger account whereas Credit entries are made to the right side. Ledger
accounts are maintained in respect of every component of the financial
statements. Ledger accounts may be divided into two main types: balance sheet
ledger accounts and income statement ledger accounts.
Business transactions are financial in nature and so every transaction affects the financial position of the business. These transactions increase or decrease the assets, liabilities or capital. Every business has certain assets.
These assets are purchased with the funds supplied to the business by its proprietors or creditors. Proprietors’ and creditors’ funds, in whatever form they are, create assets. For example, if the business receives Rs. 1, 00,000 as capital from the proprietor and retains that in the firm, it will create an asset i.e. cash in hand. If Rs. 80,000 are deposited in to bank, the total capital will be represented by two assets i.e. cash in hand Rs. 20,000 and cash at bank Rs. 80,000.
It machines, worth Rs. 20,000 are purchased and payment is made out of bank deposit, the assets will now consist of cash in hand Rs. 20,000, cash at bank Rs. 60,000 ( due to purchase of furniture, bank balance has reduced by Rs. 20,000 ) and furniture Rs. 20,000. As such accounting equation is a statement of equality between debits and credits.
Double entry is recorded in a manner that the accounting equation is
always in balance:
Assets = Liabilities + Equity
Assets of an entity may be financed either by external borrowing (i.e.
Liabilities) or from internal sources of finance such as share capital and
retained profits (i.e. Equity). Therefore, assets of an entity will always
equal to the sum of its liabilities and equity.
The accounting equation may be re-arranged as follows:
Assets - Liabilities = Equity
We may test the Accounting Equation by incorporating the effects of
several transactions to see whether it still balances as theorized in the
accountancy literature. For the purpose of this test, we may classify
accounting transaction into the following generic types:
1. Transactions that
only affect Assets of the entity
2. Transactions that
affect Assets and Liabilities of the entity
3. Transactions that
affect Assets and Equity of the entity
4. Transactions that
affect Liabilities and Equity of the entity
Note:
For all the examples on the next pages, it will be assumed that before
any transaction, Assets of ABC LTD are $10,000 while its Liabilities and Equity
are $5,000 each.
Accounting Equations Example. pdf. download for more
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