Constituents of the Accounting Equation

Consider the following accounting equation
Capital + Liabilities = Assets
1,00,000 + 5,000 (Mr. Shyam Rao) =   13,000 (Cash)
+ 25,000 (Furniture)
+ 5,000 (Stock)
+ 60,000 (Bank)
+ M/s Bharat & Co (2,000)

The accounting equation being a mathematical equation is a statement of equality between two expressions. "Capital + Liabilities" is an expression and "Assets" being the other expression.

An expression is formed by one or more terms combined together using the mathematical operations of addition and subtraction. Thus the sub divisions into which we break down the expressions within the accounting equation would be an equivalent of terms in mathematics. Each such term in the equation is nothing but an element of accounting or an account head.

We should understand that certain elements are part of the expression called Liabilities, certain others are part of the expression called Assets. Where Liabilities are segregated as "Capital" and "Liabilities", each of these would be an expression in itself.

The above equation can also be presented as below
Capital + Liabilities = Assets
1,00,000 + 5,000 (Mr. Shyam Rao) = 13,000 (Cash) + 25,000 (Furniture) + 5,000 (Stock)
+ 60,000 (Bank) + M/s Bharat & Co (2,000)

Effect of a Transaction

Every accounting transaction (i.e. every business transaction which can be considered for accounting based on the money measurement concept) has its effect on the elements of accounting, called accounts or account heads. This implies that every transaction has its effect on the constituents of the accounting equation and thereby the accounting equation.

Illustration

Consider the earlier example of business transactions relating to Mr. Oberoi. The elements that are affected by each transaction are marked in distinct color within the equation.
1. The business is proposed to be started.

Since the business has only been proposed and not yet started it has neither assets nor liabilities.
Capital + Liabilities = Assets
0 + 0 = 0
2. Started Business with a Capital of 1,00,000.

Since capital in the form of cash is being brought into the business:
• The value of capital has increased from zero to 1,00,000 and
• The cash available with the business would increase from zero to 1,00,000.

Cash since it is capable of being liquidated is an asset.

Capital + Liabilities = Assets
1,00,000 (Capital) + 0 = 1,00,000 (Cash)
3. Bought Furniture for cash 25,000.

Since Furniture is being bought by paying cash,
• The value of Furniture has increased from zero to 25,000.
• The cash available with the business would reduce by 25,000 to 75,000.

Furniture, since it is capable of being liquidated, is an asset.

Capital + Liabilities = Assets
1,00,000 + 0 =    75,000 (Cash)
+ 25,000 (Furniture)
4. Bought Goods for cash 25,000 from M/s Roxy Brothers.

Since goods are bought by paying cash :
• The value of Goods/Stock has increased from zero to 25,000 and
• The cash available with the business would reduce by 25,000 to 50,000.

Goods/Stock since it is capable of being liquidated is an asset.

Capital + Liabilities = Assets
1,00,000 + 0 =    50,000 (Cash)
+ 25,000 (Furniture)
+ 25,000 (Stock)
5. Bought Goods from Mr. Shyam Rao on credit for 10,000.

Since goods are bought on credit :
• The value of Goods/Stock has increased from 25,000 to 35,000 and
• The liabilities of the business would increase from zero to 10,000.

This liability is identified by the name of the vendor who gave the goods on credit i.e. Mr. Shyam Rao and he is a creditor for the business.

Capital + Liabilities = Assets
1,00,000 + 10,000 (Mr. Shyam Rao) =    50,000 (Cash)
+ 25,000 (Furniture)
+ 35,000 (Stock)
1. Sold Goods for cash 20,000 to Mr. Peter.

Since 20,000 worth of goods are sold by taking cash :
• The value of Goods/Stock has decreased from 35,000 to 15,000 and
• The cash available with the business would increase from 50,000 to 70,000.
Capital + Liabilities = Assets
1,00,000 + 10,000 (Mr. Shyam Rao) =    70,000 (Cash)
+ 25,000 (Furniture)
+ 15,000 (Stock)
2. Sold Goods on credit to M/s Bharat & Co., for 10,000.

Since 10,000 worth of goods have been sold on credit :
• The value of Goods/Stock has decreased from 15,000 to 5,000 and
• The buyer falls due to the extent of the sale value and is known as a debtor to the organisation. A debtor can be liquidated by collecting dues form him and therefore can be considered as an asset.

This asset is identified by the name of the buyer i.e M/s Bharat & Co. whose value increases from zero to 10,000.

Capital + Liabilities = Assets
1,00,000 + 10,000 (Mr. Shyam Rao) =    70,000 (Cash)
+ 25,000 (Furniture)
+ 5,000 (Stock)
+ 10,000 (M/s Bharat & Co)
3. Paid Cash into Bank 60,000.

Since cash is paid into bank,
• The available cash reduces from 70,000 to 10,000 and
• The amount paid into the bank is held by the bank on our behalf. The bank has to pay us the same whenever we ask for it. The bank therefore stands in the position of a debtor to us (those who owe us money).

The new asset is identified as "Bank".

Since "Bank" can be liquidated (converted into cash) by withdrawing money from it, can be treated as an asset.

Capital + Liabilities = Assets
1,00,000 + 10,000 (Mr. Shyam Rao) =    10,000 (Cash)
+ 25,000 (Furniture)
+ 5,000 (Stock)
+ 10,000 (M/s Bharat & Co)
+ 60,000 (Bank)
4. Paid Cash to Mr. Shyam Rao, 5,000.

Since cash is paid to Mr. Shyam Rao :
• The available cash reduces from 10,000 to 5,000 and
• The amount due to Mr. Shyam Rao, the value of the liability represented by his name i.e. creditors also reduces from 10,000 to 5,000.
Capital + Liabilities = Assets
1,00,000 + 5,000 (Mr. Shyam Rao) =    5,000 (Cash)
+ 25,000 (Furniture)
+ 5,000 (Stock)
+ 10,000 (M/s Bharat & Co)
+ 60,000 (Bank)
5. Received cash from M/s Bharat & Co., on account, 8,000.

Since cash is received from M/s Bharat & Co.
• The available cash increases from 5,000 to 13,000 and
• The amount due from M/s. Bharat & Co, the value of the asset represented by his name i.e. debtors also reduces from 10,000 to 2,000.
Capital + Liabilities = Assets
1,00,000 + 5,000 (Mr. Shyam Rao) =    13,000 (Cash)
+ 25,000 (Furniture)
+ 5,000 (Stock)
+ 2,000 (M/s Bharat & Co)
+ 60,000 (Bank)

Dual Entity Concept

From analysing accounting transactions, we can notice that each transaction has its effect on two elements.

This explains the dual entity concept which forms the foundation for the total activity in accounting.

Dual Entity Concept

Every transaction relating to business has its effect on two distinct elements/accounts.

Dual

• Consisting of or involving two parts or components usually in pairs
• double

Duel

• Consisting of or involving two parts or components usually in pairs

Double Entry System

The process of accounting that we are learning about is called the "Double Entry System of Accounting".

This is so called based on the dual entity concept which states that every transaction relating to business has its effect on two elements.