Consider the following accounting equation

Mathematical Interpretation of the Accounting Equation

• Equation

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

• Terms

  Each element of accounting i.e. each account head forms a term.

  Thus the accounting equation can be interpreted as

  __ a/c + ___ a/c + ___ a/c = ___ a/c + ___ a/c

The above equation can also be presented as below

Effect of a Transaction

Every business transaction that can be considered for accounting based on the money measurement concept, i.e. every accounting transaction, 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

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 has also increased from zero to 1,00,000.

   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.

   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.

   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 10,000 worth of goods have been bought on credit,

   • The value of Goods/Stock has increased from the existing 25,000 to 35,000.
   • The liabilities of the business, in the name of Mr. Shyam Rao, the creditor, would increase from zero to 10,000.

   Capital	+	Liabilities	=	Assets
   1,00,000	+	10,000 (Mr. Shyam Rao)	=	50,000 (Cash) + 25,000 (Furniture) + 35,000 (Stock)

6. Sold Goods for cash 20,000 to Mr. Peter.

   Since 20,000 worth of goods are sold for cash,

   • The value of Goods/Stock has decreased from 35,000 to 15,000.
   • 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)

7. 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 decreases from 15,000 to 5,000.
   • The value of assets, debtors, in the name of M/s Bharat & Co., would increase 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)

8. Paid Cash into Bank 60,000.

   Since cash is paid into bank,

   • The available cash reduces from 70,000 to 10,000.
   • The value of the asset, debtor, in the name of Bank, increases from zero to 60,000.

   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)

9. 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.
   • The value of the liability represented by Mr. Shyam Rao 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)

10. Received cash from M/s Bharat & Co., on account, 8,000.

    Since cash is received,

    • The available cash increases from 5,000 to 13,000.
    • The value of the asset, debtors, represented by M/s Bharat & Co., 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)

We can notice that each accounting transaction had its effect on two elements.

Practice Problems - Dual Entity Concept

The fact that every accounting transaction has its effect on two elements of accounting, explains the dual entity concept, which forms the foundation for the total activity in accounting.

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.