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ACCOUNTING EQUATIONS | Company Vakil

ACCOUNTING EQUATIONS

Every day, any step or work done by us is revolving around actions and reactions of people and things around us. We can take a number of examples to prove this point, may it be something as simple as a see-saw or even something as complicated as the working of our body. Every action of our registers has some kind of reaction. These reactions and actions happen every time around us, certainly not taken into records for every one of them. It is because these actions and reactions, or as we may call them transactions of various things, do not need to be taken into account by registering or documenting them. But whenever these transactions or exchange happens in the terms of money, there is felt a pressing need to record or document these transactions in a systematic manner for future use. These systematic record or documentation of monetary is called accounts in commercial language.

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In every transaction that is made there is always an exchange of resources, whatever those resources may be. If a person pays money in exchange they get either a good or a service, therefore resulting into two very basic elements which are income and expense. This concept is the very base of accounts and has resulted into the concept of Debit and Credit and double entry system. The financial elements of any business are essentially based on two major terms of accounting, i.e. the income received and the other is the expenses made. These two terms in two different situations, the income received and expenses made in the current financial year and the income receivable and expenses related to the future years, are the essence of the financial elements in any business. Any account that does not relate itself to the incomes and expenses of current years broadly gets classified into two heads, either it is an asset or it becomes a liability. Maintaining accounts is important for the business when any day in future the state of its expenses and income needs to checked or calculated or ascertained. The two important aspects that affect the state of ant business on any given time are as followed:

 

  • A short yet completely explained account of previously possessed income and expenditure data to calculate the profitable value that it had during any given time period.
  • Checking the possession of resources and their ability to earn income in future just as much as to balance the expenditure and calculate if or if not the accounts can maintain a profitable position in coming future.

 

At any given time whenever necessary, if there is a need to calculate the state of business, a single balance sheet of accounts is created covering all the income and expenses made in that given period of time, which in turn results into the calculation if profit and loss at that given period. This entire process is what leads to the maintaining of profit and loss accounts.

 

A balance sheet is created by putting together the record of any relatable future profits or benefits that is the assets and any obligations that relate to the future business, i.e. the liabilities, from that particular date they are being assessed from. On this balance sheet the total profit or the total loss if the business is also calculated based on the given record.

Each item that is mentioned in the balance sheet is mainly classified into three subheads.

 

  • Capital: capital in any balance sheet is the total money of the owner invested in the business including the money due to the owner in terms of for example profits. Hence capital is the money invested by the
  • Owner and therefore ultimately has to be paid back to him in the business. This account is also displayed under the liability slide of the balance sheet for the latter.
  • Liability: – this portrays all the economic items that are at a state of obligation to an external commodity. Liabilities can include the loans drawn, expenses payable for the future, trade creditors and so forth.
  • Asset: – This represents the economical entities that stand as a profit or a usable resource that can be extracted in the future or is used to harvest financial benefits. They include: – a) Fixed assets (Plant and machinery, buildings, land, furniture etc.) and b) intangible assets (patents, trademarks, goodwill etc.)

 

Every transaction eventually organises into any of the above mentioned. Let’s analyse different transactions with respect to the above categorization, under the double entry system:

  • The transaction of a genuine person starting a business by starting a newer bank account and investing INR 10,000 can consequently result in the bank balance occurring in the asset side of a balance sheet to go up by INR 10,000 and the main initial amount occurring in the liability side would simultaneously go up with INR 10,000.
  • Anywhere, goods are bought for INR 5,000, this would be displayed in the purchase account as an inclusive of the profit and a loss account (as the loss/credit) and the balance hence goes down by INR 5,000.
  • Anywhere, goods are sold for 6,000 Rs. this would be consequently displayed as the inclusive part of the profit or loss account (as a profit/credit) and the bank overall would increase by INR 6,000.
  • The former mentioned three transactions have the following result:-
  • The capital account displays an accounting of INR 10,000 in the liability slide.
  • The benefit and loss account would be showing an overall profit of INR 1,000 under the liability side. This would add up as 1,000 + 10,000 = 11,000, under the liability side.
  • There would be an outcome balance of INR11, 000 and thus the asset slide of the sheet would also be as INR 11,000.

From the above mentioned, it can be made out, that wherever the double entry system of accounting is principally followed and kept into mind, there also co-exists a interrelationship amongst the 3 entities of the balance sheet which can be profoundly depicted I=as the equation:-

LIABILITIES + CAPITAL = ASSETS

This is generally called as the Accounting Equation. This explains that why both the side of the balance sheet viz. asset and liability side (including the capital) eventually appear to be equal. This holds true even beside of the factual period for which the sheet is prepared, the type and number of the transactions etc.

 

Throughout the pre-computer and industrialised era, the accounts were manually prepared and improvised; the entries were inflicted with human errors and mistakes. This equation proved to be a remedy for many of these mistakes. However, this problem doesn’t exist these days since the systems are designed in a way that no entry can be passed without validated with the double entry system.

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