Accounting Equation_1.

1 2013

Accounting Period and Accounting Equation

Accounting period is the period for which the financial statements are prepared. In other words,
accounting period is the period for which profit is determined. Accounting period can be a year,
quarter, or month.

Suppose rent per month is Rs. 3000 and the firm has paid Rs. 12000. The impact on the
accounting equation depends on the definition of the accounting period. However, the impact on
the cash is same independent of the accounting period.

Source Use
Capital Cash Accounting Period = 1 year
200000 200000 Source Use
Capital Loss Cash
200000 -12000 188000
Accounting Period = 1 month
Source Use
Capital Loss Cash Advance Rent
200000 -3000 188000 9000

Show the Accounting Equation if the accounting period is a quarter

Expenses
Expenses are those whose benefits expire on one accounting period. Expenses may be for cash or
on credit. Expenses are incurred with for earning an income. If the expenses are less than the
income there will a profit otherwise there will be loss.

Let us start with an accounting equation for business started with capital of Rs 200,000 an loan
of Rs. 100,000.

Accounting Equation
Source = Asset
Loan+ Capital Cash
100,000 200000 200000

• See the impact of salary paid: Rs. 3000

Accounting Equation
Profit+ Loan+ capital = Cash

1
 Accounting Equation_1.1 2013
-3000 100,000 100,000 197000

An expense without corresponding revenue is generally treated as loss. In other words. during
the period there were no incomes, so the entire expense is treated as loss. Observe the decrease in
cash

• Expense due but not paid: Outstanding Salary : Rs. 3000

Accounting Equation
Outstanding Salary + Profit+ Loan+ capital = Cash
3000 -3000 100,000 100,000 200000

This is a credit transaction so no change in cash. However, due to the accrual concept of
accounting, expenses without corresponding revenue is generally treated as loss. Money payable
to the employees is shown as source/ liability

• Expense paid but not due: Salary for the next accounting period paid in the current
period.

Accounting Equation
Advance
Loan+ capital = Cash + Salary
100,000 100,000 197000 3000

Cash payment towards expenses of the subsequent period. According to the Accounting Period
Principle the benefit of this will arise in the next time period. So in the current accounting
period it will be treated as an asset. Asset is something which has the potential to generate
income.

Show the Accounting Equation for: Salary paid for the previous time period

Payments:
Payment is the outflow of money. However, every outflow of money is not an expense. See the
following:
• Payment, the benefit of which expires in one accounting period is called expense or
revenue expenditure.

2
 Accounting Equation_1.1 2013
• Payment, the benefit of which expires over a long period of time is called capital
expenditure

Payment may result in the following:

• Incurring expense
• Acquiring asset
• Repayment of liability

Let take the following accounting equation to understand the impact of the above transactions.

Accounting Equation
Source = Use
Capital + Loan Cash
100000 +100000 200000

Revenue Expense
Those payments the benefits from which expire in one accounting period. Paid rent for the
month at the end of the month: Rs.15000. No other income. Accounting equation at the end of
the month (accounting period) will be as follows:

Accounting Equation
Profit + Loan + Capital = Cash +
-15000 100,000 100000 185000

Deferred Revenue Expenses

Deferred revenue expenses are those expenses whose benefits accrue for more than one year (for
2-5 years). For example, acquired a patent for Rs. 60,000. If patent can be used for three years,
one third of the payment will be treated as the expense and the balance is shown as an asset.

Accounting Equation
Profit + Loan + Capital = Cash + Patent
-20000 100,000 100,000 140000 40000

Capital Expenditure
Payment results in acquiring an asset. Such assets will remain with the business for a longer
period and enable the company to generate incomes. Purchased furniture and paid by cash:
Rs.50000

Accounting Equation
Loan + Capital = Cash + Furniture
3
 Accounting Equation_1.1 2013
100,000 100,000 150000 50000

Reduction in Liabilities
Sometimes payment results in decrease in liabilities. Suppose the company uses the cash to pay
off 20% of the loan.

Accounting Equation
Loan + Capital = Cash +
80,000 100,000 180,000

Cash and Capital

Capital is a source and cash is an asset. Capital can be contributed in any form. There may be
situation when a firm will have huge capital but no cash, or huge cash and very small amount of
capital.

• Started business with cash of Rs. 200,000

• Purchased stock for Rs. 150,000
• Purchased computer for cash: 50,000
• Sold stock at a profit of 100,000
Source Application
Source Application
Capital = Cash + Stock
Capital Cash 200000 50000 150000
200000 200000

Source Application Source Application

Capital + Profit = Cash+ Stock + Computer Capital = Cash + Stock + Computer
200000 100000 250000 0 50000 200000 0 150000 50000
4
 Accounting Equation_1.1 2013

Explain the change in capital and cash position in the above accounting equations.

Investments and Fixed Assets

If money is investment outside the business i.e. in other businesses, it is shown as investment on
the accounting equation. Whereas, if the investment is made in the same business, it is called
fixed assets

Source Application Investment in the business (Fixed Asset)

Capital Cash Source Application

200000 200000 Capital = Plant + Cash
200000 150000 50000

Investment in outside the business (Investment)

Source Application
Capital = Shares in B + Cash
200000
Interest 150000
paid/Outstanding 50000

Interest on loan is an expense and as per the accural concept, it has to be recorded and charged
against the income of the particular period whether paid or not.

Source Application Interest paid: Expense and Cash outflow

Capital + Loan Cash Plant Source Application
400000 100000 300000 200000 Capital + Loss Loan Cash Plant
400000 -12000 100000 288000 200000

Interest due but not paid: Expense and liability

Source Application
Capital + Loss Interest Due Loan Cash Plant
400000 -12000 12000 100000 300000 200000

Show the Accounting Equation for

• Interest received/Interest due but not received
• Interest on borrowing accrued but not due. 5
 Accounting Equation_1.1 2013

Bad debts
Bad debt is a loss due to the non-recovery of credit sales, which arises due to the insolvency of
the customer (debtor). Suppose a customer Mr. Z becomes insolvent and the entire amount due
to him becomes bad-debt. Impact on the accounting equation is shown below: reduction in
debtors (Mr.Z), increase in loss (from profit to loss), and no change in the cash balance.

Accounting Equation
Y ltd X Ltd Capital Goods
+ + Loan + Profit + = Cash + + Mr Z+ Fixed Assets
70000 30000 100000 55000 400000 180000 0 175000 300000

Accounting Equation
Y ltd X Ltd Capital Goods Mr
+ + Loan + Profit + = Cash + + Z+ Fixed Assets
-
70000 30000 100000 120000 400000 180000 0 0 300000

Provision for doubtful debts

As per the conservative principle, a firm is required to provide for the future losses. This would
reduce the profit of the period.
Accounting Equation
Y ltd X Ltd Capital Goods
+ + Loan + Profit + = Cash + + Mr Z+ Fixed Assets
70000 30000 100000 55000 400000 180000 0 175000 300000

Suppose the firm expects that 10% of money due from Mr. Z will become bad.

Accounting Equation
Y ltd X Ltd Goods
+ + Loan + Provision + Profit + Capital = Cash + + Mr Z+ Fixed Assets
70000 30000 100000 17500 37500 400000 180000 0 175000 300000

6
 Accounting Equation_1.1 2013
( a separate item called provision has created in the equation to show the amount of expected
loss)

Or
Accounting Equation
Fixed
Y ltd + X Ltd + Loan + Profit + Capital = Cash + Goods + Mr Z+ Assets
70000 30000 100000 37500 400000 180000 0 157500 300000
(In this case provision has not been shown as a separate item. It has been reduced from the
debtor: Mr. Z)

7
 Accounting Equation_1.1 2013

Discount
Discount is the benefit given by the firm to the customers as an incentive for prompt payment.

Accounting Equation
Y ltd X Ltd Capital Goods
+ + Loan + Profit + = Cash + + Mr Z+ Fixed Assets
70000 30000 100000 55000 400000 180000 0 175000 300000

Firm gives discount of Rs. 25000 to Mr. Z. Impact on the accounting equation is shown below:
reduction in debtors (Mr.Z), decrease in profit (from Rs.55000 to Rs. 30000) and increase in cash
by Rs. 150000 (175000-25000).

Accounting Equation
Y ltd X Ltd Profit Capital Goods Mr Fixed
+ + Loan + + = Cash + + Z+ Assets
70000 30000 100000 30000 400000 330000 0 0 300000

Depreciation
Depreciation can be explained in one of the following ways:

• Loss due to the wear and tear of fixed asset.

• Cost apportioned over the life of the fixed asset.
• Provision for replacement of fixed asset
• Charge for using the fixed asset

Impact of depreciation on the accounting equation can be seen from the following transactions.

• Purchase of plant • Depreciation at 10% for the period

Source Application
Source Application
Capital = Cash + Plant
Capital + Loss = Cash+ Plant
200000 50000 150000
200000 -15000 50000 135000

Some times depreciation is not deducted from the cost of the plant. Plant is shown at the original
cost and the depreciation is shown under a separate head called “Accumulated Depreciation”.
The accounting equation will be as follows:

8
 Accounting Equation_1.1 2013

Source Application
Capital+ Loss + Accumulated Depreciation= Cash+ Plant

200000 -15000 15000 50000 150000

Revaluation of Assets
If the market value of the assets is more than the book value of the asset, the company can
revalue the assets . However, such revaluation should be supported by the corresponding source
of revaluation reserve.

Sources Application
Capital + Profit + Loans = Cash Plant
300000 30000 200000 330000 200000

Suppose the firm revalues the assets to Rs. 300000. The impact on the accounting equation will
be as follows: Increase in assets is matched with revaluation reserve.

Sources Application
Capital + Profit + Revaluation Reserve+ Loans= Cash + Plant
300000 30000 100000 200000 330000 300000

Cash Dividend:
Dividend is the part of the profit distributed among the shareholders. Generally it is given in the
form of cash. It leads to reduction of cash and the accumulated profit. Dividend is given as
percentage of capital..

Sources Application
Capital Profit Loans Cash Other Assets
400000 30000 200000 330000 300000

Suppose 5% of capital is declared and distributed as dividend

Sources Application
Capital Profit Loans Cash Other Assets
400000 10000 200000 310000 300000
• Profit reduced by 20,000 and there was corresponding reduction in the cash.

9
 Accounting Equation_1.1 2013
Stock Dividend/Bonus Share
Dividend can be distributed in the form of shares. Such declaration of dividend shares does not
involve any outflow of cash. The impact of issue of bonus shares on the accounting equation is
shown below:
Sources Application
Capital + Profit + Loans = Cash + Other Assets
400000 30000 200000 330000 300000
Suppose 5% of capital is declared as bonus shares

Sources Application
Capital + Profit + Loans = Cash + Other Assets
420000 10000 200000 330000 300000
• Profit reduced by 20,000 without the corresponding increase in the cash. However, the
capital increases due to the bonus shares.

Rights Issue
Shares issued to the existing share holders at the time of subsequent issue of shares are called
Right shares. Unlike the issue of bonus share, issue of right shares involves cash flows.

Sources Application
Capital + Profit + Loans = Cash + Other Assets
400000 30000 200000 330000 300000
If right shares are issued to the tune of Rs. 50000, the impact on the accounting equation will be
as follows:

Sources Application
Capital + Profit + Loans = Cash + Other Assets
450000 30000 200000 380000 300000

Buyback of shares

Sources Application
Capital + Profit + Loans = Cash + Other Assets
400000 130000 100000 330000 300000

If shares worth of Rs. 50000 are bought back, the impact on the accounting equation will be as
follows:

Sources Application
Capital Profit Loans Other
+ CRR + = Cash + Assets
350000 50000 80000 100000 280000 300000

10
 Accounting Equation_1.1 2013

• Cash reduces by 50,000

• Capital reduces by 50,000
• Profit to the extent of 50,000 transferred to a new accounting “Capital Redemption
Reserve (CRR):

Show the accounting equation

• Issue of Shares in consideration of other assets
• Conversion of shares to debentures

Composite Items

Owners’ Fund:
Capital and accumulated profit/loss is called owners’ fund. Owners’ fund is also known as net
worth or equity. See the following accounting equation:

Source Application Source Application

Capital + Loss = Cash+ Plant Capital Profit Cash + Stock
200000 -15000 50000 135000 200000 100000 300000 0

Source Application Source Application

Owners’ Fund = Cash+ Plant Owners’ Fund Cash + Stock
185000 50000 135000 300000 300000 0

Capital Employed:
Capital employed is the sum of owners’ fund and long-term borrowing. See the following
accounting equations:

Source Use Source Use

Capital + IDBI Loan = Cash + Computer Capital Employed = Cash + Computer
400000 100000 300000 200000 500000 300000 200000

11
 Accounting Equation_1.1 2013
Accounting Equation and Financial Statements

In the last two chapters we made an attempt to understand accounting equation. One can see that
all business transactions can be understood by using the accounting equation. However, every
business organization is required to prepare the financial statements: Balance Sheet, Income
Statement, and Cash Flow Statement.

It may be necessary to understand the impact to the financial items and the financial transactions
on the financial statements. Some questions that one need to answer on day to day basis as a
business manager, investment advisor, or a banker are as follows:
• What is the impact of high debt equity ratio on the financial statements?
• Why the company is not having cash despite having huge profits?
• Why the cash hand has increased during the period?

Before we make an effort to answer the above questions it may be necessary to understand the
financial statements.
a) Balance Sheet: Shows total sources and total assets at a particular point of time
b) Income Statement: Shows the profit or loss for the period
c) Cash Flow Statement: Shows the cash in hand at a particular point of time.

As we have already seen in the previous chapter that the accounting equation also shows the
above items. So where is the need for preparing the other financial statement (IS and CFS). Let
us take the following transactions:

• Started business with cash Rs. 50,000

• Availed 12% loan: Rs. 100,000
• Purchased furniture on credit from Mr. X: 10000
• Purchased stock for cash : Rs. 50000
• Sold 50% of the stock: 50,000
• Paid salaries: 10000
• Rent due but not paid: Rs.5000

Accounting Equation
Sources = Assets
Rent Capital Furniture
Due Profit Mr. X + Loan + = Cash + + Stock
D1 50000 50000
D2 100000 50000 150000
D3 10000 100000 50000 150000 10000
D4 10000 100000 50000 100000 10000 50000
D5 25000 10000 100000 50000 150000 10000 25000
D6 15000 10000 100000 50000 140000 10000 25000
D7 5000 10000 10000 100000 50000 140000 10000 25000

12
 Accounting Equation_1.1 2013

The accounting equation on a particular day represents the balance sheet as on that date. For
example if we take the day7, the balance sheet will be as follows:

Balance Sheet as on Day 7

Capital 50,000 Furniture 10,000
Profit 10,000 Stock 25,000
Loan 100,000 Cash 140,000
Mr. X 10,000
Rent
Due 5,000
175,000 175,000

One can prepare the balance sheet after every transaction. Balance sheet shows all sources and
assets of the business as on that date. It changes with every transaction. The change can be seen
from the accounting equation shown in the above table.

Now observe the change two items: profit and cash. Profit and cash change with every
transaction. The position of profit and cash as on particular date can be seen from the equation.
However, to get the details of why the profit and cash changed one has to prepare the Income
Statement and Cash Flow Statement.

Income Cash Flow Statement

Statement Inflows
Sales 50000 Capital 50000
Less Loan 100000
COGS 25000 Sales 50000
Rent 5000 200000
Salary 10000 Outflows
Total 40000 Stock 50000
Profit 10000 Salary 10000
60000
CIH 140000

Cash flow statement and income statement help in understanding the balance sheet better.
Therefore, in most of the countries all three statements: Balance Sheet, Income Statement, and
Cash Flow Statement are statutory in nature.

13
 Accounting Equation_1.1 2013

Different ways of Balance Sheet presentation

Balance Sheet as on Day 7

Balance Sheet as on Day 7
Capital 50000 Furniture 10000
Sources Assets
Profit 10000 Stock 25000
OF 60000 FA 10000
Loan 100000 Cash 140000
LTL 110000 CA 165000
Mr. X 10000
CL 5000
Rent Due 5000
175000 175000
175000 175000

Balance Sheet as Balance Sheet as Balance Sheet as

on Day 7 on Day 7 on Day 7
CE 170000 OF 60000 CE 170000
CL 5000
170000 FA 10000 175000
FA 10000 WC 160000 FA 10000
WC df 160000 170000 CA 165000
170000 Less 175000
LTL 110000

60000

14
 Accounting Equation_1.1 2013
Let take the accounting equation as on the last date

Accounting Equation
Sources = Assets
Rent Capital Furniture
Due Profit Mr. X + Loan + = Cash + + Stock
D7 5000 10000 10000 100000 50000 140000 10000 25000

Accounting Equation
Sources Assets
Owners Fund + LTL + CL = FA + Investment+ CA
60000 110000 5000 10000 0 165000

Accounting Equation
Sources Assets
Capital Employed + CL FA + Investment+ CA
170000 5000 10000 0 165000

Accounting Equation
Sources Assets
Capital Employed
= FA + Working Capital
170000 10000 160000

Accounting Equation
W capital
Owners Fund = FA + - LTL
-
60000 10000 160000 110000

To make the balance sheet more useful we can combine some items as follows (refer to the
above balance sheet):

• Owners Fund or Net-worth = Capital + Profits –loss = 50,000 +10,000 = 60000

• Long Term Liabilities (LTL) = Loan + Credit for purchase of furniture = 110,000
• Capital Employed = Owners Fund + LTL
• Current Liabilities (CL) = Rent Due = 5,000
• Fixed Assets = 10,000
• Investments= 0
• Current Assets (CA) = 165,000
• Working Capital = CA – CL =160,000

15
 Accounting Equation_1.1 2013

Refer to the balance sheet of Mindtree at http://www.mindtree.com

Accounting Equation of Mind Tree Ltd as on 31st March 2011 (Rs. In Crs.)
Sources Assets
CL Debts + Reserves+ Capital = FA Invest. CA
235 5 736 40 303 114 599

Accounting Equation as on 31s March 2011 (Rs.

In Crs.)
Sources Assets
CE CL FA + Invest CA
781 235 303 114 599

Accounting Equation as on 31st March 2011 (Rs.

In Crs.)
Sources Assets
CE FA + Invest NWC
781 303 114 364

Accounting Equation as on 31st March 2011 (Rs.

In Crs)
Sources Assets
Equity FA + Invest NWC - Debts
776 303 114 364 5

Accounting Equation as on 31st March

(Rs. in crs)
Equity Assets - Liabilities
776 1,016 239

Where
• CL: Current Liabilitis
• FA:Fixed Assets
• CA: Current Assets
• NWC: Net Working Capital (CA-CL)
• Invest: Investments
• CE = Capital Employed = Equity +Long Term Debts
• Equity =Capital +Reserves
16
 Accounting Equation_1.1 2013

Dr. Reddys Labs: Balanace sheet as on 31st March 2011

sources Assets
Equity 6,020 Fixed Assets 2,261
Loans 1,445 Investments 2,462
Current Liabilities 1,822 Current Assets 4,564
9,287 9,287

Equity = FA Invest+ CA - Liabilities

6,020 2,261 2,462 4,564 3,267

Equity = Assets - Liabilities

6,020 9,287 3,267

Capital Employed = FA Invest+ CA - CL

7,465 2,261 2,462 4,564 1,822

Capital Employed = FA + Invest+ NWC

7,465 2,261 2,462 2,742

Capital Employed = Equity + Loans

7,465 6,020 1,445

Capital Employed = Assets - CL

7,465 9,287 1,822

Working Capital = CA- CL

2,742 4,564 1,822

17
 Accounting Equation_1.1 2013

Following Exhibit Shows the financial transactions and financial statements

Financial transaction and Financial statements.

• Started business with cash: Affects BS and CFS
• Availed loan: Affects BS and CFS
• Purchased furniture on credit: Affects BS only
• Purchased furniture for cash: Affects BS and CFS
• Paid Salary: Affects IS and CFS
• Salary due but not paid: Affects IS and BS
• Sold goods for cash: Affects IS, BS, CSF
• Sold goods on credit: Affects IS, BS
• Purchased goods for cash: Affects BS, CFS
• Purchased goods on credit: Affects BS only
• Interest received: Affects IS and CFS
• Interest due but not received: Affects IS and BS

18
Accounting Equation_1.1 2013

19