Accounting Equation Chapter # 2

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Introduction
We have discussed basic terms used in accounting. One of the most important term is the Balance Sheet. In this chapter we shall explain this term and show the effect of transaction on the balance sheet.

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Assets and Equities

Assets refer to all the valuable proprieties possessed by the business, while the equities means the claim against these assets. The equity are further divided into Capital And Liability. Capital refer to the owner equity which means right of the owner in the asset of the business and liabilities refer to outsider equities which means the right of outsider in the assets of the business.

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Balance Sheet Equation

When any assets is purchased, the owner not only acquire the

property but also right associated to that property. These right in assets are equal to the value of assets. In accounting we refer these rights as Clime against assets or equities. From this concept the following equation is derived,

ASSETS

EQUITIES

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.
As we know that a single person cannot contribute all the required funds from his own pocket. He has to raise fund by means of credit purchase, loan from banks, friends and from many sources. In this way the right against the assets i.e. equities into owner equity and outsider equities. Therefore the balance sheet equation can be written as:

ASSETS

LIABILITIES + CAPITAL

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Transaction and Accounting equation

When a transaction takes place, it effect in terms of increase or decrease two basic component of accounting equation. To illustrate this concepts the following business transaction are assumed;

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Illustration # 1
1.

Mr. Ali started business with Capital of $20000. The effect of this transaction will be that the cash will increase in business by $ 20000, and Capital of Mr. Ali will also increase by similar amount. The equation will appear as follow;

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ASSATS CASH $ 20000

= =

EQUITIES Alis CAPITAL $ 20000

NOTE: It is important to note that while analyzing business transaction, we are concerned with the business activities of the enterprise which is treated as distinct entity from its owner. Therefore investment of owner is treated as increase in business assets on one hand as will as increase in Capital on the other hand, and vice versa.
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2. Ali purchase building for $ 3000. The transaction will change the composition of assets. The cash will decrease by $ 3000, and building will increase by the similar amount. The equation will be as follows:
ASSATS CASH $ 20000 -(3000) + Building $ 3000
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= =

EQUITIES Alis CAPITAL $ 20000

3. Purchase Machinery from Ahmad for $ 1000. In this transaction the assets increase on one side, while the liability are also increase.
ASSATS CASH + Building + Machinery $ 17000 $ 3000 $ 1000 = = EQUITIES CAPITAL + Account Pay $ 20000 $ 1000

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4. Purchase raw material for cash $ 2000. The transaction will change the composition of assets. The cash will decrease by $ 2000, and material will increase by the similar amount. The equation will be as follows:

ASSATS
CASH + Building + Machinery + Material

= =

EQUITIES CAPITAL + Account Pay $ 20000 $ 1000

$ 17000 ( 2000 )

$ 3000

$ 1000 2000

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5. Paid salaries $ 2000.

The effect of this transaction will decrease Cash and decrease Owner Equity by $ 2000, The equation will be as follows:
ASSATS
CASH + Building + Machinery + Material $ 15000 $ 3000 $ 1000 2000 ( 2000 ) . 13000 + 3000 + 1000 + 20000

= =

EQUITIES CAPITAL + Account Pay $ 20000 $ 1000 ( 2000 ) . 18000 + 1000 19000

190000

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Accounting Equation
ASSETS CASH 20000 Building Machinery Material = EQUITIES Capital 20000 Account Pay

(3000)
17000

3000
3000 1000 20000 1000 20000 2000 3000 3000 1000 1000 =
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17000 (2000) 15000 (2000) 13000 19000

3000

1000 2000 2000

1000 1000 1000

20000 (2000) 18000 19000

ILLUSTRATION # 2
Show the effect of following transaction on assets liabilities and owners equity. 1. Ali commenced a business by investing Rs.30000. 2. Bought Office equipment for Cash Rs.500. 3. Bought furniture on account Rs.1000. 4. Paid office rent Rs.200. 5. Earned Rs.2000, by performing service. 6. Paid salary to a worker Rs.300.

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ACCOUNTING EQUATION
ASSETS
S.No CASH EQUIPEMEN T

=
FURNITURE A/C REC

EQUITIES
CAPITAL A/C PAY

1 Balance 2 Balance 3 Balance 4 Balance 5 Balance 6 Balance

30000 30000 -500 29500 29500 -200 29300 29300 -300 29000

30000 30000 500 500 1000 500 500 500 1000 1000 2000 1000 2000 30000 -200 29800 2000 31800 -300 31500 30000 1000 1000 1000 1000 1000

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ILLUSTRATION # 3
Rehman repair shop has the following assets and Equities on April 2012. Cash 3300 Account receivable $ 1900 Supplies $ 1700 Tools $ 8150 Capital $ 3050 Account Payable $ 12000 During the month the following transaction take place;
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Paid one month rent $ 400. Bought repair supplies $ 100. Paid for supply previously purchase on credit $ 500. Bought tools on credit $ 350. Receive for service rendered $ 900. Service rendered on account $ 210 Received from customer ( Account Receivable) $ 650. Paid for oil and gas used $ 150. Required: Show the effect of above transaction on the accounting equation.
1. 2. 3. 4. 5. 6. 7. 8.
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ACCOUNTING EQUATION
ASSETS
S.No CASH Account Receivable Supplies

=
Tools

EQUITIES
CAPITAL Account Payable

Balances 1 Balance 2 Balance 3 Balance 4 Balance 5 Balance 6 Balance 7 Balance 8

3300 -400 2900 -100 2800 -500 2300 2300 + 900 3200 3200 +650 3850 -150

1900 1900 1900 1900 1900 1900 + 210 2110 -650 1460

1700 1700 + 100 1800 1800 1800 1800 1800 1800

8150 8150 8150 8150 +350 8500 8500 8500 8500

3050 -400 2650 2650 2650 2650 +900 3350 + 210 3760 3760 - 150

12000 12000 15000 -500 11500 + 350 11850 11850 11850 11850

Balance

3700

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3610

11850

Accounting Equation for Merchandise Business

A merchandise business is one where the goods are purchased on a lower cost and they are sold on a higher price. The difference between sale and purchase is called profit. The profit increase owner equity, therefore, it is added in the capital. When the goods are purchased, their cost price is recorded under merchandise inventory as addition on assets side. When the goods are sold, the cost price is deducted from merchandise inventory on the assets side and profit is added to the capital. If the sale is on credit basis, it will increase the Account receivable, and if it is on cash basis it will increase Cash on asset side.
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ILLUSTRATION # 4
Show the effect of the following transaction on Accounting Equation; 1. Anwar started Business with cash $ 55000. 2. Merchandise purchase for cash $ 12000. 3. Sold merchandise to Ali for $ 5600. Cost is $ 4480. 4. Purchase merchandise from Ahmad $ 7500. 5. Cash sales $ 1250. ( Cost $ 1000) 6. Return merchandise to Ahmad $ 150. 7. Credit purchases from Zia $ 2500. 8. Give away merchandise as charity worth $ 100. 9. Owner withdrew merchandise for personal use worth $ 250.

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ACCOUNTING EQUATION
ASSETS
S.No CASH Merchandise Inventory

=
Account Receivable

EQUITIES
CAPITAL Account Payable

1 2 Balance 3 Balance 4 Balance

55000 - 12000 43000 43000 43000 + 1250 44250

55000 12000 12000 - 4480 7520 + 7500 15020 - 1000 14020 - 150 13870 + 2500 16370 - 100 16270 5600 5600 5600 5600 5600 5600 5600 55000 + 1120 56120 7500 56120 + 250 56370 56370 56370 - 100 56270 - 250 7500 7500 - 150 7350 + 2500 9850 9850

5
Balance 6 Balance 7 Balance 8 Balance 9

44250 44250 44250 - 250

Balance

44000

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56020

9850

ILLUSTRATION # 5
Following are the transaction of Mr. Nazeef & Co. 1. Introduce cash as capital $ 20000 2. Purchase merchandise for cash $ 5000. 3. Purchase computer for cash $ 10000. 4. Merchandise costing $ 1400. sold to Ahmad for $ 1800. 5. Purchase merchandise from Akbar for $ 500. 6. Received $ 1000, from Ahmad. 7. Sold merchandise for cash $ 800. which cost $ 750. 8. Paid salaries $ 400.

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ACCOUNTING EQUATION
ASSETS
S.No CASH Merchandise Inventory Computer

=
Account Receivable

EQUITIES
CAPITAL Account Payable

1 2 Balance 3 Balance 4 Balance 5 Balance 6 Balance 7 Balance 8 Balance

20000 - 5000 15000 - 10000 5000 5000 5000 + 1000 6000 + 800 6800 - 400 6400

20000 5000 5000 5000 - 1400 3600 + 500 4100 4100 - 750 3350 3350 10000 10000 1800 10000 10000 10000 10000 10000 1800 1800 - 1000 800 800 800 20000 + 400 20400 500 20400 20400 + 50 20450 -400 20050 500 500 500 500

Totals

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20550

To be sold by students
Q # 1 Mr. Naseer started business with Cash Rs. 10000, and Furniture Rs. 2000. His other transaction were as follows, 1. Purchase merchandise on account Rs. 5000. 2. Purchase equipment for cash Rs. 5000. 3. Sold merchandise costing Rs. 5000, for Rs. 8000, on credit. 4. Received cash against Account Receivable Rs. 5000. 5. Payment to creditor in full settlement of account Rs. 4900. 6. Rs. 500, was privately used by Mr. Naseer. 7. Paid salary for the month Rs. 500.

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Q#2
Show the effect of the following transaction on assets, liabilities and owner equities, 1. Introduce cash by owner Rs. 60000. 2. Purchase merchandise on account from Yasir for Rs. 3500. 3. Sold merchandise to Ali for Rs. 1500 (cost Rs.1000) 4. Paid advertisement expenses Rs. 1000. 5. Sold merchandise for cash for Rs. 1400, cost Rs. 1500. 6. Merchandise given as charity Rs. 150.

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