The recording of business transaction in books of accounts is based on a fundamental equation called Accounting Equation. Whatever business possesses in the form of assets is financed by proprietor or by outsiders. This equation expresses the equality of assets on one side and the claims of outsiders (liabilities) and owners or proprietors (capital) on the other side.

An Accounting Equation is a mathematical expression which shows that the assets and liabilities of a firm are equal.

Assets = Liabilities + Capital

Whenever an asset is introduced in the business, a corresponding liability also appears.

Effect of Transactions on Accounting Equation

1. Suppose, Mr.John starts business with cash INR 2,00,000 introduced as capital.

Assets (cash) = Liabilities + Capital

INR 2,00,000 = 0 + INR 2,00,000

This transaction means that INR 2,00,000 have been introduced by Mr.John in terms of cash, which is the capital for the business concern.

2. He purchased furniture for cash worth INR 20,000.

Assets = Cash + Furniture = INR 1,80,000 + INR 20,000 = INR 2,00,000

This transaction has its effect only on the assets, as one asset has been purchased against the other. In this transaction, furniture is purchased against cash. Furniture and cash both are assets.

3. He purchased goods from for INR 40,000 on credit

Asset = Cash + Furniture + Goods = 1,80,000 + 20,000 + 40,000 = INR 2,40,000

Capital + Liabilities = 2,00,000 + 40,000 = INR 2,40,000

Types of Transactions

The inter-relationship between assets, liabilities and capital can be expressed in various forms. Nine combinations can be created.

1. Increase in asset with corresponding increase in capital

  • Example: Started business with cash.

2. Increase in asset with corresponding increase in liabilities

  • Example: Goods purchased on credit.

3. Decrease in asset with corresponding decrease in capital

  • Example: Cash withdrawn from the business by the proprietor for personal use.

4. Decrease in asset with corresponding decrease in liability

  • Example: Cash paid to the creditor.

5. Increase and decrease in assets

  • Example: Furniture purchased for cash, Goods purchased for cash, etc.

6. Increase and decrease in liabilities

  • Example: Payment made to creditors by taking loan from bank.

7. Increase and decrease in capital

  • Example: Interest on Capital.

8. Increase in liabilities and decrease in capital

  • Example: Wages due but not yet paid, outstanding salaries.

9. Increase in capital and decrease in liabilities

  • Example: Conversion of loan (provided by the owner) into capital.

Rules for Accounting Equation

  1. Capital: When capital is increased, it is credited (+) and when some part of the capital is withdrawn, i.e., drawings are made, it is debited (-).
  2. Revenue: Owner's equity (Capital) is increased by the amount of revenue.
  3. Expenses: Owner's equity (Capital) is decreased by the amount of expenses.
  4. Outsider's Equity: When liabilities are increased, outsiders' liabilities are credited (+).
  5. Assets: If there is an increase in Assets, the increase is debited (+) in the Asset Account. If there is decrease in Assets, the decrease in credited (-) in the Asset Account.
  6. Effects of Outstanding Expenses: Increase in liabilities and decrease in capital.
  7. Accrued Income: Increase in asset and increase in capital.
  8. Income Received in Advance: Increase in asset (as cash) and increase in liabilities.
  9. Interest on Capital is an expense for the business, and thus, profit is reduced by the amount and since interest on capital is an income for the owner it is added to capital. So the net effect of this transaction is nil on capital.
  10. Asset and Liabilities will not be affected by interest on capital and interest on drawings.