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.
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
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
2. Increase in asset with corresponding increase in liabilities
3. Decrease in asset with corresponding decrease in capital
4. Decrease in asset with corresponding decrease in liability
5. Increase and decrease in assets
6. Increase and decrease in liabilities
7. Increase and decrease in capital
8. Increase in liabilities and decrease in capital
9. Increase in capital and decrease in liabilities