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Accounting Equation Explanation

Impact of all previous transactions on Accounting Equation:

Suppose Mr. Gill, a sole trader, has decided to establish a business in leather jackets. He made all of the above transactions. Let’s look the impact of above transactions on accounting equation one by one.


Introduction of capital
Mr. Gill starts his business by putting Rs. 500,000 as capital into his business and put all the cash into newly opened business bank account.

 Impact on accounting equation:
Asset will be increased by Rs. 500,000 under a new head cash or Bank account.
Equity will be increased by Rs. 500,000 under a new head owner’s capital.

 Assets                                   =    Equity                                    +    Liabilities
                 Rs.                                                  Rs.                                                      Rs Cash/Bank      500,000          Capital               500,000                                        ----------
                  
              500,000 =                                   500,000    +                                 ----------

Total assets are equal to combined total of equity plus liabilities. Both sides of accounting equation are increased by Rs. 500,000.


Purchase of asset on cash
Mr. Gill purchases furniture for his office and pays Rs. 70,000 in cash.

 Impact on accounting equation:
Cash will be decreased by Rs. 70,000.
There will be a new asset i.e. furniture of Rs. 70,000.
Assets                                   =            Equity                                   +            Liabilities
                                    Rs.                                                          Rs.                                                          Rs.
Cash                      430,000
Furniture               70,000                 Capital                  500,000                                 ----------
                                500,000 =                                             500,000 +                                             ----------

Total assets are equal to combined total of equity plus liabilities. L.H.S. of accounting equation is just divided into two categories of assets.

Purchase of asset on credit
Mr. Gill Purchases a van for Rs. 150,000 on credit from a supplier and does not have to pay immediately.

 Impact on accounting equation:
There will be a new asset i.e. van of Rs. 150,000.
By acquiring van on credit it created a liability because Mr. Gill owes Rs. 150,000 to his supplier. This liability will be recorded under the head “Trade Payables”.
Assets                                   =            Equity                                   +            Liabilities
                                    Rs.                                                          Rs.                                                          Rs.
Cash                      430,000
Furniture               70,000
Van                        150,000 Capital                  500,000 Trade Payables 150,000
                                650,000 =                                             500,000 +                                             150,000
Total assets are equal to combined total of equity plus liabilities. Both sides of accounting equation are increased by Rs. 150,000.
Purchase of inventory on cash
Mr. Gill purchases 100 units of leather jackets @ Rs. 500 each, paying total amount of Rs. 50,000 in cash.

 Impact on accounting equation:
There will be a new asset i.e. inventory (leather jackets) of Rs. 50,000.
Cash will be decreased by Rs. 50,000.
Assets                                   =            Equity                                   +            Liabilities
                                    Rs.                                                          Rs.                                                          Rs.
Cash                      380,000
Furniture               70,000
Van                        150,000
Inventory              50,000                 Capital                  500,000 Trade Payables 150,000
                                650,000 =                                             500,000 +                                             150,000
Total assets are equal to combined total of equity plus liabilities. L.H.S. of accounting equation is just divided into more categories of assets.


Purchase of inventory on credit
Mr. Gill purchases 1,000 units of leather jackets @ Rs. 500 each on credit and does not have to pay immediately. Total amount due is Rs. 500,000 (1,000 x 500).

 Impact on accounting equation:
Inventory will be increased by worth Rs. 500,000.
Trade Payables will be increased by Rs. 500,000.
Assets                                   =            Equity                                   +            Liabilities
                                    Rs.                                                          Rs.                                                          Rs.
Cash                      380,000
Furniture               70,000
Van                        150,000
Inventory            550,000 Capital                  500,000 Trade Payables 650,000
                                1,150,000 =                                         500,000 +                                             650,000
Total assets are equal to combined total of equity plus liabilities. Both sides of accounting equation are increased by Rs. 500,000.


Cash sales
Mr. Gill sells 400 units of leather jackets @ Rs. 700 each, receiving total amount of Rs. 280,000 in cash.

 Impact on accounting equation:
Inventory will be decreased by worth Rs. 200,000. (At cost)
Cash will be increased by Rs. 280,000.
Difference of sales value and cost value of the units sold is the profit of the business i.e. (400x700) – (400x500) = 80,000 and will be treated as profit under equity.
Assets                                   =            Equity                                   +            Liabilities
                                    Rs.                                                          Rs.                                                          Rs.
Cash                      660,000
Furniture               70,000
Van                        150,000 Capital                  500,000
Inventory            350,000 Profit                     80,000                   Trade Payables 650,000
                                1,230,000 =                                         580,000 +                                             650,000
Total assets are equal to combined total of equity plus liabilities. R.H.S. of accounting equation is just divided into more categories of Equity and both sides of accounting equation are increased by Rs. 80,000.


Credit sales
Mr. Gill sells 600 units of leather jackets @ Rs. 900 each and will not receive cash immediately. Total amount receivable is Rs. 540,000 (600 x 900).

 Impact on accounting equation:
Inventory will be decreased by worth Rs. 300,000. (At cost)
The amount receivable will be treated as an asset under a new head i.e. Trade Receivables with Rs. 540,000.
Difference of sales value and cost value of the units sold is the profit of the business i.e. (600x900) – (600x500) = 240,000 and will be added in profit under equity.
Assets                                   =            Equity                                   +            Liabilities
                                    Rs.                                                          Rs.                                                          Rs.
Cash                      660,000
Furniture               70,000
Van                        150,000
Inventory            50,000                   Capital                  500,000
Trade Receivables           540,000 Profit                     320,000 Trade Payables 650,000
                                1,470,000 =                                         820,000 +                                             650,000
Total assets are equal to combined total of equity plus liabilities. L.H.S. of accounting equation is just divided into more categories of Assets and both sides of accounting equation are increased by Rs. 240,000.


Borrowing Money (Loan)
Mr. Gill borrows Rs. 150,000 from his friend in order to make an urgent payment to his payables for the settlement of van he purchased earlier.

 Impact on accounting equation:
Trade Payable will be decreased by Rs. 150,000.
The amount borrowed from the friend will be treated as a liability under a new head i.e. loan with Rs. 150,000.
Assets                                   =            Equity                                   +            Liabilities
                                    Rs.                                                          Rs.                                                          Rs.
Cash                      660,000
Furniture             70,000
Van                        150,000
Inventory            50,000                   Capital                  500,000 Trade Payables 500,000
Trade Receivables           540,000 Profit                     320,000 Loan                      150,000
                                1,470,000 =                                         820,000 +                                             650,000
Total assets are equal to combined total of equity plus liabilities. R.H.S. of accounting equation is just divided into more categories of Liabilities.


Cash received from customers (trade receivables)
Mr. Gill receives Rs. 140,000 from his customers against some of the credit sales he made earlier.

 Impact on accounting equation:
Trade receivables will be decreased by Rs. 140,000.
Cash will be increased by Rs. 140,000.
Assets                                   =            Equity                                   +            Liabilities
                                    Rs.                                                          Rs.                                                          Rs.
Cash                      800,000
Furniture             70,000
Van                        150,000
Inventory            50,000                   Capital                  500,000 Trade Payables 500,000
Trade Receivables           400,000 Profit                     320,000 Loan                      150,000
                                1,470,000 =                                         820,000 +                                             650,000
Total assets are equal to combined total of equity plus liabilities. L.H.S. of accounting equation remains the same as both aspects of the business transaction cancel each other and net effect is zero.


Payment to suppliers (Trade Payables)
Mr. Gill pays Rs. 100,000 to his supplier against some of the credit purchase he made earlier.

 Impact on accounting equation:
Trade payables will be decreased by Rs. 100,000.
Cash will be decreased by Rs. 100,000.
Assets                                   =            Equity                                   +            Liabilities
                                    Rs.                                                          Rs.                                                          Rs.
Cash                      700,000
Furniture             70,000
Van                        150,000
Inventory            50,000                   Capital                  500,000 Trade Payables 400,000
Trade Receivables           400,000 Profit                     320,000 Loan                      150,000
                                1,370,000 =                                         820,000 +                                             550,000
Total assets are equal to combined total of equity plus liabilities and both sides of accounting equation are decreased by Rs. 100,000.


Drawings (Both in cash & in kind)
Mr. Gill takes a cash out of Rs. 100,000 for his personal use (cash drawings) and he also take 10 leather jackets (drawings in kind) worth Rs. 500 each. (Total worth 500x10 = 10,000)

 Impact on accounting equation:
Cash Drawings:
Cash will be decreased by Rs. 100,000
Capital will be decreased by Rs. 100,000 but under another head i.e. Drawings
Drawings in kind:
Inventory will be decreased by worth Rs. 10,000
Capital will be decreased by Rs. 10,000 but under another head i.e. Drawings

Assets                                   =            Equity                                   +            Liabilities
                                    Rs.                                                          Rs.                                                          Rs.
Cash                      600,000
Furniture             70,000
Van                        150,000 Capital                  500,000
Inventory            40,000                   Profit                     320,000 Trade Payables 400,000
Trade Receivables           400,000 Drawings             (110,000)             Loan                      150,000
                                1,260,000 =                                         710,000 +                                             550,000
Total assets are equal to combined total of equity plus liabilities. R.H.S. of accounting equation is just divided into more categories of Equity and both sides of accounting equation are decreased by Rs. 110,000.


Payment against Loan
Mr. Gill settles the entire amount against loan; he borrowed from his from, by paying cash of Rs. 150,000.

 Impact on accounting equation:
Cash will be decreased by Rs. 150,000
Loan will be written off against its payment leaving no record of loan in the liabilities side of accounting equation.

Assets                                   =            Equity                                   +            Liabilities
                                    Rs.                                                          Rs.                                                          Rs.
Cash                      450,000
Furniture             70,000
Van                        150,000 Capital                  500,000
Inventory            40,000                   Profit                     320,000 Trade Payables 400,000
Trade Receivables           400,000 Drawings             (110,000)            
                                1,110,000 =                                         710,000 +                                             400,000

Total assets are equal to combined total of equity plus liabilities. R.H.S. of accounting equation is just divided into fewer categories of liabilities by writing off the loan and both sides of accounting equation are decreased by Rs. 150,000.

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