Accounting Equation
Accounting Equation
Commercial accounting is the key factor for the accounting
equation which means that there must be matching debit and credit entries in the
books of accounts and the balances of both sides of the balance sheet ( assets
and liability) must be equal.
Suppose company A purchased plant & machinery worth Rs. 1,00,00,000 (1 crore) and paid through a bank account. Now the entry will be as under:
P & L
A/c Debit Rs.1,00,00,000
To
bank A/c Credit Rs. 1,00,00,000
Hence, if
company A purchased the plant and machinery, they have to pay its worth either
by way of cash or bank A/c. So there will be two transactions in one deal i. e
receipt of plant and machinery and payment of money in cash or via bank.
In
this deal plant and machinery and cash or bank balance are the assets of
company A. Now, in this case, again the value of plant and machinery will
increase by Rs. 1,00,00,000 (1 crore) whereas the cash or bank balance will
decrease by the corresponding amount of Rs. 1,00,00,000 (1 crore) and therefore,
there will not be any effect in the total of the assets side and the balance of
both sides of the balance sheet (assets and liability) will remain the
same.
This is called the double entry system of bookkeeping or commercial
accounting which is based on the accounting equation.
Basis of Accounting Equation
There are
three main pillars of the accounting equation viz. Assets, Liabilities, and
Shareholder's Equity. The shareholder's equity is shown on the liability side
of the balance sheet.
Thus, there are only two sides to the balance sheet
wherein all transactions of a business are entered. For example:
Mr. A, the
owner of company A, invest Rs. 5 crores in his business. His company purchased
goods worth Rs. 2 crores. The company entry A accounts will be as under:
1. Bank
A/c Debit 5,00,00,000
To
Mr. A (equity) credit 5,00,00,000
2. Goods
A/c Debit 2,00,00,000
To Bank A/c Credit 2,00,00,000
Now again
in these transactions, the bank A/c and goods are the assets of the
company whereas the owner's equity (Mr. A's investment) is a liability. Thus, the
assets ( goods) increased by Rs. 2 crores and the other head of assets (Bank
balance) decreased by the same amount of Rs. 2 crores.
Hence, the assets side
will remain the same at Rs. 5 crore and liability will remain unchanged i. e. Rs.
5 crore (owner's equity)
An NGO
received govt aid of Rs. 50 lakh and a donation of Rs. 75 lakh during the year. So its
total receipt will be Rs. 1 crore 25 lacks during that year.
Now that NGO
incurred expenditure of Rs. 10 lakh on transportation, 10 lacks on other
activities, and 50 lacks on its main activity. Hence the income of the NGO will
be Rs. 1 Crore 25 lakh (50+75) and expenditure against it is Rs. 70 lakh
(10+10+50). The income of that NGO will be Rs. 55 lacks (1.25 crore - .70 crore)
during that year.
This income will appear in the assets side of the balance
sheet by increasing the cash or bank a/c with Rs. .70 crore and also as
reflected in the liability side by increasing the liability with the same
amount i.e. Rs. .70 crore.
In this
way, both sides of income and expenditure and the balance sheet will remain the
same and tally at the end of the year because these are prepared based on double entry booking of accounting or based on the accounting
equation.
CONCLUSION
As stated
above, the double entry system or commercial accounting system is the backbone of the accounting equation wherein for every business transaction, there will be
double entry i.e. one on the debt side and the other on the credit side.
In this way, the final balances of all ledger accounts when taken into final accounts i.e
balance sheet via trial balance will give the result of telly both the side of
the balance sheet (assets and liability) and will not only create confidence in
the accountants that they have prepared the correct accounts but also will
reflect that the accounts of the company are prepared based on accounting equation or double entry system or commercial accounting which is
accepted all over the world.