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Assets, liabilities and capital are the three basic elements of every business transaction. The relationship between these terms, as mentioned above in the form of Accounting Equation remains unchanged. It has been a mathematical truth. No business transaction can upset the relationship between these items. The interrelationship of assets, liabilities and capital results into nine transactions. These transactions show that change in one element results in corresponding change in the same item or in other element. These nine basic transactions are as under :

(i) Increase in assets with corresponding increase in capital.

(ii) Increase in assets with corresponding increase in liabilities.

(iii) Increase and decrease in assets.

(iv) Decrease in assets with corresponding decrease in liabilities.

(v) Decrease in assets with corresponding decrease in capital.

(vi) Increase and decrease in liabilities.

(vii) Increase and decrease in capital.

(viii) Increase in liabilities and decrease in capital.

(ix) Increase in capital and decrease in liabilities.

(i) Increase in assets with corresponding increase in capital. Commencement of business with $ 20,000 increases both the assets and capital of the firm. At the same time, it will affect the financial position of the business as under : 

Financial Position (Balance Sheet)

(ii) Increase in assets with corresponding increase in liabilities. Purchase of goods on credit for $ 7,000 will increase stock of goods with $ 7,000 and also increase creditors ‘liabilities. The transaction will affect the financial position as under :

Financial Position (Balance Sheet)

The position can be presented alternatively as under :

(iii) Increase and decrease in assets. Purchase of furniture worth $ 3,000 involves furniture and cash, the two assets. The transaction will increase furniture as an asset and decrease cash, also an asset Increase and decrease in the assets with the same amount will not upset the equation. The transaction can be expressed as follows :

(iv) Decrease in assets with corresponding decrease in liabilities. Payment of dolor 2,000 to creditors will decrease creditors, the liabilities of the business and at the same time cash an asset will decrease. The decrease in assets and liabilities simultaneously with the same amount will hold the Accounting Equation true. The transaction will effect the Accounting Equation as follows :

(v) Decrease in assets with corresponding decrease in capital. $ 4,000 withdrawn by the proprietor for personal use will reduce capital and also cash, an asset simultaneously with $ 4,000. The transaction still proves the validity of Accounting Equation as under :

The financial position of the business up to 5th transaction will be as under : 

Financial Position (Balance Sheet)

(vi) Increase and decrease in liabilities. Creditors for goods sometimes draw a bill of exchange on us as per the arrangement of the payment. After acceptance of the bill, the payment becomes due for payment after the expiry of certain specified period. Acceptance of the bill reduces creditor’s liability and creates another liability, known as bills payable, the bill whose payment has to be made. If we accept a bill for dolor 1,500 creditors will be reduced to $ 5,000- 1,500 = 3,500 and fresh liability known as Bills Payable will come into our records. The transaction will affect the financial position of the business as under :

Financial Position (Balance Sheet)

       The above position can alternatively be presented as under :

(vii) Increase and decrease in capital. Certain transactions involve capital only, such as transfer of share of the company from one shareholder to another shareholder. In this case, the capital of the company will increase and decrease with the same amount and this will remain unchanged. There will be change in the name of shareholder which will be recorded in the transfer register of the company. Interest on capital is another item affecting capital only. Proprietors capital will increase with the amount of interest allowed to him. Interest – . on capital is the expense of the business, so it will have to be borne by the proprietor and thus charged out of capital account. The net result will be an increase and decrease in capital simultaneously with the same figure and accounting equation will still prove to be true. Financial position of the business will remain unchanged.

(viii) Increase in liabilities and decrease in capital. In certain cases, capital may be converted into loan, as a liability. Such transactions may happen, when a partner retires from the firm and the capital refundable.to him is transferred to his loan account. In this case, the firm will be showing partner’s loan as a liability instead of partner’s capital. In case of death of a partner amount payable to the legal inheritor of the deceased partner is transferred to partner’s executor’s loan account. This transaction will also decrease capital and increase liability. If $ 5,000 is transferred from capital account to loan account the financial position will be as under:

Financial Position (Balance Sheet)

            The above position can also be presented as under :

( ix) Increase in capital and decrease in liabilities. Conversion of loan into capital reduces the liability of the business on one hand and increases capital on the other hand. Conversion of debentures into share capital is an example of such transaction. Creditors may also be converted into share capital. If creditors for $ 1,000 are allotted shares against their loan, the financial position will be affected as under: 

Financial Position (Balance Sheet)

 

The financial position shows that capital has increased by $ l, 000 and is now $ 11,000 + l, 000 = 12,000 and at the same time creditors have been reduced to $ 3,500- I, 000 = 2,500.

The fact can alternatively be presented as under :

The basic nine transactions discussed above are summarised through the following illustrations. 

Illustration 1. Develop accounting equation from the following transactions :  

(i) Adi commenced business with cash …………… …………………………………….. …………… .. 50,000

(ii) Purchased goods for cash ……………………………………………………… ,………………………. 30,000

(iii) Purchased goods on credit…….. ………………………………………………………………………. 20,000

(iv) Sold goods (cost Rs. 10,000) for …………… ……………………………………… …………… …. 12,000

(v) Bought furniture on credit ………………………………………………………………………………….. 2,000

(vi) Paid cash to a creditor………………………………………………………………….. ……………….. 15,000

Solution. 

Accounting Equation

TREATMENT OF REVENUE PAYMENTS AND RECEIPTS

(a)    Revenue Payments 

(i)                 Treatment of expenses paid. The business had to pay certain expenses in its day-to- ay operations, such as payment of salaries, rent, insurance premium, office expenses, wages, repairs, etc. These expenses are paid regularly. These business expenses are paid in cash, so cash will reduce and thus payment of expenses are reduced from cash balance. These expenses will also reduce net income of the business. As the income is the reward paid to proprietor for the risk undertaken by him so expenses will reduce proprietor’s reward. Proprietor is represented by Capital Account so the payment of expenses will decrease capital.

(ii)               Treatment of outstanding expenses. If expenses relate to accounting period and remain unpaid, they are termed as outstanding expenses. Outstanding salaries, rent unpaid, wages due, repairs due but not paid are its certain examples. As these expenses relate to the accounting period, so they will reduce capital of the proprietor. Both the cases of expenses paid and expenses due are treated at par as regards decrease in the capital of the proprietor. They are different in the sense that expenses paid reduce cash balance but expenses outstanding do not reduce cash balance. As these expenses are still payable, it is a liability of the business and thus increase liability. 

(iii)             Treatment of prepaid or unexpired expenses. There may be certain cases where expense may have been paid in advance. In certain cases, expenses relating to the next accounting period may be paid during the current year. These expenses are prepaid or unexpired i. ~., insurance and rent paid in advance for the next following year. Prepaid expenses increase and decrease assets simultaneously. The payment has been made in cash, so cash will be reduced. As the expenses have been paid during the current year for the next year, it will be an asset for the current year because the amount has to be realised by the current year from the following year : 

 

Illustration 2. Show the effect of following transactions on accounting equation and also prepare a Balance Sheet :

(i)                 Started business with cash amounting to dolor 35,000 and goods ……………….. …. ……..

  1. a.      dolo 15,000

(ii)               Salaries paid……………….. ….. …… …… ………. ………. …………………….. …………… … .. 2,000

(iii)             Wages outstanding … ……….. …… ……… ….. ……….. ……….. ….. ………………………….. ..200

(iv)             Prepaid insurance ……… ………………………………….. ……… . . .. .. . … . ..   ……. …… . … 7oo

(v)               Interest due but nor paid .. ….. …. . …. ……………. …… …………………… … …… ……….  100

(vi)             Rent paid in advance ..  … ….. ….. . ..  ………. .. . ….. …. …  ……… .. …..  · .. . ….. ……..150

Solution. 

Accounting Equation

The accounting facts presented by the above accounting equation can also be verified by the  following Balance Sheet :

Balance Sheet 

(b) Revenue Receipts

(i) Income received. The business receives certain income during its day-to-day operations. The  income is received regularly. Rent received, commission earned and discount received, etc. are its examples. As the income is received in cash it increases cash balance on the one hand and also increases proprietor’s car its!. Proprietor’s claim against the assets of business increases with every income, so the income earned is added to capital.

(ii) Income due but not received or accrued income. The income has been earned  using the year, so proprietors capital will increase but as income is accrued or still to be received it will be treated as assets. The income relates to the current year, so it will increase current year’s income. The income has become due from other parties so the concerned party will be the debtor of the firm . Debtor’s being assets, accrued income will also be an asset. 

(iii) Unearned income or income received in advance. It is just possible that we may have received certain income in advance. The income has been received during the current year, although it relates to the next year. As the income has been received in cash, it will increase cash balance. The income actually belongs to the next year but has been received by the current year, as such it will be a liability of the current year towards next year. 

 

Illustration 3. Show the effect of the following transactions on assets, liabilities and capital using accounting equation. Also prepare Balance Sheet.

(i)                 Started business with cash…………………………………………………………………….. $ 60,000

(ii)               Rent received. ………… ………….. ………………………………….. ………. …. ……………. $ 2,000

(iii)             Accrued interest ……… …………………………………………………….. …………………. …… $ 500

(ii)               Commissionreceived in advance ……………………………………………………………….. $ 1,000 

Solution

Account Equation

Accounting facts presented by the above accounting equation is also presented in the form of  balance Sheet.

Balance Sheet

TREATMENT OF PURCHASES AND SALES 

(a) Purchases

(i) Cash purchases. Purchases of goods for cash affects assets only. It increases stock of goods with the business a Paid at the same time decreases cash, because the payment for goods has been made in cash.

(ii) Credit purchases. The transaction increases stock of goods, an asset but also creates a liability. Payments to creditors have not been made so far, as such liability to creditors is still there. Credit purchases, therefore increase both assets and liabilities at the same time.

Payment to creditors in cash will reduce cash, an asset and also creditors, a liability. If creditors draw a bill of exchange, the fi1m will accept the bill and thus a liability, as Bills Payable will be created in place of creditors. In this way, the transaction will decrease creditors and also create a liability as Bills Payable. In certain cases, if the payment to creditors is made immediately and creditors allow us discount, the transaction will reduce cash with actual amount paid, increase capital with the amount of discount received and decrease creditors with the amount of actual payment plus discount. For example, if we purchase goods worth Dolor 1,000 from Anshu on credit and make a payment of $ 990 in full settlement. The payment will reduce creditors by$1, 000, cash by $ 990 and also increase capital by $10. 

 (b) Sales

(i) Cash sales. It is the sincere effort of every business to sell goods at a price more than its cost price. Excess of sales price over the cost price is profit and will increase capital. For example, if goods costing $ 1,740 are sold for $2,000, it will increase cash by $ 2,000, reduce stock of goods by $ 1,740 and the resultant profit i.e., $ 2,000- 1,740 = 260 will be added to capital. 

(ii) Credit sales. In case goods costing $ 2,700 are sold for $ 3,000 on credit, it will increase debtors, the assets of the firm by $ 3,000, reduce stock of goods by $ 2,700 and also increase capital with $ 3,000- 2,700 = $ 300. In this case, if full payment is received from debtors, it will increase cash and decrease debtors. Cash and debtors are both assets, so the effect of the transaction will be restricted to assets only. In the above case, if we receive $ 2,900 from debtors and allow them dolor 100 as discount, the transaction will increase cash by $ 2,900, reduce capital with the amount of discount allowed i.e., $ 100 and at the same time decrease debtors, by $ 3,000. · 

TREATMENT OF MISCELLANEOUS TRANSACTIONS 

(a) Amount withdrawn by the proprietor. If the proprietor withdraws $ 2,000 for personal use, the transaction will reduce cash by $ 2,000 and at the same time reduce proprietor’s capital. In case the proprietor takes certain goods for domestic use, it will decrease his capital and the stock of goods. 

(b) Depreciation on assets. Depreciation is the wear and tear or loss in the value of assets due to its use, so it will reduce assets and capital at the same time. For example, if there is a depreciation of $ 2,000 on plant, the transaction will reduce plant by $ 2,000. As depreciation is a loss it will also reduce capital.

(c) Interest on capital. Capital is the liability of the business. Interest on a liability is an expense and thus capital will be reduced. Interest on capital is credited to capital account, so capital will be Increased. The transaction will increase and also decrease the capital. 

(d) Drawing is the amount withdrawn by the proprietor from the business. In – other words, it is the amount advanced by the firm to the proprietor and thus interest on drawings will be received by the firm and capital will be increased. Interest ort drawings will be charged on proprietor’s capital, so the capital will be reduced. This transaction will also result in the increase and decrease of capital. 

 

Illustration 4. Show the effect of the following business transactions on assets, liabilities and

Capital through accounting equation: 

(i) Commenced business with cash……………………………………………………………………….. $20.000

(ii) Goods purchased on credit ………………………………………………………………………………$ 7,000

(iii) Furniture purchased ……………………………………………………………………………………… $3,000

(i v) Paid to creditors …………………………………………………………………………………………… $2,000

(v) Amount withdrawn by the proprietor ………………………………………………………………… $4,000

(vi) Creditors accepted a bill for…………………………………………………………………………… $1,500

(v1i) Interest on capital ………………………………………………………………………………….. ….. $1,000

(viii) Transfer from capital to loan …………………………….. ………………….. ……. …………… $5,000

(ix) Allotted shares to creditors ……………………………………………………………………………. $1,000 

Solution. The inter-relationship of nine transactions may be summarized as under :

The above accounting equation proves that whatever the transaction, assets are always equal to capital and liabilities. The fact can also be verified by the Previous Financial Position (Balance Sheet).

 

Illustration 5. Prove that the accounting equation is satisfied in all the following transactions.

Verify the result with Balance Sheet of the last new equation:

(i) Rajesh started business with:

Cash ………………………………………………………………………………. $20,000

Goods ………………………………………………………………………………………$12,000

Machine ……………………………………………………………………………………..$8,000

(ii) He purchased goods …………………………………………………………………. ………………………$5,000

(iii) Sold goods (Costing $ 2,000) for $ . ………………………………………….. ……. ……..……..$2,500

(iv) Purchased goods on credit ……….. ………………… ……….. …………………. ……………… ….$7,000

(v) Payment made to creditors in full settlement.. ………….. ………….. ………………………… .$6,9000

(vi) Sold goods on credit (Costing $ 5,400) ………………………………………………………….. .. ..$6,000

(vii) Payment received from debtors ……………….. .. , ………………………. ……… ………………..$5,800

Discount allowed ………………………………………….. …. ……………….. ………… ……….. .$200

(viii) Salaries paid ……………………. ……………. ………… …… ………… ……………………………….$4,000

(ix) Wages outstanding. ……………………………………………………………….. ….. ……….. …. …… .$400

(x) Prepaid insurance ……. …. ……….. …. …… ……. … ……………………………………………………..$100

(xi) Rent received ……………………… ………………………… ……………………………….. …………….. ..$300

(xii)Amount withdrawn………………………………………………………………………………………$3,000

(xiii) Interest on drawing ………………………………………. ….. …… .. …………………. ……………… .$200

(xiv) Depreciation on machinery …………………………………………. ……. …………….. …… ……… .$810

(xv) Purchased goods on credit …………………………… ………….. ………….. …….. ………………$17,000

Solution.                                            

Accounting Equation

 Balance Sheet