Accounting Equestion and Double Entry
In its simplest form, the accounting equation states that Total Assets equal Total Capital. Total capital is made up all funds which finance all resources or assets of a business. Total assets of a business are financed by the owners who inject capital. Often, the owners are unable to finance all activities of a business on their own, particularly for large businesses. Some other parties who do not have ownership interest also finance activities of a business by extending credit and loans. These are known as liabilities. Thus, Total capital consists of liabilities and owner's equity.
Assets are resources of value the firm utilizes in conducting business. Two common distinctions are made between Non-current assets and Current assets. Non-current assets are those resources acquired by the business not for the intention of re-selling but are kept to facilitate smooth operation of the business. Usually they retain their form, have long lives and cost substantial amounts of money. Examples of non-current assets are Land, Buildings, Machinery, Motor Vehicles, Furniture and Equipment.
Current assets are those resources acquired by the business and which change from one form to another within an accounting cycle as a result of business activities. In other words, current assets are resources either in the form of cash or are close to being converted into cash within a short period of time normally a year. Stocks in the stores are converted into Debtors when they are sold on credit. Debtors are then converted into Cash when outstanding amounts are settled. Cash can then be converted into Stocks again. Stocks, Debtors and Cash are therefore, examples of current assets.
Liabilities are what other individuals and firms have temporarily contributed towards financing assets of the firm and amounts that are owing to parties external to the firm. These are distinguished between current and long-term liabilities. Current liabilities are those obligations which have to be repaid within one accounting cycle, usually 12 months. Long-term liabilities are those obligations which do not have to be met within one accounting cycle. These extend over twelve months. Examples of current liabilities are Trade Creditors, Unpaid electricity bills, Bank overdrafts, etc. Examples of long-term liabilities are Bank loans extending over one year, long term lease financing obligations, etc.
The accounting equation can at this stage be expressed as:
Assets = Liabilities + Owner’s Equity
This equation may be proved with a number of simple examples.
Transaction | Assets | Liabilities | Owner’s Equity |
---|---|---|---|
Owner puts shs. 50,000 cash to start business | +50,000 cash | +50,000 | |
Firm buys lorry for cash shs. 10,000 | -10,000 cash | ||
+10,000 lorry | |||
Firm borrows shs. 30,000 from a bank | +30,000 cash | +30,000 loan | |
Firm buys shs. 20,000 stock on credit from a supplier | +20,000 stock | +20,000 creditor | |
Total Assets, Liabilities and Capital | +100,000 | +50,000 | +50,000 |
Note that up to this point no sales have been made.
Owner's Equity is increased by additional capital contributions and profits. Profits is the excess of revenues over expenses. Owner's equity is decreased by capital withdrawals and losses. Losses occur when revenues are unable to cover expenses.
The expanded accounting equation can be shown as follows:
Assets = Liabilities + Owner's Equity + (Revenues - Expenses)
The example may be extended to consider the following independent cases:
Before considering (a), (b) and (c) above a summary of assets, liabilities and owner’s equity is as follows:
Assets | Liabilities | Capital | ||
---|---|---|---|---|
Cash | 70,000 | Loan | 30,000 | |
Stocks | 20,000 | Creditors | 20,000 | 50,000 |
Lorry | 10,000 | |||
100,000 | 50,000 | 50,000 |
In this case cash increases by shs. 20,000 while stocks decrease by a similar value. Since cash and stocks are all assets by definition, this transaction does not affect the total assets figure.
This situation results in a decrease in stocks by a value of shs. 20,000. Although this is also a sale as in situation (a), no cash is received. Instead the firm is promised to be paid at a later date. Such a transaction results in creation of an asset in the form of a debt. Again there is no change in total assets as this is also a swap between two forms of assets, which is stocks and a debtor.
In this case a difference is encountered because stock was sold at a profit, that is, at a price more than it cost to the firm to acquire. Stocks decreased by a value of shs. 20,000 but cash increased by a larger value of shs. 30,000. The net change in total assets was an increase of shs. 10,000. Since profits increase capital, the profit of shs. 10,000 increased owner's equity. Profits always increase owner's equity, if not withdrawn.
The ending position of the equation would be as follows, assuming transaction (c) was effected:
Assets | Amount(TZS) | Liabilities | Amount (TZS) | Capital(TZS) |
---|---|---|---|---|
Cash | 100,000 | Loan | 30,000 | 50,000 |
Lorry | 10,000 | Creditors | 20,000 | 10,000 |
110,000 | 50,000 | 60,000 |
In addition to cost of stock, firms incur expenses in the course of conducting business; these must also be deducted from Revenues.
Using the accounting equation, the dual aspects or compensating effects of every transaction in the different categories of accounts may be summarized as follow:
It can be observed from the above summary that to maintain the equality of the accounting equation: Assets = Liabilities + Owner's equity; an increase on one side of the equation will have the corresponding effect of either:
In the same way a decrease on one side of the equation will have the corresponding effect of either:
Every business transaction affects two sides, the debit and credit sides. Equal debit and credit entries are made for every transaction. When an amount is entered on the left side, the account is said to be debited, and when an amount is entered on the right side the account is said to be credited. The difference between the total debits and total credits is the balance of the account. The balance may be either a debit balance if the debit side exceeds the credit side; or a credit balance if the credit side exceeds the debit side. When the total debits equal the total credits, the account is said to have nil or zero balance.
The words "debit" and "credit" should not be confused with "increase" or "decrease". Certain accounts may increase when debited and other accounts may increase when credited depending on the type of account involved.
For journalizing the transaction, it is better to analyze the transaction into the type of account so that it may help in recognizing the transaction into which account it is related. The account can be classified into three categories.
These accounts are relating to transactions with persons. The transaction may be concerning the amount received or receivable, paid or payable t any person like Mr. Musa, Kaleb, BM Company Limited. etc.
These are accounts of assets. Resources of value owned by the business which are expected to benefit future operations of the business are known as assets.
The balances of real assets are carried forward into the succeeding accounting year.
These are accounts relating to gains or losses and expenses such as the accounts of salaries, rent, interest, discount allowed, electricity expenses, commission received or dividend received etc.
The balances of such accounts are transferred to the income statement at the end of the accounting period.
From the following information, state the nature of account (Personal, Real or Nominal) and show which account will be debited and which account will be credited:
Name of account | Nature of account | Debit or Credit | Analysis |
---|---|---|---|
Building Cash |
Real Real |
Debited Credited |
Building comes in Cash goes out from business. |
Furniture Sangoti Ltd. |
Real Personal |
Debited Credited |
Furniture comes in The person gave asset to the business. |
Bank Cash |
Personal Real |
Debited Credited |
Bank receives cash Cash goes out of the business. |
Office Rent Cash |
Nominal Real |
Debited Credited |
Office rent is an Expense Cash goes out of the business |
From the following information, state the nature of account (Personal, Real or Nominal) and show which account will be debited and which account will be credited along with analysis. Also Journalize the transaction in the General Journal
date: Jan | Transactions | Amount (TZS) |
---|---|---|
1 | Mr. Temba invested in business | 30,000 |
3 | Deposited with Bank in the account of the business | 20,000 |
7 | Goods purchased for cash | 1,500 |
10 | Purchased furniture and issued a cheque | 3,000 |
15 | Purchased goods and issued a cheque | 12,700 |
18 | Sold goods for cash | 1,800 |
20 | Sold goods on credit to Frank | 870 |
25 | Purchased goods on credit from Lilian | 4,000 |
27 | Payment received from Frank | 870 |
30 | Payment made to Lilian | 4,000 |
31 | Withdrew from Bank for office use | 1,000 |
Explanations | General Journal | Name of account | Nature of account | Debited or credited | Analysis | Date | Account Titles and Explanations | Dr. (TZS) | Cr. (TZS) |
---|---|---|---|---|---|---|---|
Cash Temba, Capital |
Real Personal |
Debited Credited |
Cash comes in the business Owner gave cash to the business |
Jan. 1 | Dr: Cash A/C Cr: Temba, Capital Temba introduced capital |
30,000 | 30,000 |
Bank Cash |
Personal Real |
Debited Credited |
Bank receives cash Cash goes out from business |
Jan. 3 | Dr: Bank Cr: Cash (Cash deposited with Bank) |
20,000 | 20,000 |
Purchases ** Cash |
Nominal Real |
Debited Credited |
The expenses incurred Cash goes out from the business |
Jan. 7 | Dr: Purchases Cr: Cash (Goods purchased for cash) |
1,500 | 1,500 |
Furniture Bank |
Real Personal |
Debited Credited |
The asset, furniture comes in the business Bank pays cash on behalf of the business |
Jan. 10 | Dr: Furniture Cr: Bank (Furniture bought against cheque) |
3,000 | 3,000 |
Purchase Bank |
Nominal Personal |
Debited Credited |
Expenses incurred Bank pays cash on behalf of the business |
Jan. 15 | Dr: Purchases Cr: Bank (Goods purchased against cheque) |
12,700 | 12,700 |
Cash Sales |
Real Nominal |
Debited Credited |
The asset, cash comes in the business Revenue earned |
Jan. 18 | Dr: Cash Cr: Sales** (Goods sold for cash) |
1,800 | 1,800 |
Frank Sales** |
Personal Nominal |
Debited Credited |
Frank receives goods Revenue earned |
Jan. 20 | Dr: Frank Cr: Sales (Goods sold on Credit to Frank) |
870 | 870 |
Purchases Lilian |
Nominal Personal |
Debited Credited |
Expenses Incurred Lilian Supplied the goods on credit |
Jan. 25 | Dr: Purchases Cr: Lilian (Goods purchased on credit) |
4,00 | 4,000 |
Cash Frank |
Real Personal |
Debited Credited |
The asset, cash comes in the business Frank gives cash to the business |
Jan. 27 | Dr: Cash Cr: Frank (Cash received from Frank) |
870 | 870 |
Lilian Cash |
Personal Real |
Debited Credited |
Lilian receives cash from the business The asset, cash goes out of the business. |
Jan. 30 | Dr:Lilian Cr: Cash (Payment made to Lilian) |
4,000 | 4,000 |
Cash Bank |
Real Personal |
Debited Credited |
The asset, cash comes in the business The bank gives cash to the business |
Jan. 31 | Dr: Cash Cr: Bank (Cash withdrawal from Bank) |
1,000 | 1,000 |
Give analysis of the following transactions relating to Hellar Company for the month of July 20XX as per American Approach:
Analysis | Rule | Entry |
---|---|---|
Bw. Hellar invested Shs. 40,000 Cash in the business The asset cash is increases Owner’s equity is increases |
Increases in assets are recorded by debits Increases in owner’s equity are recorded by credits |
Cash: Dr.40,000 Hellar capital: Cr. 40,000 |
Purchased a building for Shs. 10,000 cash The asses building is increased The asset cash is decreased |
Increases in assets are recorded by debits Decreases in assets are recorded by credits |
Buildings: Dr. 10,000 Cash: Cr. 10,000 |
Purchase furniture for Shs. 2,000 on credit from Dar Furniture Co. Ltd The asset furniture is increased A new liability (Creditor) is incurred |
Increases in assets are recorded by debits Increases in liability are recorded by credits |
Furniture: Dr. 2,000 Dar Furniture Cr. 2,000 |
Sold part of the building for Shs. 3,000 on credit to Mashingo The new asset (debtor) is acquired The asset building is decreased |
Increases in assets are recorded by debits Decreases in assets are recorded by credits |
Mashingo: Dr. 3,000 Building: Cr. 3,000 |
Paid Shs. 1,000 to Dar Furniture Co. Ltd The liability (creditor) is decreased The asset Cash is decreased |
Decreases in liability are recorded by debits Decreases in assets are recorded by credits |
Dar Furniture: Dr. 1,000 Cash: Cr. 1,000 |
Received Shs. 3,000 from Mashingo The asset cash is increased The asset debtor is decreased |
Increases in assets are recorded by debits Decreases in assets are recorded by credits |
Cash: Dr. 3,000 Mashingo: Cr. 3,000 |
Salaries paid to staff Shs. 1,200 Salaries of staff are expenses The asset cash is decreased |
Expenses are recorded by debits Decreases in assets are recorded by credits |
Salaries: Dr. 1,200 Cash: Cr. 1,200 |
Fee received for services rendered Shs. 8,000 The asset Cash is increased Revenue is earned |
Increases in assets are recorded by debits Revenue are recorded by credits |
Cash: Dr. 8,000 Fees earned: Cr. 8,000 |