Accounting Equestion and Double Entry

The accounting equation

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:

  1. All of the stock was sold for shs. 20,000 cash.
  2. All of the stock was sold on credit for shs. 20,000.
  3. All of the stock was sold for shs. 30,000 cash.

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

Case (a)

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.

Case (b)

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.

Case (c)

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:

  1. An increase in an asset will result in:
    an increase in a liability or
    an increase in owner's equity or
    a decrease in another asset.
  2. a decrease in an asset will result in:
    a decrease in a liability or
    a decrease in owner's equity or
    an increase in another asset
  3. An increase in liability will result in:
    an increase in an asset or
    a decrease in owner's equity or
    a decrease in another liability
  4. a decrease in a liability will result in:
    a decrease in an asset or
    an increase in owner's equity or
    an increase in another liability.
  5. an increase in owner's equity will result in:
    an increase in an asset or
    a decrease in a liability or
    a decrease in another form of owner's equity
  6. a decrease in owner's equity will result in:
    a decrease in an asset or
    an increase in liability or
    an increase in another form of owner's equity

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:

  1. an increase on the other side or
  2. a decrease on the same side.

In the same way a decrease on one side of the equation will have the corresponding effect of either:

  1. a decrease on the other side or
  2. an increase on the same side.

The double entry system

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.

  1. Personal accounts
  2. Real accounts and
  3. Nominal accounts

Personal accounts

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.

Real accounts

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.

Nominal accounts

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.

Rules of Double Entry System

There are “Three Cardinal Rules” of double entry system.
  1. Rule of Personal Account “Debit the receiver, Credit the Supplier”
  2. Rule of Real Accounts “Debit what comes in; and Credit what goes out”
  3. Rule of Nominal Accounts “Debit Losses and Expenses; and Credit Gains and Income”.

Example one

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:

  1. Building purchased for cash
  2. Furniture purchased on credit from Sangoti Ltd.
  3. Deposited cash with bank
  4. Office rent paid for cash

Solution

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

Example 2

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

Solution

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

**In practice, when goods are sold, Sales Account is credited and not Goods Account. Similarly, when goods are purchased for the purpose of resale, Purchases Account is debited instead of Goods Account.

Example 3

Give analysis of the following transactions relating to Hellar Company for the month of July 20XX as per American Approach:

  1. Bw. Hellar, the owner of the company, invested Shs. 40,000 cash in the business
  2. Purchased a building for Shs. 10,000 cash.
  3. Purchase furniture for Shs. 2,000 on credit from Dar Furniture Co. Ltd
  4. Sold part of the building for Shs. 3,000 on credit to Mashingo
  5. Paid Shs. 1,000 to Dar Furniture Co. Ltd
  6. Received Shs. 3,000 from Mashingo
  7. Salaries paid to staff Shs. 1,200
  8. Fee received for services rendered Shs. 8,000

Solution

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

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