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Every single day of our life is filled with actions and reactions. When we choose to perform the action of drinking water, our glass becomes empty but at the same time our body reacts and our thirst is quenched. We charge our phones when they are low on battery – electricity is consumed and simultaneously the battery is recharged.
Looking at a simple see-saw in a playground we observe that for one side to go up, the other side has to go down. Thus we can say that all such actions and reactions are nothing but transactions that we enter into on a daily basis. There may not be a need to keep a track of these ordinary transactions but when such transactions are made in cash, a systematic record of such transactions is necessitated. This is exactly what accounts are – a systematic record of financial transactions. The basis of preparing such accounts is purely logical.
Let us try to arrive at this logic by ourselves: Every transaction has two basic elements: One is income and the other is expense. No matter what, every transaction is an exchange of resources. We pay money and we receive goods/services. This is the basis of ‘Debit’ and ‘Credit’ in accounts and is also how the double entry system got its name. The various financial elements in a business are in essence, in the nature of income received in the current year, income receivable in future years, expense relating to the current year and expenses relating to future years. The accounts that represent income and expenditure that does not relate to the current year can broadly be classified as either an asset or a liability. Our main objective behind maintaining accounts is that at any given date, the state of affairs of the business can be ascertained. There are two aspects to the state of affairs of a business:
Therefore, when there is a necessity to ascertain the state of affairs during a certain period, all the current items of income and expenditure are summarized into a single account and the resulting profit or loss for the period is arrived at. This is how a profit and loss account comes into being. To understand the financial position of a business on a particular date, the accounts that relate to future benefits called ‘assets’ and those that relate to future obligations called ‘liabilities’ are summarized together and shown in a statement which is known as the balance sheet. It is important to note that the net profit or loss would also end up in the balance sheet. All the items appearing in the balance sheet can be classified into 3 basic heads:
Every financial transaction ultimately fits into either of the above heads. Let us examine various financial transactions using the above logic under the double entry system of accounting:
|Liabilities||Amt (in Rs.)||Assets||Amt (in Rs.)|
|Profit and loss account||1,000|
From the above, it can be observed that where the double entry system of accounting is strictly followed, there also exists a relationship between the 3 items of the Balance Sheet which can be depicted in the form of the following equation:
CAPITAL + LIABILITIES = ASSETS
This equation is commonly known as the Accounting Equation. It is also why both the sides of a balance sheet i.e., the asset side and liability side (including capital) end up being equal. This is true irrespective of the period for which the balance sheet is prepared, the nature of transactions, the number of transactions, etc. During the pre-computer era, when accounts were prepared manually, many mistakes used to creep in while passing entries due to human error.
The accounting equation played a vital role in detecting many of these errors. However, in this day and age where computers are used to pass entries automatically, this problem has become redundant since controls are placed in such a way that no entry can be passed without following the rules of the double entry system.