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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:

  1. Summary of past income and expenditure – to ascertain whether they have been profitable during a given period.
  2. The availability of resources to earn income and incur expenditure in the future – to ascertain whether they can at least maintain the same level of profitability or not.

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:

  • Capital: This represents the owner’s investment in the business and all the money that is due to the owner (for e.g., profits). The business is treated as separate entity from the owner and whatever money the owner invests in the business will have to be ultimately paid back to him. The Capital Account is also shown under the liability side of the balance sheet for the same reason.
  • Liability: This represents all the financial items that are in the nature of an obligation to an external entity. Liabilities would include loans and deposits taken, expenses payable in the future, trade creditors, bank overdraft, etc.
  • Asset: This represents all the financial items that are in the nature of a benefit or a resource that is receivable in the future or is used to reap future economic benefits. Assets would include Tangible fixed assets (Plant & machinery, building, land, furniture, etc.), Intangible assets (Patents, trademarks, goodwill, etc.), trading stock that remains unsold at the end of the period, Loans given to other parties, Deposits given, Cash and bank balances, etc.

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:

  • The transaction of a sole proprietor starting a business by opening a new bank account and investing Rs. 10,000 would result in the bank balance appearing in the Asset side of a balance sheet to increase by Rs. 10,000 and the Capital account appearing in the Liability side would also increase by Rs. 10,000.
  • Where goods are purchased for Rs. 5,000, this amount would show up in the Purchase account as a part of the profit and loss account (as a loss/debit) and the bank balance reduces by Rs. 5,000.
  • Where goods are sold for Rs. 6,000, this amount would show up in the Sales account as a part of the profit or loss account (as a profit/credit) and the bank balance increase by Rs. 6,000.
  • The above 3 transactions would have the following result in the Balance Sheet:
    • The Capital account would be showing a balance of Rs. 10,000 in the liability side.
    • The profit and loss account would be depicting a net profit of Rs. 1,000 in the liability side. This would bring the total of the liability side to 10,000 + 1,000 = 11,000.
    • The bank account would have a total balance of Rs. 11,000 and hence the asset side of the balance sheet would also be Rs. 11,000
Liabilities Amt (in Rs.) Assets Amt (in Rs.)
Capital 10,000 Bank Balance 11,000
Profit and loss account 1,000
Total 11,000 Total 11,000

 

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.

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