Accounting Equation

ACCOUNTING EQUATION

An accounting equation is a formula of accounting which shows that the assets of a business are always equal to the total of Capital and Liabilities. A business transaction will result in the change in either of the assets, liabilities or capital of the firm. After the change, assets will be again equal to the total of capital and liabilities. Therefore,

ASSETS = LIABILITIES + CAPITAL

OR

LIABILITIES = ASSETS - CAPITAL

OR

CAPITAL = ASSETS - LIABILITIES

We can understand it by an example.

Example: Show the Accounting Equation on the basis of the following transactions and prepare a Balance Sheet on the basis of last new equation:-

                                                                                                                             ₹          

1. A started business with cash                                         90,000
2.  Purchased goods for cash                                              30,000
3.  Purchased goods on credit                                            20,000
4.  Purchased furniture for cash                                           6,000
5.  Paid rent                                                                              5,000
6. Received commission                                                        1,000
7.  Withdrew cash for private use                                         3,000
8. Sold goods on credit (cost price ₹20,000)                    30,000
9. Paid to creditors                                                                10,000

 Solution:

 

S. No.	Transaction	Assets                                              = Liabilities + Capital  Cash+Stock+Furniture+Debtors=Creditors+Capital
1.	A started busi-ness with cash ₹90,000	90,000 + 0 + 0 + 0                               = 0 + 90,000
2.	Equation Purchased goods for cash ₹30,000	90,000 + 0 + 0 + 0                               = 0 + 90,000   (-)30,000 + 30,000 + 0 + 0                 = 0 + 0
3.	Equation Purchased goods on credit ₹20,000	60,000 + 30,000 + 0 + 0                     = 0 + 90,000    0 + 20,000 +0 +0                                 = 20,000 + 90,000
4.	Equation Purchased furni-ture for cash ₹6,000	60,000 + 50,000 + 0 + 0                     = 20,000 + 90,000     (-)6,000 + 0 + 6,000 + 0                      = 0 + 0
5.	Equation Paid rent ₹5,000	54,000 + 50,000 + 6,000 + 0             = 20,000 + 90,000   (-)5,000 + 0 + 0 + 0                             = 0+ (-)5,000
6.	Equation Received commi-ssion ₹1,000	49,000 + 50,000 + 6,000 + 0             = 20,000 + 85,000   1,000 + 0 + 0 + 0                                 = 0 + 1,000
7.	Equation Withdrew cash for private use ₹3,000	50,000 + 50,000 +6,000 + 0              = 20,000 + 86,000     (-)3,000 + 0 + 0 + 0                             = 0 + (-)3,000
8.	Equation Sold goods on credit ₹30,000  (cost price ₹20,000)	47,000 + 50,000 + 6,000 + 0             = 20,000 + 83,000     0 – 20,000 + 0 + 30,000                     = 0 + 10,000
9.	Equation Paid to creditors ₹10,000	47,000 + 30,000 + 6,000 + 30,000   = 20,000 + 93,000   (-)10,000 + 0 + 0 + 0                           = (-)10,000 + 0
	Final Equation	37,000 + 30,000 + 6,000 + 30,000   = 10,000 + 93,000

 

EXPLANATION

Serial No.	Transactions	Accounts Affected
		Assets	Liabilities & Capital
1	Capital brought in	Cash increases	Capital increases
2	Purchased goods for cash	Stock increases Cash decreases
3	Purchased goods on credit	Stock increases	Creditors increase
4	Purchased furniture for cash	Cash decreases Furniture increases
5	Paid rent	Cash decreases	Rent = Expenses Capital decreases
6	Received Commission	Cash increases	Commission = Income Capital increases
7	Withdrew cash for private use	Cash decreases	Capital decreases
8	Sold goods on credit for ₹30,000(cost price ₹20,000)	Debtors increase by ₹30,000. Stock decreases by ₹20,000	Capital increases by ₹10,000
9	Paid to creditors	Cash decreases	Creditors decrease

 Balance Sheet of A

As at ---------------

Liabilities + Capital	₹	Assets	₹
Creditors Capital	10,000 93,000	Cash Stock Furniture Debtors	37,000 30,000 6,000 30,000
	1,03,000		1,03,000

 

At any point of time, the total of the both sides of the Balance Sheet is always equal because the assets of a business are purchased either from the Funds (capital) supplied by the proprietor or from the funds provided by the external parties. From the study of above example, it may be concluded that every transaction has a double effect and in each case Assets = Liabilities + Capital. In other words, we can say that ‘Accounting Equation is true in all cases’.

  

Discount

DISCOUNT

It is a rebate or an allowance given by the seller to the buyer. It is of two types:

1.     Trade Discount

2.     Cash Discount

Trade Discount: When discount is allowed by a seller to its customers at a fixed percentage on the list or catalogue price of the goods, it is called trade discount. It is allowed when goods are purchased in bulk i.e. large quantity. It is allowed both on credit as well as cash transactions since it is related to the purchases and not to the payment. Main Features:

·        It is allowed by a wholesaler or manufacturer to the retailers at a fixed percentage on the printed price list.

·        It is allowed to the retailers to enable them to make some profit even if they sell the goods at their catalogue price.

·        It is deducted from the invoice.

·        It is not recorded separately in the books of accounts.

·        It is allowed when goods are purchased in a specific quantity.

·        No separate entry is passed for the trade discount, as it is deducted from the cash memo or invoice of the goods.

·        If the goods sold at trade discount are returned by the customer, the amount of trade discount is again deducted from the list price of returned goods.

Cash Discount: When discount is allowed to the customers for making prompt payment, it is called cash discount. It is allowed only if the customer makes the payment within a fixed period. Such discount motivates the customer to make the payment at the earliest. Main Features:

·        It is allowed if the customer makes the payment immediately or within a fixed period.

·        It is allowed to encourage quick or prompt payment.

·        It is not deducted from the invoice.

·        It is recorded separately in the books of accounts.

·        It is allowed when payment is made on or before a specified date.

·        It is allowed at the time of making payment, so the entry for the cash discount is recorded along with the entry for payment.

·        Discount is a nominal account. So it is debited when it is allowed to a customer and credited when it is received.

 

             Sometimes, a customer is allowed both the discounts, i.e. trade discount as well as cash discount. In such a case, first trade discount is to be deducted from the price of the goods and then, cash discount is to be calculated on the balance of the amount.

Bases of Accounting

BASES OF ACCOUNTING

One of the main objectives of accounting is to ascertain the profit or loss of a business enterprise at the end of an accounting period. There are three bases of ascertaining the profit or loss:

1.     Cash Basis

2.     Accrual Basis

3.     Mixed or Hybrid Basis

Cash Basis of Accounting: Under this basis, incomes are not recorded unless they are received in cash. Similarly, expenses are recorded only when they are paid in cash. That means credit transactions are not recorded at all and are ignored till cash is actually received or paid for them. Thus Profit is merely the excess of actual cash receipts over actual cash payments. Income or Profit is calculated with the help of a Receipts and Payments A/c. This basis is useful for professional people like Lawyers, Doctors etc.

Accrual Basis of Accounting:  Under this basis, incomes are recorded when they are earned or accrued, irrespective of the fact whether cash is received or not. Similarly, expenses are recorded when they are incurred or become due and not when the cash is paid for them. Hence, Profit or Loss of a particular period is the result of matching of the revenues earned and expenses incurred during the period. Therefore, outstanding expenses, prepaid expenses, accrued incomes, incomes received in advance etc. are considered for the preparation of Financial Statements. All companies are required to maintain their accounts according to this basis of accounting under the Companies Act, 1956.

Hybrid or Mixed Basis of Accounting: This basis of accounting is the mixture of cash basis and accrual basis. Under this system, revenues and assets are recorded on cash basis whereas expenses and liabilities are recorded on accrual basis. Usually professional people such as Doctors, Lawyers etc. adopt this method and prepare Receipt and Expenditure A/c to ascertain their net income.

Inventory

STOCK OR INVENTORY

The term Stock includes the value of those goods which are lying unsold at the end of accounting period. The Stock may be of two types:

1.     Opening Stock: The value of goods lying unsold at the beginning of the accounting period.

2.     Closing Stock: The value of goods lying unsold at the end of the accounting period.

Types of Stock: In case of manufacturer, there can be three types of Opening or Closing Stock:-

·        Stock of Raw Material

·        Stock of Work-in-Progress

·        Stock of Finished Goods

Raw Material: It includes stock of raw materials purchased for using them in the products manufactured but still lying unused.

Work-in-Progress: It means goods in semi-finished form. Such goods need further processing for converting into finished products. Therefore they are termed as partly finished goods. For the valuation of work-in-progress, the value of raw material used in it, the cost of labour, power, fuel and other expenses on proportionate basis are included.

Finished Goods: It includes the stock of those goods which have been completely processed and are ready for sale but are lying unsold at the end of the accounting period.

Calculation of closing stock

It is very important to ascertain the value of closing stock because it affects the Net Profit & hence Balance Sheet also. According to the new rule, closing stock is valued at cost price or realizable value whichever is less. For example: if certain goods were purchased for ₹1,00,000 but at present its realisable value is ₹1,20,000, it will be valued at ₹1,00,000 and not ₹1,20,000. But if realizable value of same goods is ₹90,000, it will be valued only at ₹90,000. The basic principle under this is that anticipated losses should be taken into account, but all unrealized gains should be ignored.

To ascertain the value of closing stock, a complete list of all items in the godown is prepared with their quantities. Raw material, semi-finished goods and finished goods are mentioned in a separate list which is called stock taking.

The following points should be kept in mind while stock taking:-

·        Goods which have been sold but remain undelivered should not be included in the list of stock.

·        Goods purchased and received but which have not been recorded in the purchase book should also not be included in the list.

·        Goods sent to the customers on sale or return basis should be included.

·        Goods sent to agents for sale but remain lying with them as unsold should be included.

  

Expenditure

EXPENDITURE

 

Any type of payment for the receipt of a benefit is termed as Expenditure. It may be in cash or transfer of property or incurring a liability for the purpose of acquiring assets, goods or services.

Expenditure may be classified into 3 categories:

1.     Capital Expenditure

2.     Revenue Expenditure

3.     Deferred Revenue Expenditure

Capital Expenditure: Any expenditure which is incurred in acquiring or increasing the value of a fixed asset is termed as Capital Expenditure. Such expenditure yields benefit over a long period and written in Assets. Examples: amount spent on the purchase or erection of Building, Plant, and Furniture etc.

Main Features:

·        It is incurred for the acquisition or erection of a fixed asset.

·        It is incurred for the purpose of increasing the earning capacity of the business.

·        It yields benefit normally over a long period.

·        It is written in the Balance Sheet.

 

Revenue Expenditure: Any expenditure, the full benefit of which is received during one accounting period is termed as Revenue Expenditure. It does not result in an increase in the earning capacity of the business. It only helps in maintaining the existing earning capacity. It also does not bring into existence an asset of an enduring nature.

Main Features:

·        It is incurred for the day to day running of the business.

·        It is incurred for the maintenance of earning capacity i.e. for keeping the assets in an efficient working order.

·        It yields benefit for a maximum period of one year.

·        It is written in Trading or Profit &Loss A/c.

 

Deferred Revenue Expenditure: There are certain expenditures which are revenue in nature but the benefit of which is likely to be derived over a number of years. Such expenditures are termed as Deferred Revenue Expenditure.

Main Features:

·        It is revenue in nature.

·        Its benefit lasts between 3 to 7 years.

·        The whole of such expenditure is not debited to Profit and Loss A/c of the current year but spread over the years for which the benefit is likely to last.

·        Only a part of such expenditure is taken to Profit & Loss A/c every year and the unwritten off portion is allowed to stand on the Asset side of the Balance Sheet.

Assets & Liabilities

LIABILITY

LIABILITY: It refers to the amount which the firm owes to outsiders. But it does not include the amount owed to proprietors (owners). When a firm purchases goods on credit from someone, then the amount owing to that person is a liability. Likewise when a bank account is overdrawn, the amount owing to the bank (i.e. bank overdraft) is known as a liability. Other examples of liabilities are:- Bills Payable, Creditors, Unpaid wages, Loans etc.

Liabilities may be divided into two parts:

1.     Internal Liabilities

2.     External Liabilities

INTERNAL LIABILITIES: All amounts which a business entity has to pay to the proprietor or the owners are internal liabilities. For example, Capital, Accumulated Profits.

EXTERNAL LIABILITIES: All amounts which a business entity has to pay to the outsiders are known as external liabilities. For example, Creditors, Bills Payables, Loans etc.

Liabilities can be classified as under also:

Long Term Liabilities: These refer to those liabilities which fall due for payment in a relatively long period normally after more than one year. For example, Long Term Loans, Debentures etc. These are also called Fixed liabilities.

Short Term Liabilities: These refer to those liabilities which are to be paid in near future, normally within one year. For example, Bank Overdraft, Creditors, Outstanding Expenses, Short Term Loans etc. These are also called Current Liabilities.

 ASSETS

ASSETS: Anything which is in the possession or is the property of a business enterprise including the amounts due to it from others is called an asset. In other words, anything which will enable a business enterprise to get cash or a benefit in future is an asset. Examples:- Cash and Bank Balances, Stock, Furniture, Machinery, Land and Building etc.

Main characteristics of an asset:

1.     It must be valuable.

2.     It must be owned by the business.

3.     It must be acquired at a measurable money cost.

Assets may be classified into following categories:-

·        Fixed Assets

·        Current Assets

·        Tangible Assets

·        Intangible Assets

·        Liquid Assets

·        Fictitious or Nominal Assets

Fixed Assets: Those assets which are held for continued use in the business for the purpose of producing goods or services are called fixed assets. They are not for resale. Examples: Land & Building, Plant & Machinery, Motor Vehicles, Furniture etc.

Current Assets: Those assets which are meant for sale or which the management would want to convert into cash within one year are called Current Assets. Examples: Debtors, Stock, Bills Receivables etc. These assets are also termed as Short-lived or Active Assets. Current Assets are also known as Floating Assets or Circulating Assets as the amount and nature of such assets keeps changing continuously.

Tangible assets: They refer to those assets which can be seen and touched. In other words, which have a physical existence such as Land, Building, Plant, Machinery etc.

Intangible Assets: Those assets which do not have a physical existence and which cannot be seen or felt are intangible assets. Examples: Goodwill, Patents, Trade Marks etc. These are also valuable assets. They help the firm in earning profits as much as the tangible assets. Value of intangible assets is based on the benefit and facility available to the business from such assets.

Liquid Assets: These are those assets which are either in the form of cash or can be quickly converted into cash. Examples: Cash, Bills Receivable, Short Term Investments, Debtors, Accrued Income etc. In other words, if Prepaid Expenses and Closing Stock are excluded from Current Assets, the balance will be Liquid Assets.

Fictitious or Nominal Assets: These are the assets which cannot be realized in Cash or no further benefit can be derived from these assets. Example: Debit Balance of Profit & Loss A/c, Expenditure not yet written off etc. These assets are not really assets but are shown on the Assets side only for the purpose of transferring them to the Profit and Loss Account gradually over a period of time.

window dressing

Window Dressing: It refers to the practice of manipulating accounts. Means to prepare financial statements in that way that they do not disclose the actual position of the concern. By doing this financial statements which are prepared in the end of the year may disclose a more favorable position than the actual position. For example, the purchases made at the end of the year may not be recorded or the closing stock may be over-valued. Hence, correct decisions cannot be taken on the basis of such financial statements.

Although window dressing is illegal or fraudulent, it is slightly dishonest and is usually done to mislead investors. Companies typically window dress their financial statements by selling off assets and either purchasing new assets or using this money to funds other operations. This way the cash balance on the balance sheet appears to be at a normal amount. Window dressing is probably most commonly found in investment brokers and mutual fund houses. Mutual fund managers often sell off poor performing stock and other investments near the end of a period and use the money to buy high performing stock. This way new investors see the portfolio of high performing stock and want to invest.

In short, window dressing is a short-term strategy to make financial statements and financial portfolios appear more consistent and desirable than they really are. Although window dressing does not amount to fraud in most circumstances, it is usually done to mislead investors from the true company or fund performance.

·         Examples of window dressing are:

Cash: Postpone paying suppliers, so that the period-end cash balance appears higher than it should be.

 Accounts receivable: Record an unusually low bad debt expense, so that the accounts receivable (and therefore the current ratio) look better than is really the case.

 Fixed assets: Sell off those fixed assets with large amounts of accumulated depreciation associated with them, so the net book value of the remaining assets appears to indicate a relatively new cluster of assets.

 Revenue: Offer customers an early shipment discount, thereby accelerating revenues from a future period into the current period.

 Depreciation: Switch from accelerated to straight-line depreciation in order to reduce the amount of depreciation charged to expense in the current period.

 Expenses: Withhold supplier expenses, so that they are recorded in a later period.

How to spot Window Dressing

The ability to compare and attentiveness to detail can help recognize window dressing in a company or mutual fund’s reporting.

When analyzing overall management performance, business owners and shareholders should review all financial statements (i.e., balance sheet, income statement, statement of cash flows, and statement of changes in equity) and any additional available information to determine whether:

· A positive cash balance is a result of short-term borrowing or non-operating activities (refer to the statement of cash flows to see which activities generated cash)

· There is an abnormal increase or decrease in any balances

· The company’s policies were changed during the period

· Strong sales are accompanied by increases in accounts payable

When choosing a mutual fund, an investor should compare the year-end reports with the quarterly reports side by side to determine whether:

· The portfolio consists of only the most popular investments without any nonperforming investment

· There are abnormal period-end selling or purchase transactions

· The portfolio is diversified

· The portfolio structure and investment style are supported