5 – Accounting Equation and Accounting Cycle

Introduction:

The basic accounting equation is the core of the double-entry bookkeeping system. It demonstrates how assets were funded: by borrowing money from someone (debt) or paying your own (shareholders’ equity).

Assets = Liabilities + (Shareholders or Owners equity)

The accounting equation also serves as the foundation for the most fundamental of accounting reports, the aptly named Balance Sheet. A balance sheet shows what a company owns (assets), what it owes (liabilities), and what the owners possess (equity) as of a specific date. Because of double-entry accounting or bookkeeping, this equation should always be in balance. The following illustrations will help you understand this even further.

An owner’s investment in the company increases both the company’s assets and the owner’s equity. When a firm borrows money from a bank, its assets increase, but its liabilities increase. When the corporation repays the loan, its assets drop, and its liabilities fall. When the corporation pays cash for a new delivery van, one asset (cash) decreases, but another asset (vehicles) increases. If a firm provides a service to a client and instantly receives cash, the company’s assets grow, and the owner’s equity grows because the company has made revenue. Suppose a firm offers a service and permits the client to pay in 30 days. In that case, the company’s assets (Accounts Receivable) and its owner’s equity have increased because it has received service revenue. If the firm runs a radio advertisement and agrees to pay later, it incurs an expense that reduces the owner’s equity while increasing its liabilities.

For instance, if a company has $1,000 in assets at any given time, the sum of its creditors’ and owners’ claims must equal that amount. Here’s one of an endless number of possible balance sheets:

Abhishek and Sons.

Balance Sheet

Residual Claims as Equity

Put, equity is the difference between assets and liabilities. Only when assets exceed liabilities does the owner have positive equity.

For example, if a company has ‘1,000 in assets and ‘600 in liabilities, the ‘600 in liabilities is effectively a claim on the assets. Equity is defined as the difference between assets and liabilities, or ‘400.

Assets – Liabilities = Equity

Put, equity is the difference between assets and liabilities. Only when assets surpass liabilities does the owner have positive equity.

For example, if a company has ‘1,000 in assets and ‘500 in liabilities, the ‘500 in liabilities is effectively a claim on the assets. Equity is defined as the difference between assets and liabilities, or ‘500.

If a company ceases operations, its remaining assets are distributed to outside creditors first. Owners’ claims can be realised only after outside creditors’ claims have been satisfied. As a result, equity represents the owners’ residual claim on the company’s assets.

5.1 Transactional Influence on the Accounting Equation

You’ve learned that the three essential aspects of any business transaction are assets, liabilities, and capital, and their connection is expressed in the form of an accounting equation that always remains equal. Individual assets, liabilities, and capital can alter at any time, but the two sides of the accounting equation always remain equal. Let us test this by looking at some transactions and seeing how they affect the accounting equation:

Example:

1. Mr. Kedar began his firm with $2,000 in cash.

In this transaction, one side brings cash into the business while the other brings capital. Thus:

Capital = Assets (Cash)

` 2,00,000 = ` 2,00,000

2. If a plant worth $50,000 is purchased in cash in the next transaction, this transaction will have two sides. On one side, cash is leaving, while on the other, the plant is arriving. In this case, the accounting equation is as follows:

Capital = Plant + Cash (Assets)

` 2,00,000 = ` 50,000 + (` 2,00,000 – 50,000)

1. If a loan of ‘1,50,000 is obtained from the SBI, it will have a two-sided effect on the accounting equation. On the one hand, cash will increase, while the business’s liabilities will increase. This can be illustrated as follows:

Capital + Liability (Loan) = Plant + Cash

` 2,00,000 + 1,50,000 = ` 50,000 + (1,50,000 + 1,50,000)

` 3,50,000 = ` 3,50,000

2. If some $20,000 worth of goods are purchased on credit, the accounting equation will be affected in two ways. On the one hand, it increases the quantity of goods, while on the other hand, it increases the liability (creditors). The accounting above equation will now take on a new form, which is as follows:

Capital – Liabilities = Assets.

Plant + Cash + Goods = Capital + Loan + Creditors

‘ 50,000 + 3,00,000 + 20,000 =’50,000 + 1,50,000 + 20,000

3,70,000 = 3,70,000

5.2 The Accounting Cycle

Accounting is defined as the origin of information creation and the continual utility of information. The question now is, how is this data generated? There is a step-by-step procedure for this, as indicated below. The following are the essential steps in the accounting cycle:

1. Examine Transactions: The first step in an accounting cycle is to determine what type of transaction we are dealing with; we must also verify that the information is accurate and that transactions have occurred solely with authorised authorization. Most accounting transactions begin with source documents, which include invoices, orders, time cards, checks, and other “paperwork” (or, increasingly, digital data) that offer the initial evidence that a transaction has occurred (or will be taking place in the future.)

2. Preparing Journals: The journal is the “book of initial entry,” where transactions become part of the organization’s official financial records. We create journal entries that detail the accounts affected by a transaction and the amount of money involved.

3. Post to Ledger A/c: A ledger is an organization’s entire group of accounts. Posting is the transfer of journal entries to the ledger. Posting was a distinct step in a manual system, but it is often done concurrently with entering the transaction in the journal in computerised systems.

4. Trial Balance Preparation: A trial balance is simply a summation of the account balances to ensure the book’s balance.

5. Construct financial statements: Following the preparation of the trial balance, financial statements such as the income statement, balance sheet, and cash flow statement are prepared.

6. Closing Entries: We make entries to close temporary accounts (expense and revenue accounts). In manual systems, each closing entry had to be made manually. A single command in a computerised system closes the books.

7. Financial Statement Preparation: The final step is preparing the trading, profit, and loss accounts and the opening and closing balance sheets.