Basic concepts of Financial Accounting {Part-4}

The article explains the basic concepts of financial accounting. The accounting can be understood only after understanding its base.

Basic concepts of Financial Accounting {Part-4}

-Dr. Lalit Kumar Setia*

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Accounting Equation:

Double-entry bookkeeping is governed by the accounting equation. In all times, even after happening of all types of transactions, accounting equation remains true which states that Assets are always equals to the sum of capital and liablities.

Assets = Capital + Liabilities  

For example, a person started business with cash of Rs. 50,000. The equation will states that

            Assets(cash)= Capital + Liablities

            Rs. 50,000   = Rs.50,000+ Nil liabilities

After a few time, the person purchased furniture of Rs. 10,000 from Ram, on credit. Its financial implication will increase the furniture and a creditor Ram. The equation will be:

Assets             =          Capital             +          Liabilities

 Cash + Furniture         =          Capital +          Creditors(Ram)

            50,000+10,000            =          50,000 +          10,000.

So on all transactions are passed and the effect is entered according to their financial implication in the accounting equation. We see that in all conditions, the accounting equation remains same after a nominal changes in the values of accounts.

After the inclusion of two other elements i.e. income and expenses, the accounting equation can be extended to the following:

Assets = Capital + Liabilities  + (Incomes − expenses) 

This equation must be true, for any time period. If it is, then the accounts are said to be in balance. If the accounts are not in balance, an error has occurred.

Debit and Credit:

On the basis of accounting equation, we can understand the basic and most used terms of Debit and Credit.

Assets =          Capital             +          Liablitities

The left side has debit balances         =          The right side has credit balances

In this way, we can say that Assets has the debit balance and liabilities and capital have the credit balance. The items(assets) having debit balance are debited with an increase in the amount and credited with a decrease in the amount. The items(capital and liabilities) having credit  balance are credited with an increase in the amount and dedited with a decrease in the amount. On the basis of these two rules, we can debit and credit all the items in reation with these three elements of the financial transactions.

After the extension of the accounting equation, the accounting equation will become:

Assets =          Capital             +          Liabilities

Assets =          [Capital+Revenues-Expenses] +Liabilities

Assets +Expenses      =Capital +Revenues+Liabilities

Assets + Expenses     =          [Capital – Drawing] + Revenues +Liabilities

Assets + Expenses + Drawing = Capital + Revenues + Liabilities.

Whether one uses a debit or credit to increase or decrease an account depends on the normal balance of the account. Assets, Expenses, and Drawings accounts (on the left side of the equation) have a normal balance of debit. Liability, Revenue, and Capital accounts (on the right side of the equation) have a normal balance of credit.

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*Copyright © 2018 Dr. Lalit Kumar. All rights reserved. Dr. Lalit Kumar is a free-lance writer with publication of research papers in various esteemed and reputed journals. Presently he is working as Assistant Professor (Faculty of Financial Management), HIPA, Gurugram (Delhi-NCR), India (Asia).

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