TABLE OF CONTENT

1
• Acknowledgment

• Accounting Equation: Basic Tool for

Understanding Accounting

• Accounting Equation and some specific

financial items

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 ACKNOWLEDGMENT

I wish to praise almighty ALLAH, the most Merciful, the Beneficent and
the HOLY PROPHET MUHAMMAD (peace be upon him) who give courage
and enable me in accomplishment and submission of this project

I specially want to pay my thanks and regards to most respected,

proficient, distinguished and well learned guide Mr. ZAHEER QAMAR (Lect.
Financial reporting & disclosure practices) for their keen interest, noble
guidance, encouraging attitude which inspired me to carry on the task.

I am especially thankful to Mr. YASIN ZIA (Ast. Professor Finance),

who provided his great cooperation in spite of his personal engagements and
gave his valuable suggestions during my research work.

My parents, classmate, friends come next in the list of those whom I have to
thank.

Accounting Equation: Basic Tool for Understanding Accounting

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 Accounting equation is the basic tool for understanding and analyzing the
financial transactions. In fact, every transaction, irrespective of its size, nature, can be
explained with the help of the accounting equation.

Accounting equation is based on the basic principle of accounting: Dual Aspect

Principle. According to the principle every business owns some property i.e. some
economic resources. These resources in accounting are called ‘Asset’. We will
understand the meaning of assets in details during our sessions. These assets
(resources) can be in any form: Cash, stock, land, plant etc.

However, these resources should have some source of financing. In other

words, one needs funds to acquire these assets. So every asset should be supported
by some funds. Accounting equation captures that relationship as follows:
Total Sources = Total Assets

Sources can be divided into following three categories

• Equity: Money contributed by the owners
• Loan: Money contributed by the outsiders (Banks and Creditors)
• Profit: Money generated by the business

As mentioned in the previous paragraph assets can be in the form of investment in the
business (fixed assets and current assets), investments outside the business.

So accounting equation can be presented as follows:

Capital + Profit+ Borrowings = Fixed assets + Current assets + Investments

Business transactions affect the equation as follows:

• Change capital, or
• Change profit, or
• Change Borrowings, or
• Change in the investment in the business, or
• Change in the investment outside the business, or
• All or some of the above.

Let us take some of the financial transactions and understand the accounting equation
in greater detail.

1. A and B started AB ltd. each contributing Rs. 100000 as capital.

Source of money is the owners’ money which known as Capital. Since on this
date the money has not been used to acquire anything, the entire capital would be
available in the business in the form of Cash. The necessary accounting equation
will be as follows:

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 Accounting Equation
Source = Use
Capital = Cash
200000 200000

2. B transferred two computers worth of Rs. 50,000 to the business. They agreed to
treat the computers as the capital contributed by B. The equation will be as
follows:
Accounting Equation
Source Use/Assets Increase in Assets , Increase in Capital
Capital can be contributed in cash or
Cash 200000 kind
Capital 400000 Computer 200000
Total 400000 Total 400000

3. They took 10% loan from IDBI Rs.100 000.

Accounting Equation
Source Use Increase in Source, Increase in
Cash or any other asset.
40000
Capital 0 Cash 300000
10000 Compute
IDBI Loan 0r 200000
50000
Total 0 Total 500000

4. Purchased machinery costing Rs.20 000 for cash.

Accounting Equation
Source Use
Increase in one asset, Decrease
40000 in Cash or any other asset. No change
Capital 0 Cash 280000 in total sources
Computer 200000
10000
IDBI Loan 0 Machinery 20000
50000
Total 0 Total 500000

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 5. Purchase furniture on credit from X ltd for Rs. 30 000.

Accounting Equation
Source Use
Increase in one asset, Increase
in borrowings. No change in cash and
40000 capital
Capital 0 Cash 280000
10000
IDBI Loan 0 Furniture 30000
X Ltd. 30000 Computer 200000
Machinery 20000
53000
Total 0 Total 530000

6. Purchased land for cash Rs. 50 000.

Accounting Equation
Source Use
Increase in one asset, decrease
40000
in cash. No change in borrowings and
Capital 0 Cash 230000
capital
10000
IDBI Loan 0 Furniture 30000
X Ltd. 30000 Computer 200000
Machinery 20000
Land 50000
53000
Total 0 Total 530000

7. Purchased goods worth of Rs. 50 000 for cash.

Accounting Equation
Source Use
Increase in one asset, decrease
40000 in cash. No change in borrowings and
Capital 0 Cash 180000 capital
Goods 50000
10000
IDBI Loan 0 Furniture 30000
X Ltd. 30000 Computer 200000

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 Machinery 20000
Land 50000
53000
Total 0 Total 530000

8. Purchased goods worth of Rs. 70 000 on credit from Y Ltd.

Accounting Equation
Source Use
Increase in one asset, Increase
40000 in borrowings. No change in cash and
Capital 0 Cash 180000 capital
Goods 120000
10000
IDBI Loan 0 Furniture 30000
X Ltd. 30000 Computer 200000
Yltd 70000 Machinery 20000
Land 50000
60000
Total 0 Total 600000

9. Sales:
Let us understand the impact of sales on the accounting equation in the following
cases:
• Sold all goods for Rs. 150 000 for cash
• Sold all goods for Rs. 175000 on credit to Mr. Z
• Sold 75% of the stock on credit at profit of 25% on cost

 Sold all goods for Rs. 150 000 for cash.

Accounting Equation
Source Use
• Profit is the balancing figure. If all
40000 transactions have been entered, and
Capital 0 Cash 330000 Use is more than Source, it will be
Profit 30000 Goods 0 treated as profit. In this case entire
10000 sales have been realized in the form
IDBI Loan 0 Furniture 30000 of cash.
X Ltd. 30000 Computer 200000
Yltd 70000 Machinery 20000

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 Land 50000
63000
Total 0 Total 630000

 Sold all goods for Rs. 175000 on credit to Mr. Z

Accounting Equation
Source Use
• Profit is the balancing figure. If all
Capital 400000 Cash 180000 transactions have been entered, and
Profit 55000 Goods 0 Use is more than Source, it will be
treated as profit. In this case entire
Mr. Z 175000
sales is on credit cash.. No change in
IDBI Loan 100000 Furniture 30000 cash. New item Mr. Z, a debtor has
X Ltd. 30000 Computer 200000 been created.
Yltd 70000 Machinery 20000
Land 50000
Total 655000 Total 655000

 Sold 75% of the stock on credit at profit of 25% on cost

Accounting Equation
Source Use
• Profit is the balancing figure. If all
transactions have been entered, and
40000 Use is more than Source, it will be
Capital 0 Cash 180000 treated as profit. In this case entire
Profit 22500 Goods 30000 sales is on credit cash.. No change in
Mr Z 112500 cash. New item Mr. Z, a debtor has
10000 been created. Since parts of the
IDBI Loan 0 Furniture 30000 goods have been sold, the unsold
X Ltd. 30000 Computer 200000 goods are shown as stock (goods) at
Yltd 70000 Machinery 20000 cost price.
Land 50000
62250
Total 0 Total 622500

 Sold all goods for Rs. 100000 on credit to Mr. Z

Accounting Equation
Source Use
• Loss is the balancing figure. If all
40000 transactions have been entered, and
Capital 0 Cash 180000 Use is less than Source, it will be
Profit -20000 Goods 0 treated as loss. In this case entire
Mr Z 100000 sales is on credit cash.. No change in
cash. New item Mr. Z, a debtor has
been created.
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 10000
IDBI Loan 0 Furniture 30000
X Ltd. 30000 Computer 200000
Yltd 70000 Machinery 20000
Land 50000
58000
Total 0 Total 580000

Above transactions can be put in the form of an equation i.e. Accounting Equation

Sources Application/Uses/Assets
Transac Creditor
tion Profit Creditor s Loan Capital Total Cash Computer Machinery Furniture Land Goods Debtors Total
1 200000 200000 200000 200000
2 400000 400000 200000 200000 400000
3 100000 400000 500000 300000 200000 500000
4 100000 400000 500000 280000 200000 20000 500000
5 30000 100000 400000 530000 280000 200000 20000 30000 530000
6 30000 100000 400000 530000 230000 200000 20000 30000 50000 530000
7 30000 100000 400000 530000 180000 200000 20000 30000 50000 50000 530000
8 70000 30000 100000 400000 600000 180000 200000 20000 30000 50000 120000 600000
9 30000 70000 30000 100000 400000 630000 330000 200000 20000 30000 50000 0 630000
10 55000 70000 30000 100000 400000 655000 180000 200000 20000 30000 50000 0 175000 655000
11 22500 70000 30000 100000 400000 622500 180000 200000 20000 30000 50000 30000 112500 622500
12 -20000 70000 30000 100000 400000 580000 180000 200000 20000 30000 50000 0 100000 580000

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Accounting Equation and some specific financial items

Expenses and Payments

Expenses
Expenses may be for cash or on credit. Let us start with an accounting equation
for business started with cash o Rs 200,000.

Accounting Equation
Source = Use
Capital = Cash
200000 200000

• See the impact of salary paid: Rs. 3000

Decrease in cash without
Accounting Equation corresponding revenue or asset is
Source Use generally treated as loss. In other
words during the period there
Capital 200000 Cash 197000 were no incomes, so the entire
Loss -3000 expense is loss. Observe the
Total 197000 Total 197000

• Expense due but not paid: Outstanding Salary : Rs. 3000

Accounting Equation
This is a credit transaction so no
Source Use change in cash. However, due to
the accrual concept of accounting,
20000 expenses without corresponding
Capital 0 Cash 200000 revenue is generally treated as
Loss -3000 loss. Money payable to the
Outstanding Salary 3000 employees is shown as
20000
Total 0 Total 200000

• Expense paid but not due: Salary for the next accounting period paid in the
current period.
Accounting Equation
Source Use/Asset Cash payment towards expenses of the
subsequent period. According to the
Accounting Period Principle the benefit of
20000
this will arise in the next time period. So in
Capital 0 Cash 197000
the current accounting period it will be
treated as an asset. Asset is something
which has the potential to generate 10
 Advance
Salary 3000

20000
Total 0 Total 197000

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Payments:

Payment is the outflow of money. However every outflow of money is not an

expense. See the following:
• Payment, the benefit of which expires in one accounting period is called expense
or Revenue Expenditure.
• Payment, the benefit of which expires over a long period of time is called Capital
Expenditure

Payment may take one of the following shapes:

• Incurring expense
• Acquiring asset
• Repayment of liability

Let take the following accounting to understand the impact of the above
transactions

Accounting Equation
Source = Use
Capital + Loan = Cash
100000 +100000 200000

Incurring expense: Paid rent for the month at the end of the month: Rs.12000

Accounting Equation
Source Use

Capital 200000 Cash 185000

Loss -15000

Total 185000 Total 200000

Purchased furniture for Rs.50000

Sometimes payment results in some expenses whose benefits accrue for more than
one year (for 2-5 years). Such payments are called Deferred Revenue Expense
Accounting Equation
Source Use

Capital 200000 Cash 140000

Loss -20000 Patent 40000

Total 180000 Total 180000

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 Acquiring asset: Purchased furniture and paid by cash: Rs.50000

Accounting Equation
Source Use

20000
Capital 0 Cash 175000
Furniture 25000

20000
Total 0 Total 200000

Sometimes payment results in decrease in liabilities.

Accounting Period and Accounting Equation

Suppose rent per month is Rs. 3000 and the firm has paid Rs. 12000. The impact on
the accounting equation depends on the definition of accounting period. However, the
impact on the cash is same independent of the accounting period.

Source Use
Capital Cash Source Use
200000 200000 Capital Loss Cash
200000 -12000 188000

Source Use
Capital Loss Cash Advance Rent
18800
200000 -3000 0 9000

Cash and Capital

Capital is a source and cash is form. Capital can be contributed in any form.
There may be situation when a firm will have huge capital but no cash, or huge cash
and very small amount of capital.

Source Application Source Application

Capital Cash Capital Cash Stock
200000 200000 200000 50000 150000

Applicatio Source Application

Source Source n Capital Cash Stock Computer
Capital Profit Cash Stock Computer 200000 0 150000 50000

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Investment and Fixed Assets
If money is investment outside the business ie in other businesses, it called investment.
Whereas, if the investment is made in the same business, it is called Fixed Assets

Investment in the business (Fixed Asset)

Source Application
Capital Cash Source Application
200000 200000 Capital Plant Cash
200000 150000 50000
Investment in outside the business (Investment)
Source Application
Capital Shares in B Cash
200000 150000 50000

Revenue Expenses and Capital Expenses Deferred Revenue

Expenses
Revenue expense: the benefits of which expire within one accounting period.
Salary paid or outstanding. Capital expenses are those whose benefits extend over a
very long period

Interest paid/Accrued/Due

Source Application Interest paid: Expense and Cash outflow

Capital Source Application
+ Loan Cash Plant Capital + Loss Loan Cash Plant
400000 100000 300000 200000 400000 -12000 100000 288000 200000

Interest due but not paid: Expense and liability

Source Application
Capital
+ Loss
Interest Due Loan Cash Plant
10000
400000 -12000 12000 0 300000 200000

Bad debts
Source
Bad debt is loss due to the non-recovery Use arises due to the
of credit sales, which
insolvency of the customer (debtor). Suppose a customer Mr. Z becomes insolvent and
the entire amount due to him becomes bad-debt. Impact400000
Capital on theCash
accounting180000
equation is
shown below: reduction in debtors (Mr.Z), increase in loss (from- profit to loss), and no
change in the cash balance. Profit 120000 Goods 0
Mr. Z 0
IDBI Loan 100000 Furniture 30000
X Ltd. 30000 Computer 200000
Yltd 70000 Machinery 20000 14
Land 50000
Total 480000 Total 480000
Source Use

40000
Capital 0 Cash 180000
Profit 55000 Goods 0
Mr. Z 175000
10000
IDBI Loan 0 Furniture 30000
X Ltd. 30000 Computer 200000
Yltd 70000 Machinery 20000
Land 50000
65500
Total 0 Total 655000

Provision for doubtful debts

As per the conservative principle a firm is required to provide for the future losses. This
would reduce the profit of the period. Suppose the firm expects that 10% of money due
from Mr. Z.

Accounting Equation Source Use

Source Use
Capital 400000 Cash 180000
40000 Profit 37500 Goods 0
Capital 0 Cash 180000 Mr. Z 175000
Profit 55000 Goods 0 Less
Mr. Z 175000 Provision -17500
10000 IDBI Loan 100000 Furniture 30000
IDBI Loan 0 Furniture 30000 X Ltd. 30000 Computer 200000
X Ltd. 30000 Computer 200000 Y ltd 70000 Machinery 20000
Y ltd 70000 Machinery 20000 Land 50000
Land 50000 Total 637500 Total 637500
65500
Total 0 Total 655000

Discount Accounting Equation

Discount is the benefit given by the firmSource
to the customers Use
as an incentive for
prompt payment. Suppose Mr. Z is given a discount of Rs. 25000. Impact on the
accounting equation is shown below: reduction in debtors (Mr.Z), decrease in profit
40000
(from Rs.55000 to Rs. 30000) and increase in cash by Rs. 150000 (175000-25000).
Capital 0 Cash 330000
Profit 30000 Goods 0
Mr. Z 0
10000
IDBI Loan 0 Furniture 30000 15
X Ltd. 30000 Computer 200000
Yltd 70000 Machinery 20000
 Accounting Equation
Source Use

40000
Capital 0 Cash 180000
Profit 55000 Goods 0
Mr. Z 175000
10000
IDBI Loan 0 Furniture 30000
X Ltd. 30000 Computer 200000
Yltd 70000 Machinery 20000
Land 50000
65500
Total 0 Total 655000

Depreciation

Depreciation can be explained in one of the following ways:

• Loss due to the wear and tear of fixed asset.
• Cost apportioned over the life of the fixed asset.
• Provision for replacement of fixed asset
• Charge for using the fixed asset

Impact of depreciation on the accounting equation can be seen from the following
transactions.

• Purchase of plant
• Depreciation at 10% for the period
Source Application
Source Application
Capital = Cash Plant
Capital
200000 50000 150000 + Loss = Cash Plant
200000 -15000 50000 135000
Some times depreciation is not deducted from the cost of the plant. Plant is
shown at the original cost and the depreciation is shown under a separate head called
“Accumulated Depreciation”. The accounting equation will be as follows:

Source Application
Capital Loss Accumulated Depreciation = Cash Plant
20000
0 -15000 15000 50000 150000

The final profit or loss is not affected the presentation of depreciation in the
accounting equation.

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Composite Items
Owners’ Fund:
Capital and accumulated profit/loss is called owners’ fund. Owners’ fund is also
known as net worth or equity. See the following accounting equation:

Source Application Applicatio

Capital Source n
+ Loss = Cash Plant Capital Profit Cash Stock
200000 -15000 50000 135000 200000 100000 300000 0

Source Application Applicatio

Owners’ Fund = Cash Plant Source n
185000 50000 135000 Owners’ Fund Cash Stock
300000 300000 0
Capital Employed:
Capital employed is the sum of owners’ fund and long-term borrowing. See the following accounting
equations:

Source Use Source Use

Capital IDBI Loan Cash Computer Capital Employed Cash Computer
40000 30000 30000
0 100000 0 200000 500000 0 200000

Dividend:
Dividend is the part of the profit distributed among the shareholders. Generally it
is given in the form of cash. It leads to reduction of cash and the accumulated profit.
Dividend is given as percentage of capital..

Sources Application
Capital Profit Loans Cash Other Assets
33000
400000 30000 200000 0 300000
Suppose 5% of capital is declared and distributed as dividend

Sources Application
Capital Profit Loans Cash Other Assets
400000 10000 200000 310000 300000

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Bonus Share:
Sometimes dividend can be declared in the form of shares. So the declaration of
bonus shares does not involve any outflow of cash. The impact of issue of bonus shares
on the accounting equation is shown below:

Sources Application
Capital Profit Loans Cash Other Assets
33000
400000 30000 200000 0 300000
Suppose 5% of capital is declared as bonus shares

Sources Application
Capital Profit Loans Cash Other Assets
420000 10000 200000 330000 300000

Right Shares
Shares issued to the existing share holders at the time of subsequent issue of
shares are called Right shares. Unlike the issue of bonus share, issue of right shares
involves cash flows.

Sources Application
Capital Profit Loans Cash Other Assets
33000
400000 30000 200000 0 300000
If Right Shares are issued to the tune of Rs. 50000. The equation will be as follows:

Sources Application
Capital Profit Loans Cash Other Assets
450000 30000 200000 380000 300000

Buyback of shares
Sources Application
Capital Profit Loans Cash Other Assets
33000
400000 30000 200000 0 300000

If shares worth of Rs. 50000 are bought back. The equation will be as follows:

Sources Application
Capital Profit Loans Cash Other Assets
33000
400000 30000 200000 0 300000 18
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