Page 49 - DCOM101_FINANCIAL_ACCOUNTING_I

Unit 5: Accounting Equation and Accounting Cycle

5.1 Effect of Transactions on the Accounting Equation Notes

You have learnt that assets, liabilities and capital are the three basic elements of every business
transaction, and their relationship is expressed in the form of accounting equation which always
remains equal. At any point of time, there can be a change in the individual asset, liability or
capital, but the two side of the accounting equation always remain equal. Let us verify this fact by
taking up some transactions and see how these transactions affect the accounting equation:

Example:
1. Mr. Kamlesh started business with cash of `2,00,000.
In this transaction, one side cash is coming into business and in the other side capital is
being brought by Mr. Kamlesh. Thus:
Capital = Assets (Cash)
` 2,00,000 = ` 2,00,000
2. In the next transaction, if a plant of `50,000 is purchased in cash, this transaction will also
leave two sides. In one side cash is going and in other side plant is coming. In this situation,
the accounting equation will be as follows:

Capital = Plant + Cash (Assets)
` 2,00,000 = ` 50,000 + (` 2,00,000 – 50,000)
3. If a loan of `1,50,000 is taken from the SBI, it will also affect the accounting equation by two
sides. On one side, cash will increase and on the other side. liabilities of the business will
increase. This may be depicted 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
4. If some goods of ` 20,000 are purchased on credit, it will also affect the accounting equation
in two ways. On one side it increases the goods and on the other side it increases the
liability (creditors). Now the changed form of the above accounting equation will be as
follows:
Capital + Liabilities = Assets
Capital + Loan + Creditors = Plant + Cash + Goods

` 2,00,000 + 1,50,000 + 20,000 = ` 50,000 + 3,00,000 + 20,000
` 3,70,000 = ` 3,70,000

5.2 Accounting Cycle

Accounting is described as origin for the creation of information and the continuous utility of
information. Now the question is how is this information created? For this, there is a step by step
process, as shown below. The major steps involved in the accounting cycle are:

1. Analyse Transactions: The first step of a accounting cycle is to know what type of
transaction we are dealing with; we also need to verify that the information is correct
and that transactions have taken place only with proper authorization. Most accounting
transactions originate with what are called source documents, which are the invoices,
invoices, orders, time cards, checks, and other “paperwork” (or now, commonly digital

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