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Accounting Equation and Business Transactions

The accounting cycle involves 12 steps that process accounting transactions from initiation through the preparation of financial statements. Key steps include identifying transactions, recording them in journals, posting to ledger accounts, preparing a trial balance to check for errors, correcting errors, and extracting a final trial balance to generate financial statements. Double entry accounting requires equal debits and credits based on rules where increases in assets and liabilities are debited while decreases are credited. Income increases equity and is credited while expenses decrease equity and are debited.

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123 views5 pages

Accounting Equation and Business Transactions

The accounting cycle involves 12 steps that process accounting transactions from initiation through the preparation of financial statements. Key steps include identifying transactions, recording them in journals, posting to ledger accounts, preparing a trial balance to check for errors, correcting errors, and extracting a final trial balance to generate financial statements. Double entry accounting requires equal debits and credits based on rules where increases in assets and liabilities are debited while decreases are credited. Income increases equity and is credited while expenses decrease equity and are debited.

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Joseph Ondari
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THE ACCOUNTING EQUATION AND BUSINESS TRANSACTIONS

For a new business, resources supplied by the owner are known as capital while the actual
resources are assets. The accounting equation is given as follows
CAPITAL = ASSETS
Resources supplied by other people other than the owners are liabilities. If these are considered
the accounting equation becomes;
CAPITAL + LIABILITIES= ASSETS
EXERCISE.
Ali Mohamed, a sole trader has the following assets and liabilities as on 30 th December 2008.
Creditors Kshs. 20,000, equipment Kshs. 120,000, Motor vehicle Kshs. 400,000, Stock of goods
Kshs. 200,000, Debtors Kshs. 150,000, Cash at bank Kshs. 130,000, Cash in hand Kshs.
140,000.
Required: calculate the amount relating to Mohammed’s capital

THE ACCOUNTING CYCLE


An accounting cycle is a detailed step by step look into the processes that accounting information
goes through from the point of initiation of transactions up to the point that the financial
information is generated. A summary of the process of accounting cycle is outlined as shown
below;

Step 1: Identifying Transactions


This involves identifying transactions which are financial in nature. These are mostly the
transactions that depict monetary value in an entity. The examples of these transactions include
sales transaction, purchases transactions, receipts and payment transactions e.t.c

Step 2: Posting Transactions to the Journals


The transactions identified above are then posted to journals. A journal contains a debit and
credit side which details all the financial transactions of a business. All business transactions are
usually chronologically recorded in a journal using a double/ single entry system.

Step 3: Posting the Transactions to the Ledger Specific Ledger Accounts


Transactions involving sale of goods and services (sales transactions) and those for purchases
(buying of goods meant for sale) are recorded in specific ledger accounts

Step 4: Posting Transactions to General Ledger Accounts


General ledgers are used by businesses which employ a double entry system. The information
posted to general ledger account include assets, liabilities, owners’ equity/Capital, revenues and
expenses

Step 5: Preparation of an initial Trial Balance


A trial balance is a-T account where balances from the ledger accounts are posted in order to
ensure that the debit and credit entries are equal. The emphasis at this point is that the debit and
credit sides be equal. However, this does not guarantee that no error has been committed in the
accounts. This is because of errors associated with the trial balance. These errors include;
i. Errors not affecting trial balance agreement; these errors whether committed, the two
sides of the trial balance will still be equal. They include error of omission, error of
commission, error of principle, error of original entry, error of complete reversal of
entries, transposition errors and compensating errors
ii. Error affecting trial balance; these are errors whose commitment affects the two sides
of the trial balance

Step 6: Identifying and Correcting Errors in the Trial balance


The trial balance generated above is then checked for the errors highlighted above with a view to
correcting them

Step 7: Posting of the corrected errors to the ledge account


This is aimed at correcting the values of the ledge accounts before a new trial balance is
generated.

Step 8: Extract a corrected trial balance


A final trial balance is then extracted using the values in the corrected ledge accounts. This forms
the basis upon which financial statements can now be generated.

Step 9: Preparation of the financial statements


From the corrected trial balance above, basic financial statements are prepared. The financial
statements which can be prepared from the corrected trial balance include trading profit and loss
account and the balance sheet

Step 10: Preparation of closing balances


These are lists of balances for each ledge account at the end of the financial period. The values
are to be used as the opening values

Step 11: Preparation of opening balances


The balances at the end of the financial period in step 10 above form the basis of opening
balances to be used from the beginning of the next financial period.

N/B: This process continues as long as the going concern of an entity is guaranteed. At the end
of step 11, the process begins again from step one but in a different financial period hence the
tem accounting cycle.

Ledger Accounts
Ledger accounts are T- accounts where entries from journals are posted. The left hand side of the
T-account is known as debit while the right hand side is known as credit side. A T-account is as
follows;
Date Details Folio Amount Date Details Folio Amount

Double Entry Rules and Trial Balance


The accounting equation is also known as the balance sheet equation. It forms the basis upon
which the financial position of an entity in known.
At initial stages, the amount invested in an organization inform of cash/cheque (bank) is known
as the organizations equity. Thus
Equity/Capital=Assets.

When the entity borrows some funds to increase its capital the equation becomes;
Capital+ Liabilities= Assets. This can also be rearranged as:

Capital=Assets-Liabilities……………The balance sheet equation

Double Entry Rules


There are four basic rules which determine the entries made in accounting records. The entries
are as follows;
i. For increase in assets Debit
ii. For decrease in assets Credit
iii. For increase in liabilities Credit
iv. For decrease in liabilities Debit

Note: Debit (DR) means a transaction is to be entered to the Left Hand Side (LHS) of an account
while Credit (CR) means a transaction is to be posted to the Right Hand Side of an account. The
following information can illustrate this;
i. Bought motor vehicle paying by cash
ii. Bought Equipment paying by a cheque
iii. Received a loan from family bank by a cheque.
iv. Paid loan to family bank by cash

Accounting for sales, purchases, incomes and expenses.

Sales:
This is the sell of goods that were bought by a firm (the goods must have been bought with the
purpose of resale). Sales are divided into cash sales and credit sales. When a cash sale is made,
the following entries are to be made.
i. Debit cash either at bank or in hand.
ii. Credit sales account.

For a credit sale:


i. Debit debtors/ Accounts receivable account.
ii. Credit sales account.
A new account for sales is opened and credited with cash or credit sales.

Purchases:
Buying of goods meant for resale. Purchases can also be for cash or on credit. For cash
purchases:
i. Debit purchases.
ii. Credit cash at bank/cash in hand
For credit purchases, we:
i. Debit purchases.
ii. Credit creditors for goods.

A new account is also opened for purchases where both cash and credit purchases are posted.
NOTE: NO ENTRY IS MADE INTO THE STOCKS ACCOUNT.

Incomes:
A firm may have other incomes apart from that generated from trading (sales). Such incomes
include:
 Rent
 Bank interest
 Discounts received.
When the firm receives cash, from these incomes, the following entries are made:
 Debit cash in hand/at bank.
 Credit income account.
Each type of income should have its own account e.g. rent income, interest income.
Incomes increase the value of capital and that is the reason why they are posted on the credit
side of their respective accounts.

Expenses:
These are amounts paid out for services rendered other than those paid for purchases. Examples
include:
 Postage and stationery
 Salaries and wages
 Telephone bills
 Motor vehicle running expenses.
 Bank charges.
When a firm pays for an expense, we:
i. Debit the expense account.
ii. Credit cash at bank/in hand.
Each expense should also have its own account where the corresponding entry will be posted.
Expenses decrease the value of capital and thus the posting is made on the debit side of their
accounts.

Ledger Accounts and Balancing off of ledger accounts


The T- accounts must be balanced. The debit side should be equal to the credit side, therefore
when one side is more than the other, a balancing figure, known as balance carried down (Bal
c/d) is used. This is the closing figure for that account. In the next financial period, the figure is
used as opening balance commonly known as balance brought down (Bal b/d). The above
accounts are balanced as follows;

Trial Balance Preparation


A trial balance is a T-account where entries from the ledger account are posted in order to ensure
that the debit side is equal to the credit side. The figures used for making trial balance are the
opening figures (Bal b/d) in the respective ledger account. The balances brought down at the
debit are posted to the debit side of the trial balance and vice versa. The opening figures of the
above ledger accounts can be posted to a trial balance as follows;

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