Approaches of recording transactions

Approaches of recording transactions

There are two approaches for recording transactions, namely, i) Accounting equation approach and ii) Traditional approach.

1. Accounting equation approach

The relationship of assets with that of liabilities to outsiders and to owners in the equation form is known as accounting equation.

Under the double entry system of book keeping, every transaction has two fold effect, which causes the changes in assets and liabilities or capital in such a way that an accounting equation is completed and equated.

Capital + Liabilities = Assets

Capital can also be called as owner’s equity and liabilities as outsider’s equity.

Accounting equation is a mathematical expression which shows that the total of assets is equal to the total of liabilities and capital. This is based on the dual aspect concept of accounting. This means that total claims of outsiders and the proprietor against a business enterprise will always be equal to the total assets of the business enterprise

As the revenues and expenses will affect capital, the expanded equation may be given as under:

Assets = Liabilities + Capital + Revenues – Expenses

Therefore, under this approach, accounts are classified into five categories: (i) Asset account, (ii)

Liability account, (iii) Capital account, (iv) Revenue account and (v) Expense account as follows:

i. Asset account

Any physical thing or right owned that has a monetary value is called asset. The assets are grouped and shown separately; for example, Land and Buildings account, Plant and Machinery account.

ii. Liability account

Financial obligations of the enterprise towards outsiders are shown under separate heads as liabilities; for example, creditors account, expenses outstanding account.

iii. Capital account

Financial obligations of a business enterprise towards its owners are grouped under this category; for example, capital contributed by owner.

iv. Revenue account

Accounts relating to revenues of an enterprise are grouped under this category, for example; revenues from sale of goods, rent received.

v. Expense account

Expenses incurred and losses suffered for earning revenue are grouped under this category; for example, purchase of goods, salaries paid.

A transaction may have the effect on either side of the equation by the same amount or it may have the effect on one side of the equation only, by both increasing and decreasing it by an equal amount.

Recording of transactions as per accounting equation approach is explained below:

(a) Increase in capital and increase in asset

Commenced business with cash Rs. 1,00,000

Effects:               

(i) Cash comes in → Increase in asset

(ii) Capital provided by the owner → Increase in capital of owner

Capital = Assets

Capital  =  Cash

(+) Rs. 1, 00,000  =  (+) Rs. 1, 00,000

(b) Decrease in liability and decrease in asset

Paid creditors Rs. 10,000

Effects:  (i) Cash goes out → Decrease in asset

Creditors are paid → Decrease in liability

Liabilities = Assets

Creditors  =  Cash

(–) Rs. 10,000  =  (–) Rs. 10,000

(c) Decrease in one asset and increase in another asset

Bought furniture costing Rs. 5,000 by paying cash

Effects: 

(i) Furniture comes in → Increase in asset

(ii) Cash goes out → Decrease in asset

Liabilities = Assets

Liabilities = Cash + Furniture

         = (–) Rs. 5,000 (+) Rs. 5,000

(d) Decrease in one liability and increase in another liability

Accepted a bill drawn by creditors for Rs. 20,000

Effects: 

(i) Bills payable arises → Increase in liability

(ii) Reduction in creditors → Decrease in liability

Liabilities  =  Assets

+ Bills payable – Creditors  =  Assets

(+) Rs. 10,000  (–) Rs. 10,000  =  Assets

(e) Transactions affecting more than two accounts:

Goods costing Rs. 30,000 sold for Rs. 40,000

Effects: 

(i) Goods go out → Decrease in assets

Cash comes in → Increase in assets

Sold goods at a profit → Increase in capital

Liabilities + Capital  =  Assets

Capital  =  Cash – Stock

(+) Rs. 10,000  =  (+) Rs. 40,000 (–) Rs. 30,000

Illustration 1

Complete the missing items.

Illustration 2

Show the accounting equation on the basis of the following transactions for Rani, who is dealing in automobiles.

(i)  Started business with cash       80,000

(ii)  Goods bought on credit from Ramesh  Rs. 10,000

(iii)  Purchased furniture for cash    Rs. 6,000

(iv)  Paid creditors by cash      Rs. 8,000

Solution

Illustration 3

Show the accounting equation on the basis of the following:

(a)  Started business with cash          60,000

(b)  Purchased goods for cash        Rs. 20,000

(c)  Sold goods for cash costing Rs. 10,000 for    Rs. 15,000

(d)  Paid rent by cash     :   :  Rs. 500

Solution

Illustration 4

Selvi is a dealer in furniture. Show the accounting equation for the following transactions.

(i)  Started business with cash                    Rs. 1,00,000        

(ii)  Deposited cash into bank                     Rs. 60,000 

(iii)  Borrowed loan from bank                            Rs. 25,000 

(iv)  Bought goods and paid by cheque                Rs. 10,000 

(v)  Cash withdrawn for personal use                  Rs. 5,000   

(vi)  Cash withdrawn from bank for office use     Rs. 3,000   

Solution

Illustration 5

Show the effect of following business transactions on the accounting equation.

(i)  Anbu started business with cash Rs. 20,000; goods Rs. 12,000 and machine         Rs. 8,000

(ii)  Purchased goods from Ramani on credit                 Rs. 7,000

(iii)  Payment made to Ramani in full settlement           Rs. 6,900

(iv)  Sold goods to Rajan on credit costing Rs. 5,400 for                 Rs. 6,000             

Received from Rajan Rs. 5,800 in full settlement of his account

(vi)  Wages outstanding                                                 Rs. 400

Solution

Illustration 6

Veena is a dealer in textiles. On January 1, 2018, her business showed the following balances: Cash in hand: Rs. 20,000; Bank balance: Rs. 70,000; Stock: Rs. 15,000. Following are the transactions made during January 2018. Show the effect of the transactions on accounting equation.

(a) Purchased goods (readymade shirts) on credit from Subbu         Rs. 20,000                                       

(b) Goods returned to Subbu and no cash is received    Rs. 5,000                                              

(c) Goods (shirts) costing Rs. 1,600 was sold to Janani on credit     Rs. 2,000                                         

(d) Janani returned 1 shirt of sales value    Rs. 500                                                      

(e) Janani deposited the money due in cash deposit machine in a bank      Rs. 1,500                                          

(f) Insurance on building paid through net banking       Rs. 1,000                                              

(g) Of the insurance paid, prepaid during the year is     Rs. 100                                            

Solution

2. Traditional approach

Under this approach, the two fold aspects (debit and credit) in each transaction are recorded in the journal by following double entry system. For the purpose of recording the transactions, accounts are classified into personal and impersonal accounts.

1. Classification of accounts:

Under double entry system of book keeping, for the purpose of recording the various financial transactions, the accounts are classified as personal accounts and impersonal accounts.

i. Personal account: Account relating to persons is called personal account. The personal account may be natural, artificial or representative personal account.

·        Natural person’s account: Natural person means human beings. Example: Vinoth account, Malini account.

·        Artificial person’s account: Artificial person refers to the persons other than human beings recognised by law as persons. They include business concerns, charitable institutions, etc. Example: BHEL account, Bank account.

·        Representative personal accounts: These are the accounts which represent personsnatural or artificial or a group of persons. Example: Outstanding salaries account, Prepaid rent account. When expenses are outstanding, it is payable to a person. Hence, it represents a person.

ii. Impersonal accounts: All accounts which do not affect persons are called impersonal accounts. These are further classified into a) Real accounts and b) Nominal accounts.

a. Real account: All accounts relating to tangible and intangible properties and possessions are called real accounts.

·        Tangible real accounts: These include accounts of properties and possessions which can be seen and touched. These have physical existence. Example: Plant, Machinery, Building, Furniture, Stock.

·        Intangible real accounts: These include accounts of properties and possessions which can not be seen and touched. These do not have physical existence. Example: Goodwill, Patents, Copy rights.

b. Nominal account: The accounts relating to expenses, losses, revenues and gains are called nominal accounts. Example: Salaries, wages, rental income, interest income, etc. These are temporary accounts and are transferred to Trading and Profit and Loss account depending on whether these are direct or indirect respectively.