Financial Accounting and Control

Class Note
Accounting Equation
The accounting equation is a fundamental principle in accounting that represents the
relationship between a company's assets, liabilities, and equity. The accounting equation,
Assets = Liabilities + Equity, is fundamental in understanding how transactions affect a
company's financial position. It ensures that the balance sheet is always balanced, providing a
comprehensive view of the company's financial health. This equation forms the basis of double-
entry bookkeeping, which is essential for maintaining accurate and reliable financial records.
It is expressed as:

Assets = Liabilities + Equity + Profit

1. Assets: These are resources owned by a company that have economic value and can provide
future benefits. Examples include cash, inventory, property, and equipment.

2. Liabilities: These are obligations that the company owes to outsiders or creditors. Examples
include loans, accounts payable, and mortgages.

3. Equity: Also known as owner's equity or shareholders' equity, this represents the owner's
claims on the assets of the business after all liabilities have been deducted. It includes items
such as common stock paid-in capital and retained earnings (also known as Other Equity which
is an accumulated figure of retained profit over the years of business.).

1. Example:

Let's consider a series of transactions for a small business, "ABC Company," to illustrate the
accounting equation:

Assets=Liabilities+Equity+ Profit

I. Initial Investment

Transaction:
 • The owner invests $20,000 in cash to start the business.

Effect:

• Assets increase by $20,000 (Cash).

• Equity increases by $20,000 (Owner's Capital).

Accounting Equation: Assets=Liabilities+Equity+ Profit

$20,000=$0+$20,000

II. Taking a Loan

Transaction:

• The business takes a loan of $10,000 from the bank.

Effect:

• Assets increase by $10,000 (Cash).

• Liabilities increase by $10,000 (Bank Loan).

Accounting Equation: Assets=Liabilities+Equity+ Profit

$30,000=$10,000+$20,000

III. Purchasing Equipment

Transaction:

• The business buys equipment worth $5,000 using cash.

Effect:

• Assets increase by $5,000 (Equipment) and decrease by $5,000 (Cash).

Accounting Equation: Assets = Liabilities+Equity+ Profit

($25,000 Cash+$5,000 Equipment) =$10,000+$20,000

IV. Providing Services on Credit

Transaction:

• The business provides services worth $8,000 on credit.

Effect:

• Assets increase by $8,000 (Accounts Receivable).

• Equity increases by $8,000 (Service Revenue).

Accounting Equation: Assets=Liabilities+Equity+ Profit

($25,000 Cash + $5,000 Equipment + $8,000 Accounts Receivable) = $10,000 +

($20,000 Owner’s Capital+ $8,000 Service Revenue)

Accounts Receivable (AR) represents money owed to a business by its customers for
goods or services delivered but not yet paid for. It is recorded as an asset on the balance
sheet because it is expected to be converted into cash in the future. Accounts Receivable is
typically classified as a current asset because it is usually collected within a short period,
typically within a year. AR arises from credit sales, where customers are allowed to pay
for goods or services later. AR is an important component of financial ratios, such as the
accounts receivable turnover ratio, which measures how efficiently a company collects its
receivables. AR helps in assessing the effectiveness of the company's credit policies and the
creditworthiness of its customers. Regularly reviewing the age of receivables to identify
and address overdue accounts. By managing accounts receivable effectively, businesses
can maintain healthy cash flows, minimize bad debts, and ensure financial stability.
Increases the AR account, representing the amount owed by the customer. Increases the
sales revenue account, recognizing the revenue earned from the sale as a positive figure
under profit head.

V. Paying Expenses

Transaction:

• The business pays $2,000 in rent expenses using cash.

Effect:

• Assets decrease by $2,000 (Cash).

• Equity decreases by $2,000 (Expenses reduce retained earnings).

Accounting Equation: Assets=Liabilities+Equity + Profit

($23,000 Cash+$5,000 Equipment+$8,000 Accounts Receivable)
=$10,000+($20,000 Owner’s Capital+$8,000 Service Revenue−$2,000 Expenses)

Summary

Through these transactions, we see how the accounting equation remains balanced after each
transaction. The changes in assets, liabilities, and equity are consistently reflected, ensuring
accurate and reliable financial records.

2. Example
Let's use "XYZ Company" to illustrate how profit affects retained earnings within the
accounting equation:
 Assets = Liabilities + Equity+ Profit

Key Components: Assets: Cash, Accounts Receivable, Equipment, etc. Liabilities: Loans,
Accounts Payable, etc. Equity: Common Stock, Retained Earnings (including profits).

I. Initial Investment

Transaction:

• The owner invests $30,000 in cash to start the business.

Effect:

• Assets increase by $30,000 (Cash).

• Equity increases by $30,000 (Owner's Capital).

Accounting Equation: Assets=Liabilities+Equity

$30,000=$0+$30,000

II. Taking a Loan

Transaction:

• The business takes a loan of $15,000 from the bank.

Effect:

• Assets increase by $15,000 (Cash).

• Liabilities increase by $15,000 (Bank Loan).

Accounting Equation: Assets=Liabilities+Equity

$45,000=$15,000+$30,000

III. Purchasing Equipment

Transaction:

• The business buys equipment worth $10,000 using cash. 10 years of Economic Life.
Straight Line method of depreciation.

Effect:

• Assets increase by $10,000 (Equipment) and decrease by $10,000 (Cash).

Accounting Equation: Assets=Liabilities+Equity

 ($35,000 Cash+$10,000 Equipment) =$15,000+$30,000

IV. Providing Services for Cash

Transaction:

• The business provides services and earns $20,000 in cash.

Effect:

• Assets increase by $20,000 (Cash).

• Equity increases by $20,000 (Service Revenue, which increases Retained Earnings).

Accounting Equation: Assets=Liabilities+Equity+ Profit

($55,000 Cash+$10,000 Equipment) = $15,000+($30,000 Owner’s Capital)

+($20,000 because of sales it increases profit)

$65,000=$15,000+$50,000

V. Paying Expenses

Transaction:
• The business pays $5,000 in expenses using cash.
Effect:

• Assets decrease by $5,000 (Cash).

• Equity decreases by $5,000 (Expenses reduce Retained Earnings or profit).

Accounting Equation: Assets=Liabilities+Equity+ Profit

($50,000 Cash+$10,000 Equipment) =$15,000+($30,000 Owner’s Capital)+( +$20,000 Sales-
$5,000 Expenses)

$60,000=$15,000+$45,000

VI. Charging Depreciation on the Asset

Transaction:

Depreciation of Asset through SLM method = (10,000- 0)/ 10 = 1000.

Effect:

• Equipment as an Asset Decreases by $1000.

• Earnings or Profit reduces by $ 1000.

Accounting Equation: Assets=Liabilities+Equity+ Profit

($50,000 Cash) +($10,000 Equipment- $ 1000 Depreciation) = (loan $15,000)

+($30,000 Owner’s Capital) + ( +$20,000 Sales- $5,000 Expenses- $ 1000 Depreciation)
Assets $ 59,000 = Loan $ 15000 + Capital $ 30,000 + Profit $ 14,000

Depreciation is the systematic allocation of the cost of a tangible fixed asset (these are long-
term assets used in the operations of a business, such as machinery, buildings, vehicles, and
equipment) over its useful life. It represents the wearing out, consumption, or other reduction
in the useful life of an asset. Depreciation is a non-cash expense that reduces the book value
of the asset on the balance sheet and is recorded as an expense on the income statement. The
estimated period over which the asset is expected to be used by the business. Residual Value
(Salvage Value): The estimated amount that the asset will be worth at the end of its useful life.

Method of Depreciation: Straight-Line Method (SLM)

This method allocates an equal amount of depreciation each year over the useful life of the
assets. Formula: Annual Depreciation = (Cost of Asset−Residual Value)/ Useful Life. In this
example Asset or Equipment worth $10,000 using cash. 10 years of Economic Life. So
Depreciation is (10,000- 0)/ 10 = 1000. Depreciation is a non-cash expense because does not
pay to anyone outsider. However, it is charged to P&L account as an operating expense. Thus,
provides a more accurate picture of a company’s profitability and asset utilization.
Depreciation is a deductible expense for tax purposes, reducing the taxable income of a
business. Depreciation helps in matching the cost of an asset with the revenue it generates over
its useful life.

3. Example

Starting of the Journey:

Mr. Jatin started a business with initial capital contribution of (Rs.) 15,00,000. Mr. Jatin also
supplied furniture’s worth (Rs.) 3,00,000 for the office use in the business. His family
supported with a non-interest-bearing loan of (Rs.) 8,00,000. The loan will be repaid at equal
instalment after the 5th year of the business. The bank loan to purchase an office is (Rs.)
10,00,000. Additionally, he took (Rs.) 5,00, 000 loan from the bank for the working capital and
day-to-day operation of the business. The bank loan is having an interest of 10% (paid
annually). The business commenced on 1st April 2017. You are required to show the
accounting equation and the opening balance sheet. The business got a registration in the name
of Jatin Home Décor Pvt. Ltd. The primary business is home furnishing and home décor
supplies. Assume a tax rate of 30%.

Assets Liability Capital Profit/Loss

Cash 1500000 Personal Loan 8,00,000 15,00,000
Bank Loan-1 10,00,000 3,00,000
Bank 800000 Bank Loan-2 500000
500000
Building 1000000
Furniture 300000
Total 41,00,000 Total 41,00,000

Opening Balance Sheet (1st April 2017)

 Assets Rs.
Cash 1500000
Bank 1300000
Building 1000000
Furniture 300000

Total 41,00,000
Equity & Liability Rs.
Capital 18,00,000

Personal Loan 8,00,000

Bank Loan-1 10,00,000
Bank Loan-2 500000
Total 41,00,000

1st Year of the Operation: 2017-18

In the month May 2017, Jatin purchased stores and inventory of (AED) 60,00,000. 15% of
the purchase (AED) 9,00,000) is through cash and remaining 85% is on credit through
account payables. He also purchased a home delivery mini truck worth (AED) 3,00,000 for
the office use. The company prefers to charge depreciation at a rate of 10% every year.
Janit also hired some staff for the sales and technical service. The staff salary for the entire
year is (AED) 4,00,000. However, the extra commission of (AED) 50,000 due to the sales
staff is unpaid at the end of the financial year. This is expected to be paid during the year
2018-19. The electricity expenses, telephone expenses, and other operating expenses for
the financial year is (AED) 1,50,000. All expenses paid through bank. Jatin took a business
insurance of (AED) 50,00,000 for an annual premium of (AED) 50,000. In the first year he
paid premium worth (AED) 1,00,000 for the two years (i.e., 2017-18, and 2018-19). In the
financial year Jatin had a sale of (AED) 70,00,000. 80% of the sales is through cash and
remaining 20% is through credit. The credit sales is expected to be realised in the Month
of May 2018. At the end of the year (31st March 2018) there is (AED) 30,00,000 worth
stores and inventory is in the warehouse. You are required to tell Mr. Jtin how the business
doing at the end of the first year. The interest due on the company bank account is (AED)
10,000, however, interest is yet to be received or credited to the company bank account. In
the year Jatin made an interest payment of (AED) 1,00,000 for the loan. Remaining interest
is outstanding.

Note: We have kept two accounts as Cash and Bank. However, while utilising the money or adding
money to these accounts we will assume that wherever it was for less than three months it will be part
of cash and wherever it is more than 3 months we are using bank. The question, however, does not
explicitly mention whether it is more than or less than 3 months. So usage is based on assumption (Cash
or Bank).
 Assets Liability Capital Profit/Loss
Cash 600000 Personal Loan 8,00,000 15,00,000
Inventory
(900000+5100000) 6000000 Bank Loan-1 10,00,000 3,00,000 In the month May 2017, Jatin purchased
stores and inventory of Rs. 60,00,000. 15% of
Bank 800000 Bank Loan-2 500000
the purchase (Rs. 9,00,000) is through cash
500000 Accounts Payable 5100000
and remaining 85% is on credit through
Building 1000000
account payables.
Furniture 300000
Total 92,00,000 Total 92,00,000

Assets Liability Capital Profit/Loss

Cash 600000 Personal Loan 8,00,000 15,00,000
Inventory
(900000+5100000) 6000000 Bank Loan-1 10,00,000 3,00,000
He also purchased a home delivery mini
Bank 500000 Bank Loan-2 500000 truck worth Rs. 3,00,000 for the office use.
500000 Accounts Payable 5100000
Building 1000000
Furniture 300000
Mini Truck 300000
Total 92,00,000 Total 92,00,000

Assets Liability Capital Profit/Loss

Cash 600000 Personal Loan 8,00,000 15,00,000 Janit also hired some staff for the sales and
Inventory technical service. The staff salary for the
(900000+5100000) 6000000 Bank Loan-1 10,00,000 3,00,000 entire year is Rs. 4,00,000. However, the
Bank 500000 Bank Loan-2 500000 extra commission of Rs. 50,000 due to the
100000 Accounts Payable 5100000 sales staff is unpaid at the end of the
Outstanding financial year. This is expected to be paid
Building 1000000 Commission 50000 during the year 2018-19.
Furniture 300000 -50000
Mini Truck 300000 -400000
Total 88,00,000 Total 88,00,000
-400000
Assets Liability Capital Profit/Loss
Cash 600000 Personal Loan 8,00,000 15,00,000
Inventory
(900000+5100000) 6000000 Bank Loan-1 10,00,000 3,00,000
The electricity expenses, telephone
Bank 350000 Bank Loan-2 500000
expenses, and other operating expenses for
100000 Accounts Payable 5100000
the financial year is Rs. 1,50,000. All
Outstanding
expenses paid through bank.
Building 1000000 Commission 50000
Furniture 300000 -50000
Mini Truck 300000 -400000
-150000
Total 86,50,000 Total 86,50,000

Assets Liability Capital Profit/Loss

Cash 600000 Personal Loan 8,00,000 15,00,000
Inventory
(900000+5100000) 6000000 Bank Loan-1 10,00,000 3,00,000
Bank 350000 Bank Loan-2 500000 Jatin took a business insurance of Rs.
50,00,000 for an annual premium of Rs.
0 Accounts Payable 5100000
50,000. In the first year he paid premium
Outstanding
worth Rs. 1,00,000 for the two years (i.e.,
Building 1000000 Commission 50000
2017-18, and 2018-19).
Furniture 300000 -50000
Mini Truck 300000 -400000
Prepaid Insurance 50000 -150000
-50000
Total 86,00,000 Total 86,00,000
 Assets Liability Capital Profit/Loss
Cash 6200000 Personal Loan 8,00,000 15,00,000
Inventory
(900000+5100000) 6000000 Bank Loan-1 10,00,000 3,00,000
Bank 350000 Bank Loan-2 500000 In the financial year Jatin had a sales of Rs.
0 Accounts Payable 5100000 70,00,000. 80% of the sales is through cash
Outstanding and remaining 20% is through credit. The
Building 1000000 Commission 50000 credit sales is expected to be realised in the
Furniture 300000 -50000 Month of May 2018.
Mini Truck 300000 -400000
Prepaid Insurance 50000 -150000
Account Receivable 1400000 -50000
7000000
Total 1,56,00,000 Total 1,56,00,000

Assets Liability Capital Profit/Loss

Cash 6200000 Personal Loan 8,00,000 15,00,000
Inventory 3000000 Bank Loan-1 10,00,000 3,00,000
Bank 350000 Bank Loan-2 500000
0 Accounts Payable 5100000
At the end of the year (31st March 2018)
Outstanding
there is Rs. 30,00,000 worth stores and
Building 1000000 Commission 50000
inventory is in the warehouse. You are
Furniture 300000 -50000 required to tell Mr. Jtin how the business
Mini Truck 300000 -400000 doing at the end of the first year.
Prepaid Insurance 50000 -150000
Account Receivable 1400000 -50000
7000000
-3000000
Total 1,26,00,000 Total 1,26,00,000
 Assets Liability Capital Profit/Loss
Cash 6200000 Personal Loan 8,00,000 15,00,000
Inventory 3000000 Bank Loan-1 10,00,000 3,00,000
Bank 350000 Bank Loan-2 500000
0 Accounts Payable 5100000
Outstanding . The interest due on the company bank
Building 1000000 Commission 50000 -50000 account is Rs. 10,000, however, interest is
Furniture 300000 -400000 yet to be received or credited to the
Mini Truck 300000 -150000 company bank account.
Prepaid Insurance 50000 -50000
Account Receivable 1400000 7000000
Interest Receivable/
Accrued 10000 -3000000
10000
Total 1,26,10,000 Total 1,26,10,000

Assets Liability Capital Profit/Loss

Cash 6200000 Personal Loan 8,00,000 15,00,000
Inventory 3000000 Bank Loan-1 10,00,000 3,00,000
Bank 250000 Bank Loan-2 500000
0 Accounts Payable 5100000 In the year Jatin made an interest payment
Outstanding of Rs. 1,00,000 for the loan. Remaining
Building 1000000 Commission 50000 interest is outstanding. (Note: Total interest
Furniture 300000 Interest Outstanding 50000 -50000 is 10% on 15,00,000 i.e., 150000. If 100000 is
Mini Truck 300000 -400000 paid and 50,000 is outstanding)
Prepaid Insurance 50000 -150000
Account Receivable 1400000 -50000
Interest Receivable/
Accrued 10000 7000000
 -3000000
10000
-150000
Total 1,25,10,000 Total 1,25,10,000

Assets Liability Capital Profit/Loss

Cash 6200000 Personal Loan 8,00,000 15,00,000
Inventory 3000000 Bank Loan-1 10,00,000 3,00,000
Bank 250000 Bank Loan-2 500000 The company prefers to charge depreciation
0 Accounts Payable 5100000 at a rate of 10% every year. (Building: 10% of
Outstanding 10,00,000; Furniture: 10% of 300000; and,
Building 9,00,000 Commission 50000 Minitruck: 10% of 300000)
Furniture 270000 Interest Outstanding 50000 -50000
Mini Truck 270000 -400000
Prepaid Insurance 50000 -150000
Account Receivable 1400000 -50000
Intrest Receivable/ Accrued 10000 7000000
-3000000
10000
-150000
-160000
Total 1,23,50,000 Total 1,23,50,000

This part represents the total profit or Loss made by the company. Thus the
revenue is positive and all other expenses are negative. The final profit before tax
(PBT)as per this calculation is 30,50,000. If we consider 30% tax then the net
profit (Profit after tax or PAT ) will be 21,35,000. The tax amount will reduce profit
and the cash or bank will go down by the tax amount. See the next page.
 Cost of Goods Sold Income statement for the Year Ending 2017-18
(COGS) represents Revenue (Sale proceeds) 7000000
the direct costs Less: Cost of Goods Sold (COGS)
Opening stock 0
attributable to the
Add: Purchase 6000000
production of the Less: Closing stock 3000000 3000000
goods sold by a Gross Profit 4000000
company. This Less: Operating Expenses
amount includes the Salary -400000
Commission expenses -50000
cost of the materials
Electricity, telephone, and others -150000
and labour directly Insurance expenses -50000
used to create the Earnings Before Interest, Tax, Depreciation and Amortisation
product. It excludes (EBITDA) 3350000
indirect expenses Less: Depreciation (on tangible fixed assets, 10000+ 3000+3000) -160000
such as distribution Less: Amortisation 0
Earnings Before Interest, Tax (EBIT) 3190000
costs and sales force
Less: Interest Expenses -150000
costs. COGS is Earning Before Tax (EBT) 3040000
subtracted from Add: Other Income 10000
revenues (sales) to Earning Before Tax (EBT) 3050000
determine gross Less: Tax (@30%) 915000
Net Profit or Profit After Tax (PAT) 2135000
profit. Gross profit is
a key indicator of a
company's
Will be added to
production efficiency
our capital as
and profitability.
Retained Profit
 Balance Sheet as on 31-03-2018
Assets Rs. Rs.
Non-Current Assets:
Building 1000000
Less: Depreciation 100000 9,00,000
Furniture 300000
Less: Depreciation 30000 270000
Mini Truck 300000
Less: Depreciation 30000 270000
Current Assets:
Cash 6200000
Bank 250000
Inventory 3000000
Accounts Receivable 1400000
Interest Accrued 10000
Prepaid Insurance 50000
Total Assets ₹ 1,23,50,000.00
Equity and Liabilities Rs. Rs.
Capital 18,00,000
Add: Profit (Retained Earnings) 2135000
Non-Current Liability
Personal Loan 8,00,000
Bank Loan-1 10,00,000
Bank Loan-2 500000
Current Liability:
Accounts Payable 5100000
Outstanding Commission 50000
Interest Outstanding 50000
Tax Payable (It’s a liability, because it will be paid in the next financial year) 915000
Total Liabilities and Equity ₹ 1,23,50,000.00
 Start of the Business: Smokey Valley Cafe

pit l 000 sh 00
ort e o n , 00 nd 2 00
prove ents to l nd 2000
uildin 0, 00
f uip ent 000

End of the Business: Smokey Valley Cafe

pit l 000 sh n
ddition 00 nd 2 00 2 00
prove ents to l nd 2000
ort e o n , 00 epre i tion
ent 00 0, 00 uildin 0, 00 02
ounts le 20 f uip ent 000
ood te inventor 00
ottles nd ses
Other e uip ent