What is the accounting equation?
A business keeps its own accounts, separate from its owner. Everything it owns and can use, like cash, stock, furniture or money customers owe it, is called assets. Every asset was paid for by someone: either by outsiders such as suppliers and banks (liabilities) or by the owner (capital).
So the two sides must always be equal: Assets = Liabilities + Capital. This is called the accounting equation, or the balance sheet equation.
How transactions keep it balanced
Every transaction touches at least two items. There are only four kinds of change:
- One asset up, another down (buy furniture for cash): totals do not change.
- Asset up, liability up (buy goods on credit, take a loan).
- Asset down, liability down (pay a creditor, repay a loan).
- Asset and capital move together (owner brings money, owner takes drawings, profit or loss).
In each case both sides change by the same amount, so the equation stays true. This idea is the base of double-entry bookkeeping.
Other forms of the equation
You can rearrange it like any equation: Capital = Assets − Liabilities (the owner's share) and Liabilities = Assets − Capital. Profit made by the business adds to capital; drawings and losses reduce it.
Try it on the balance scale
In the 3D scale, the left pan holds assets and the right pan holds liabilities and capital. Each block is ₹5,000. In free play, choose a transaction: one side changes first and the beam tips, then the other side catches up and the beam is level again.
Key formulas and definitions
- Assets = Liabilities + Capital
- Capital = Assets − Liabilities
- Liabilities = Assets − Capital
- Closing capital = Opening capital + Additional capital + Profit − Drawings
Worked examples
1. Aman starts a business with cash ₹80,000. Show the equation.
Assets (cash) ₹80,000 = Liabilities ₹0 + Capital ₹80,000.
2. A shop has assets of ₹1,50,000 and liabilities of ₹40,000. Find the capital.
Capital = Assets − Liabilities = 1,50,000 − 40,000 = ₹1,10,000.
3. Cash ₹60,000 = Capital ₹60,000. Goods of ₹15,000 are bought on credit. Show the new equation.
Cash ₹60,000 + Goods ₹15,000 = Creditors ₹15,000 + Capital ₹60,000, so ₹75,000 = ₹75,000.
Common mistakes
- Mixing the owner's personal money with the business's money. Capital is what the business owes the owner.
- Changing only one side. Every transaction changes at least two items; check both sides after each one.
- Showing drawings as an asset or an expense. Drawings reduce cash and reduce capital.
- Forgetting that buying one asset with another (furniture for cash) does not change the total at all.