The accounting equation and double entry
Assets are things the business owns (cash, stock, furniture). Liabilities are what it owes. Capital is the owner's money in the business.
Assets = Liabilities + Capital. In our shop there are no loans, so assets = capital.
Every transaction changes two things, so the equation stays true. This is double entry: one account is debited and another is credited by the same amount.
Record and sort: journal and ledger
The journal is the first book. Each transaction is written in date order with the two accounts, the debit and the credit.
Example: buy goods for 400 cash. Debit Stock 400, credit Cash 400.
The ledger has one page (account) for each item: Cash, Stock, Rent, Sales. Posting means copying each journal line to the right account page, so you can see the total for each item.
Check and report: trial balance, profit, balance sheet
A trial balance lists every ledger balance in two columns. Debit total must equal credit total. For Ravi: debits are Cash 710, Stock 300, Rent 50, Cost of goods 100 = 1160. Credits are Capital 1000 and Sales 160 = 1160. They match.
Profit and loss statement: Sales 160 − Cost of goods 100 − Rent 50 = Profit 10.
Balance sheet: Assets 710 + 300 = 1010. Capital 1000 + Profit 10 = 1010. Equal.
A matching trial balance is a good sign, but it does not prove there are no errors. A wrong amount written on both sides still balances.
Try it and use it
Profit raises capital. A loss lowers it. If the owner takes cash for personal use (drawings), cash and capital both fall.
Try it
Take a notebook. Pretend you start a stall with 500. Write five deals: buy goods, sell some, pay a bill and so on. After each deal, write cash, stock and capital. Check that assets still equal capital. Then use the sliders in the 3D to test other prices.
Key formulas and definitions
- Assets = Liabilities + Capital
- Profit = Sales − Cost of goods sold − Expenses
- Closing capital = Opening capital + Profit − Drawings
- Trial balance: total debits = total credits
Worked examples
1. An owner starts with 1000 cash and buys goods for 400 cash. What are cash, stock and total assets?
Cash = 1000 − 400 = 600. Stock = 400. Total assets = 1000. They did not change; only the form changed.
2. Goods that cost 100 are sold for 160 cash. What is the profit and the new capital if capital was 1000?
Profit = 160 − 100 = 60. New capital = 1000 + 60 = 1060.
3. Then rent of 50 is paid. Find the final profit and capital.
Profit = 60 − 50 = 10. Capital = 1000 + 10 = 1010.
4. Write the journal entry for buying goods for 400 cash.
Debit Stock 400, credit Cash 400. Both sides are 400.
Common mistakes
- Writing a deal on only one side. Every deal has a debit and a credit.
- Counting rent as an asset. Rent paid is an expense and lowers profit.
- Counting the full sale 160 as profit. Subtract the cost of the goods first.
- Believing a matching trial balance means no errors. Check the amounts too.