AccountancyThe accounting equation, with a solved example
Whatever a business owns was paid for by someone: an outsider or the owner. That one idea is the whole equation.
The equation
Assets = Liabilities + Capital
Assets are what the business owns. Liabilities are what it owes to outsiders. Capital is what it owes to the owner. Since every asset is financed either by outsiders or by the owner, the two sides must always be equal. The equation can be turned around: Capital = Assets − Liabilities, and Liabilities = Assets − Capital.
Why it always holds
Every transaction touches at least two items, and by the same amount. This is the dual aspect. There are only four patterns:
- One asset rises and another asset falls (buying furniture for cash).
- An asset rises and a liability rises (buying goods on credit).
- An asset falls and a liability falls (paying a creditor).
- An asset and capital change together (owner brings in money; profit raises capital; expenses and drawings reduce it).
In none of these does one side change alone, so the equation cannot break.
Solved example: Meera Stores
Each row shows the position after the transaction. Check that total assets equal creditors plus capital in every row.
| After transaction | Cash | Furniture | Stock | Total assets | Creditors | Capital |
|---|---|---|---|---|---|---|
| 1. Meera starts business with cash ₹5,00,000 | 5,00,000 | 0 | 0 | 5,00,000 | 0 | 5,00,000 |
| 2. Buys furniture for cash ₹60,000 | 4,40,000 | 60,000 | 0 | 5,00,000 | 0 | 5,00,000 |
| 3. Buys goods for cash ₹1,20,000 | 3,20,000 | 60,000 | 1,20,000 | 5,00,000 | 0 | 5,00,000 |
| 4. Buys goods on credit from Gupta Traders ₹80,000 | 3,20,000 | 60,000 | 2,00,000 | 5,80,000 | 80,000 | 5,00,000 |
| 5. Sells goods costing ₹50,000 for ₹70,000 cash | 3,90,000 | 60,000 | 1,50,000 | 6,00,000 | 80,000 | 5,20,000 |
| 6. Pays rent ₹10,000 | 3,80,000 | 60,000 | 1,50,000 | 5,90,000 | 80,000 | 5,10,000 |
| 7. Pays Gupta Traders ₹30,000 | 3,50,000 | 60,000 | 1,50,000 | 5,60,000 | 50,000 | 5,10,000 |
| 8. Withdraws ₹5,000 for personal use | 3,45,000 | 60,000 | 1,50,000 | 5,55,000 | 50,000 | 5,05,000 |
The reasoning for each transaction
- Cash comes in, and the business owes the same amount to Meera: cash and capital both rise by ₹5,00,000.
- One asset is exchanged for another: cash falls, furniture rises. The total does not change.
- Again an exchange: cash falls by ₹1,20,000 and stock rises by ₹1,20,000.
- Stock rises by ₹80,000 and so does the amount owed to the supplier.
- Cash rises by ₹70,000 but stock falls by only ₹50,000, its cost. The difference of ₹20,000 is profit, and profit belongs to the owner, so capital rises by ₹20,000.
- Rent is an expense. Cash falls by ₹10,000 and capital falls by ₹10,000, because an expense reduces the owner's profit.
- Cash falls by ₹30,000 and the debt to Gupta Traders falls by the same amount.
- Drawings reduce cash and capital by ₹5,000 each.
Final position
Assets: cash ₹3,45,000 + furniture ₹60,000 + stock ₹1,50,000 = ₹5,55,000. Liabilities and capital: creditors ₹50,000 + capital ₹5,05,000 = ₹5,55,000. The two sides agree.
| Liabilities | ₹ | Assets | ₹ |
|---|---|---|---|
| Capital | 5,05,000 | Furniture | 60,000 |
| Creditors (Gupta Traders) | 50,000 | Stock | 1,50,000 |
| Cash | 3,45,000 | ||
| 5,55,000 | 5,55,000 |
Capital in more detail
Closing capital = Opening capital + Additional capital + Profit − Drawings (or − Loss). In the example, ₹5,00,000 + profit on sale ₹20,000 − rent ₹10,000 − drawings ₹5,000 = ₹5,05,000, the figure in the last row.
Common mistakes
- Reducing stock by the selling price. Stock always leaves at cost; the extra is profit.
- Forgetting that expenses and losses reduce capital, and incomes and gains increase it.
- Treating a credit purchase as a fall in cash. No cash moves until the supplier is paid.
- Recording outstanding expenses only on one side. Salary due but unpaid raises a liability and lowers capital.
Next: the same dual aspect written as debit and credit, in rules of debit and credit.
Questions students ask
What is the accounting equation?
Assets = Liabilities + Capital. It says that everything a business owns is financed either by outsiders or by the owner.
How does profit affect the accounting equation?
Profit increases capital, and an equal net increase appears in assets, usually cash or debtors. A loss or an expense reduces capital.
Can the two sides of the equation ever differ?
No. Every transaction changes two items by the same amount, so the sides stay equal. If they differ in your working, an entry is wrong or missing.
More Class 11 topics
For study, and independent. These pages explain accountancy as it is generally taught in Class 11, Class 12 and B.Com courses in India, in our own words with our own examples, reviewed in November 2026. This site is not connected with NCERT, CBSE, ICAI or any board or university. Syllabuses change: follow your own board's or university's current syllabus and textbook. Nothing here is professional accounting, tax or legal advice.