The Accounting Equation: why the books always balance
- State the accounting equation A = L + C and its forms A − L = C and A − C = L
- Explain why it is also called the balance sheet equation
- Show the effect of any transaction on assets, liabilities and capital in an analysis table
- Find missing figures and the closing capital when profit, losses, drawings and extra capital are given
Here is a promise that will make all of accounting feel logical: in any business, on any day, what the business has is exactly equal to what it owes to outsiders plus what it owes to its owner. Not roughly equal. Exactly equal, to the last rupee. This is the accounting equation. Today we will see why it is always true, and we will take one small shop through ten transactions and watch the equation stay balanced after every single one. Once you are comfortable with this, debit and credit in the next lesson become very easy.
1. Where does a business get its things from?
Kavya wants to open Kavya Mobile Store in Khurja. She puts in ₹3,00,000 of her own savings. Later she buys phones worth ₹90,000 from a distributor who says, "Pay me next month." Now the shop has ₹3,90,000 worth of things (cash and phones). Where did they come from? ₹3,00,000 came from Kavya, and ₹90,000 came from the distributor, who has not been paid yet. Everything the shop has was provided by someone, and that someone has a claim on it.
Every rupee of property in a business comes from one of two sources:
- The owner (proprietor) — the owner's claim is called capital.
- Outsiders (suppliers, banks, lenders) — the outsiders' claim is called liabilities.
The property itself (cash, bank balance, goods, furniture, machinery, amounts customers owe us) is called assets. Since every asset was provided by the owner or by outsiders, the total of assets must always equal the total of the claims.
Accounting equation: the assets of a business are always equal to the total of its liabilities and capital (owner's equity).
Assets = Liabilities + Capital (A = L + C)
Resources of the business = Claims of outsiders + Claim of the owner
1.1 Two other forms of the same equation
Like any equation in maths, you can move terms around to find a missing figure:
A − L = C (capital = what is left for the owner after paying all outsiders)
A − C = L (liabilities = assets not financed by the owner)
Why is it called the "Balance Sheet Equation"? A balance sheet is a statement showing a business's assets on one side and its liabilities and capital on the other side, on a particular date. The accounting equation is exactly this relationship written in one line, so the two sides of the balance sheet are always equal. That is why the equation is also called the balance sheet equation.
(a) Assets ₹8,00,000; Capital ₹5,50,000. Find liabilities.
(b) Capital ₹3,00,000; Liabilities ₹1,40,000. Find assets.
- (a) Use A − C = L: 8,00,000 − 5,50,000 = ₹2,50,000.
- (b) Use A = L + C: 1,40,000 + 3,00,000 = ₹4,40,000.
Gupta General Store has total assets of ₹4,50,000. It owes ₹80,000 to suppliers and ₹40,000 to a bank for a loan. What is the owner's capital?
Capital is a liability of the business towards the owner in the sense that the business owes it to the owner (business entity concept from Chapter 2). But in the equation we keep it separate from "liabilities", which means outsiders' claims only. Do not add capital into L and then add it again as C.
2. Every transaction keeps the equation balanced
A transaction changes the figures, but it can never break the balance. That is because of the dual aspect concept: every transaction has two effects of equal amount. There are only a few ways these two effects can combine:
| Type of change | Example (₹) | Effect on equation |
|---|---|---|
| Asset ↑, Capital ↑ | Owner brings cash 50,000 | Both sides go up by 50,000 |
| Asset ↑, Liability ↑ | Goods bought on credit 20,000 | Both sides go up by 20,000 |
| One asset ↑, another asset ↓ | Cash deposited in bank 10,000 | Total assets unchanged; only the mix changes |
| Asset ↓, Liability ↓ | Paid a creditor 15,000 | Both sides go down by 15,000 |
| Asset ↓, Capital ↓ | Rent paid 6,000, or owner withdraws cash 6,000 | Both sides go down by 6,000 |
| One liability ↑, another liability ↓ | Paid a supplier by taking a bank loan 25,000 | Total liabilities unchanged; assets not touched |
A transaction either moves both sides together (both up or both down by the same amount) or shuffles within one side (one item up, another down). It can never move only one side. That is why A = L + C never breaks.
2.1 Three items that change capital
Beginners are often surprised that paying rent reduces capital. Think of it this way: capital is the owner's share in the business. Anything that makes the owner richer or poorer through the business changes capital.
- Revenue / profit increases capital. If goods costing ₹30,000 are sold for ₹42,000, the business gains ₹12,000 more than it gave away. That ₹12,000 belongs to the owner, so capital goes up by ₹12,000.
- Expenses and losses reduce capital. Rent, salary, electricity: cash goes out and nothing that the business can keep comes in. The owner's share goes down.
- Drawings reduce capital. When the owner takes cash or goods for personal use, the business has less, and the owner's claim falls by the same amount.
- Additional capital brought in by the owner increases capital.
Closing Capital = Opening Capital + Additional Capital + Profit − Drawings
(If there is a loss, subtract it instead of adding profit.)
You can also write the equation as A = L + C + (Revenues − Expenses). Revenues and expenses are really small, temporary parts of capital. At the end of the year their difference (profit or loss) is added to capital. Keep this idea in mind — it explains the debit and credit rules for revenues and expenses in the next lesson.
3. Kavya Mobile Store: ten transactions, one equation
Let us follow Kavya's shop through April 2026. For each transaction, first ask: which two (or more) items change, up or down, and by how much?
- Apr 1 — Kavya started the business with cash ₹3,00,000.
Cash (asset) ↑ 3,00,000; Capital ↑ 3,00,000. - Apr 2 — Opened a bank account with Punjab National Bank and deposited ₹2,00,000.
Bank (asset) ↑ 2,00,000; Cash (asset) ↓ 2,00,000. Only the mix of assets changes. - Apr 4 — Bought display counters (furniture) for ₹40,000, paid by UPI from the bank account.
Furniture ↑ 40,000; Bank ↓ 40,000. - Apr 6 — Bought mobile phones (goods) worth ₹90,000 from Galaxy Distributors on credit.
Stock ↑ 90,000; Creditors (liability) ↑ 90,000. - Apr 10 — Sold phones costing ₹30,000 for ₹42,000 in cash.
Cash ↑ 42,000; Stock ↓ 30,000; Capital ↑ 12,000 (profit). - Apr 15 — Sold phones costing ₹20,000 to Rohan for ₹26,000 on credit.
Debtors ↑ 26,000; Stock ↓ 20,000; Capital ↑ 6,000 (profit). - Apr 20 — Paid ₹50,000 to Galaxy Distributors by cheque.
Bank ↓ 50,000; Creditors ↓ 50,000. - Apr 25 — Paid shop rent ₹8,000 in cash.
Cash ↓ 8,000; Capital ↓ 8,000 (expense). - Apr 28 — Kavya withdrew ₹5,000 cash for personal use.
Cash ↓ 5,000; Capital ↓ 5,000 (drawings). - Apr 30 — Rohan paid ₹16,000 by UPI into the bank.
Bank ↑ 16,000; Debtors ↓ 16,000.
Now put all of this in an analysis table. Decreases are shown in brackets. After each transaction we check that total assets = liabilities + capital.
| No. | Cash | Bank | Stock | Debtors | Furniture | Total Assets | Creditors | Capital | L + C |
|---|---|---|---|---|---|---|---|---|---|
| 1 | 3,00,000 | 3,00,000 | 3,00,000 | 3,00,000 | |||||
| 2 | (2,00,000) | 2,00,000 | |||||||
| Balance | 1,00,000 | 2,00,000 | 3,00,000 | 3,00,000 | 3,00,000 | ||||
| 3 | (40,000) | 40,000 | |||||||
| Balance | 1,00,000 | 1,60,000 | 40,000 | 3,00,000 | 3,00,000 | 3,00,000 | |||
| 4 | 90,000 | 90,000 | |||||||
| Balance | 1,00,000 | 1,60,000 | 90,000 | 40,000 | 3,90,000 | 90,000 | 3,00,000 | 3,90,000 | |
| 5 | 42,000 | (30,000) | 12,000 | ||||||
| Balance | 1,42,000 | 1,60,000 | 60,000 | 40,000 | 4,02,000 | 90,000 | 3,12,000 | 4,02,000 | |
| 6 | (20,000) | 26,000 | 6,000 | ||||||
| Balance | 1,42,000 | 1,60,000 | 40,000 | 26,000 | 40,000 | 4,08,000 | 90,000 | 3,18,000 | 4,08,000 |
| 7 | (50,000) | (50,000) | |||||||
| Balance | 1,42,000 | 1,10,000 | 40,000 | 26,000 | 40,000 | 3,58,000 | 40,000 | 3,18,000 | 3,58,000 |
| 8 | (8,000) | (8,000) | |||||||
| Balance | 1,34,000 | 1,10,000 | 40,000 | 26,000 | 40,000 | 3,50,000 | 40,000 | 3,10,000 | 3,50,000 |
| 9 | (5,000) | (5,000) | |||||||
| Balance | 1,29,000 | 1,10,000 | 40,000 | 26,000 | 40,000 | 3,45,000 | 40,000 | 3,05,000 | 3,45,000 |
| 10 | 16,000 | (16,000) | |||||||
| Final | 1,29,000 | 1,26,000 | 40,000 | 10,000 | 40,000 | 3,45,000 | 40,000 | 3,05,000 | 3,45,000 |
Check the final line: 1,29,000 + 1,26,000 + 40,000 + 10,000 + 40,000 = ₹3,45,000 of assets, and 40,000 + 3,05,000 = ₹3,45,000 of liabilities and capital. Balanced, as promised.
Look at how capital moved: 3,00,000 + 12,000 + 6,000 − 8,000 − 5,000 = ₹3,05,000. Profit on sales raised it; rent and drawings lowered it.
3.1 The same result as a balance sheet
| Balance Sheet of Kavya Mobile Store as at 30 April 2026 | |||
|---|---|---|---|
| Liabilities | Amount (₹) | Assets | Amount (₹) |
| Creditors (Galaxy Distributors) | 40,000 | Cash | 1,29,000 |
| Capital | 3,05,000 | Bank | 1,26,000 |
| Stock | 40,000 | ||
| Debtors (Rohan) | 10,000 | ||
| Furniture | 40,000 | ||
| 3,45,000 | 3,45,000 | ||
In transaction 5, many students write "Cash ↑ 42,000, Stock ↓ 42,000". Then the equation does not balance! Stock goes down by its cost (₹30,000). The extra ₹12,000 is profit, and profit is added to capital. Always split a sale at profit into three effects: asset received at selling price, stock reduced at cost, capital increased by the profit.
(a) Owner started business with cash ₹1,00,000 and goods ₹20,000.
(b) Bought a machine for ₹60,000, paying ₹10,000 in cash and the balance later.
(c) Goods costing ₹15,000 were sold for ₹12,000 cash (clearance sale).
- (a) Cash ↑ 1,00,000 and Stock ↑ 20,000, so assets ↑ 1,20,000. Capital ↑ 1,20,000 (goods brought in are also capital). Equation: 1,20,000 = 0 + 1,20,000.
- (b) Machine ↑ 60,000; Cash ↓ 10,000; Creditor ↑ 50,000. Assets now 1,20,000 + 60,000 − 10,000 = 1,70,000. L + C = 50,000 + 1,20,000 = 1,70,000.
- (c) Cash ↑ 12,000; Stock ↓ 15,000. Assets fall by 3,000. This is a loss of ₹3,000, so Capital ↓ 3,000. Assets = 1,67,000; L + C = 50,000 + 1,17,000 = 1,67,000.
Neha starts a tuition-material shop with cash ₹1,50,000. She buys books worth ₹60,000 on credit, and later pays ₹25,000 cash to that supplier. What are her total assets now?
4. Finding closing capital and profit
- Closing capital = 4,00,000 + 50,000 + 72,000 − 36,000 = ₹4,86,000.
- Assets = Liabilities + Capital = 1,10,000 + 4,86,000 = ₹5,96,000.
Opening capital ₹2,00,000; additional capital introduced ₹50,000; profit for the year ₹35,000; drawings ₹20,000. Find the closing capital.
A shop's capital was ₹3,00,000 at the start of the year and ₹3,40,000 at the end. During the year the owner withdrew ₹25,000 and introduced fresh capital of ₹30,000. What was the profit for the year?
- Bought goods on credit ₹10,000
- Deposited cash ₹10,000 into the bank
- Paid salary ₹10,000 in cash
- Owner brought in additional cash ₹10,000
- Debtors +13,000; Stock −13,000
- Cash +13,000; Stock −10,000; Capital +3,000
- Debtors +13,000; Stock −10,000; Capital +3,000
- Debtors +10,000; Stock −10,000
Board tip: "Show that the accounting equation is satisfied" questions (4–6 marks) are marked on the analysis table. Draw neat columns for each asset, liabilities and capital; show decreases in brackets; write a running balance after each transaction; and finish with one line proving A = L + C. Always name the effect ("Stock ↓ at cost, Capital ↑ by profit") so the examiner can follow your logic even if a figure slips.
📌 Points to remember (Quick Revision)
- Accounting equation: Assets = Liabilities + Capital; also A − L = C and A − C = L.
- It is called the balance sheet equation because it is the balance sheet written in one line.
- Every transaction either moves both sides equally or shuffles items within one side, so the equation always balances.
- Profit and fresh capital increase capital; expenses, losses and drawings decrease it.
- On a sale at profit: asset ↑ at selling price, stock ↓ at cost, capital ↑ by the profit.
- Closing Capital = Opening Capital + Additional Capital + Profit − Drawings.
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