The accounting equation

The accounting equation is: Assets = Liabilities + Capital. Everything the business owns is claimed by someone: outsiders (liabilities) or the owner (capital). You can turn it round: Capital = Assets − Liabilities, and Liabilities = Assets − Capital. Because the balance sheet is built on it, it is also called the balance sheet equation.

Assets include cash, bank, stock, debtors, bills receivable, land, buildings, machinery, prepaid expenses (paid for in advance) and accrued income (earned but not yet received). Liabilities include creditors, bills payable, loans, a bank overdraft, outstanding expenses (work done for you, not yet paid) and income received in advance.

Every transaction changes the equation in one of two ways. Either both sides move by the same amount, or only the mix on one side changes. Putting cash into the bank only moves money from one asset to another; the total does not change.

Work it as a table: one column for each asset, = capital, + one column for each liability. Check the totals after each step, so a mistake is caught at once. Here is a worked example.

• Starts business with ₹1,00,000 cash: cash +1,00,000, capital +1,00,000.
• Deposits ₹60,000 in the bank: cash −60,000, bank +60,000. Only the mix of assets changes.
• Buys goods for ₹20,000 from X, paying ₹5,000 now: stock +20,000, cash −5,000, creditors +15,000.
• Sells goods that cost ₹15,000 for ₹20,000 cash: cash +20,000, stock −15,000, capital +5,000. The profit belongs to the owner, so it goes to capital.
• Pays wages ₹6,000, with ₹1,000 more still owing: cash −6,000, outstanding wages +1,000, capital −7,000. Expenses reduce capital.

So profit and income raise capital; expenses, losses and drawings lower it. Buying goods on credit does not touch capital at all: stock goes up and creditors go up by the same amount. In the book, Rohit's business ends with assets of ₹6,80,000 = creditors ₹1,70,000 + capital ₹5,10,000.