CBSE CLASS 11 — ACCOUNTANCY

T.S. Grewal's Double Entry Book Keeping — Financial Accounting

CHAPTER 5 : ACCOUNTING EQUATION

Complete Revision Notes • Explained Simply • Solved Examples • CBSE Exam Q&A

Learning Objectives — What this chapter teaches you

● Meaning of an Accounting Equation
● Effect of Transactions on the Accounting Equation
● Process of preparing the Accounting Equation
● Rules for the Accounting Equation
● Effect of Adjustment Transactions on the Accounting Equation

1. Meaning of Accounting Equation

Explain it to me like I am 5 years old 🧸
Imagine you have a piggy bank. Everything you OWN (your toys, your cycle, the money in the piggy bank) had to
come from somewhere. Either:
● Someone GAVE you money and you must return it one day (like when you borrow ₹50 from your friend) — this
is called a LIABILITY, or
● It is truly YOURS because you earned it or your parents gave it to you as your own — this is called CAPITAL
(or Owner's Equity).
So at any moment: “Everything I own” = “What I owe to others” + “What is really mine.” That is exactly what the
Accounting Equation says about a business!

Formal Definition
The Accounting Equation is a mathematical statement showing that the total ASSETS of a business are always equal
to the total of its LIABILITIES and CAPITAL. It is based on the Dual Aspect Concept (also called the Duality
Principle) of accounting, which says every transaction has two effects (a give and a take) and both effects must be
recorded.

ASSETS = LIABILITIES + CAPITAL

This can also be written in two more useful ways — you MUST remember all three forms for exams:
● Capital = Assets − Liabilities
● Liabilities = Assets − Capital

EXAM TIP (Very Important)

★ This equation must remain TRUE and BALANCED after every single transaction — no matter how many
transactions happen.
★ It proves the business is a separate entity from its owner (Business Entity Concept) — even the owner's Capital is
treated as a liability of the business towards the owner!
★ Also called the ‘Balance Sheet Equation’ because the Balance Sheet is nothing but this equation shown in a
statement format.
 2. Key Terms You Must Know (Definitions)
Do not skip this section — almost every exam gives 1-mark questions directly from these definitions.

Term Meaning (in simple words) + Example

Asset Something of value OWNED by the business which will bring future benefit.
Example: Cash, Building, Furniture, Machinery, Stock (Goods), Debtors (people who
owe money to the business).

Fixed Asset An asset bought for long-term/continued use in the business, NOT for resale.
Example: Building, Machinery, Furniture.

Current Asset An asset that can be converted into cash within one year / used up in normal business
operations. Example: Cash, Stock, Debtors, Bank.

Liability Amount which the business OWES to outsiders (people other than the owner).
Example: Creditors (people the business owes money to), Bank Loan, Outstanding
Expenses.

Capital Amount invested by the OWNER into the business. It is what the business owes to its
own owner. Also called Owner's Equity or Net Worth.

Drawings Cash or goods withdrawn by the owner from the business for personal use. Drawings
REDUCE Capital.

Revenue / Income Amount earned by the business through its normal activities, e.g. Sales, Commission
Received, Interest Received. Income INCREASES Capital.

Expense Cost incurred to earn revenue or run the business, e.g. Rent, Salary, Wages. Expense
DECREASES Capital.

Profit Revenue − Expense (when Revenue is more). Profit is ADDED to Capital.

Loss Expense − Revenue (when Expense is more). Loss is SUBTRACTED from Capital.

Debtor A person/party who OWES money to the business (business will RECEIVE money)
— created when goods are sold ON CREDIT.

Creditor A person/party to whom the business OWES money (business will PAY money) —
created when goods are bought ON CREDIT.

Goods / Stock Articles purchased by a business for the purpose of resale (not for own use).

Business Transaction Any activity that involves an exchange of money or money's worth and changes the
financial position of a business.

3. Rules for the Accounting Equation

Every transaction affects at least TWO items — this keeps the equation balanced. Here are the possible combinations
you will see in problems:

# Effect of the Transaction Simple Example

1 Increase in one Asset & Increase in Liability Goods purchased ON CREDIT → Stock (Asset) ↑ and
Creditors (Liability) ↑

2 Increase in one Asset & Increase in Capital Owner starts business with cash → Cash (Asset) ↑ and
 # Effect of the Transaction Simple Example

Capital ↑

3 Decrease in one Asset & Decrease in Liability Paid cash to a creditor → Cash ↓ and Creditors ↓

4 Decrease in one Asset & Decrease in Capital Paid Rent / Owner withdrew cash (Drawings) → Cash ↓
and Capital ↓

5 Increase in one Asset & Decrease in another Asset Purchased furniture for cash → Furniture ↑ and Cash ↓
(total assets unchanged)

6 Increase in one Liability & Decrease in another Liability Accepted a bill of exchange in place of a creditor →
Creditors ↓, Bills Payable ↑

7 Increase in Liability & Decrease in Capital Salary becomes outstanding (unpaid) → Outstanding
Salary (Liability) ↑ and Capital ↓ (expense)

8 Decrease in Liability & Increase in Capital Creditor waives off (forgives) part of the amount owed
→ Creditors ↓ and Capital ↑ (gain)

GOLDEN RULE TO REMEMBER

★ Assets always sit on the LEFT of the equation. Liabilities + Capital always sit on the RIGHT.
★ After EVERY transaction, Left side TOTAL = Right side TOTAL. If they don't match, you have made an error!
★ Cash/Bank purchase of an asset = only asset-side change (one asset up, one asset down) — Liabilities & Capital
untouched.

4. Process (Steps) of Preparing an Accounting Equation

Follow these steps for every transaction, one at a time, like a checklist:
● STEP 1: Read the transaction carefully and identify WHICH accounts are affected (is it Cash? Goods? A
person's name — Debtor/Creditor? Capital? An expense/income?).
● STEP 2: Decide the CATEGORY of each account affected — is it an Asset, a Liability, or Capital?
● STEP 3: Decide whether that item INCREASES or DECREASES because of the transaction.
● STEP 4: If it is an income/expense/profit/loss, remember it ultimately affects CAPITAL (Capital ↑ for
income/profit, Capital ↓ for expense/loss).
● STEP 5: Show the effect against the PREVIOUS balance in a table (columns for each Asset/Liability + Capital)
and calculate a NEW balance/total after the transaction.
● STEP 6: After recording all transactions, add up both sides — Total Assets MUST equal Total Liabilities +
Capital.

5. Effect of Transactions — Fully Solved Illustration

Illustration 1: Show the Accounting Equation for the following transactions of Mr. Arjun:
1. Started business with cash ₹1,00,000.
2. Purchased goods for cash ₹20,000.
3. Purchased goods on credit ₹15,000.
4. Sold goods costing ₹10,000 for cash ₹14,000.
5. Paid rent ₹2,000.
6. Purchased furniture for cash ₹5,000.
7. Withdrew cash for personal use ₹3,000.
8. Paid cash to creditor ₹5,000.
9. Received interest in cash ₹500.
10. Salary outstanding (unpaid) ₹1,000.

Working / Reasoning for tricky steps

● Tx.4 — Sale: Stock decreases by its COST (₹10,000), Cash increases by the SELLING PRICE ( ₹14,000). The
difference ₹4,000 is PROFIT, which is added to Capital.
● Tx.5 — Rent is an expense: Cash decreases, Capital decreases by the same amount.
● Tx.7 — Drawings: Cash decreases, Capital decreases (money taken OUT by owner is not a business expense, but
it still reduces what belongs to the business on behalf of the owner).
● Tx.9 — Interest received is INCOME: Cash increases, Capital increases.
● Tx.10 — Outstanding Salary: no cash is paid yet, but the expense has still happened, so a new LIABILITY
(Outstanding Salary) is created, and Capital decreases (because the expense reduces profit).

Tr. Cash +Stock +Furniture = Creditors +O/S Salary +Capital

1 1,00,000 — — = — — 1,00,000

–20,000 +20,000
2 — = — — 1,00,000
80,000 20,000

+15,000 +15,000
3 80,000 — = — 1,00,000
35,000 15,000

+14,000 –10,000 +4,000

4 — = 15,000 —
94,000 25,000 1,04,000

–2,000
5 –2,000 92,000 25,000 — = 15,000 —
1,02,000

6 –5,000 87,000 25,000 +5,000 5,000 = 15,000 — 1,02,000

7 –3,000 84,000 25,000 5,000 = 15,000 — –3,000 99,000

8 –5,000 79,000 25,000 5,000 = –5,000 10,000 — 99,000

9 +500 79,500 25,000 5,000 = 10,000 — +500 99,500

10 79,500 25,000 5,000 = 10,000 +1,000 1,000 –1,000 98,500

Final 79,500 25,000 5,000 = 10,000 1,000 98,500

Check: Total Assets = 79,500 + 25,000 + 5,000 = ₹1,09,500. Total Liabilities + Capital = 10,000 + 1,000 + 98,500
= ₹1,09,500. ✔ Both sides match — the equation is proved!

6. Effect of Adjustment Transactions on the Accounting Equation

‘Adjustments’ are special end-of-period items that don't involve a fresh cash transaction but still affect the equation.
Examiners LOVE testing these because students often get confused. Learn each one carefully:

Term Meaning (in simple words) + Example

Depreciation on an Asset The asset (e.g., Machinery, Furniture) DECREASES in value every year due to wear
& tear. Effect: Asset ↓, Capital ↓ (treated as an expense). Example: Depreciation
 Term Meaning (in simple words) + Example

₹1,000 on Furniture → Furniture –1,000, Capital –1,000.

Interest on Capital Interest allowed to the owner on his Capital. It is an EXPENSE for the business but
INCOME for the owner. Net effect on TOTAL Capital = NIL (Capital increases as
income to owner, decreases equally as business expense) — unless it is actually paid
in cash, in which case Cash ↓ and Capital ↓ by that amount.

Interest on Drawings Interest charged FROM the owner on the amount he withdrew. It is INCOME for the
business but increases Drawings for the owner. Net effect on TOTAL Capital = NIL,
for the same reason as above (increases as income, decreases as it adds to drawings).

Bad Debts Amount owed by a Debtor that becomes irrecoverable (debtor will not pay). Effect:
Debtors (Asset) ↓, Capital ↓ (treated as a loss/expense).

Outstanding / Accrued An expense that has been incurred but NOT yet paid in cash. Effect: A new Liability is
Expense created (↑), Capital ↓ (expense reduces profit).

Prepaid Expense An expense paid in ADVANCE, for a future period. Effect: One asset (Cash) converts
into another asset (Prepaid Expense) — e.g. Cash ↓, Prepaid Expense (Asset) ↑. No net
effect on Capital since it is not yet ‘used up’.

Accrued Income Income that has been EARNED but not yet received in cash. Effect: A new Asset is
created — ‘Accrued Income’ ↑, Capital ↑ (income increases profit).

Income Received in Advance Cash received for a service not yet provided. Effect: Cash ↑, and a new Liability
‘Income Received in Advance’ ↑ (because the business still OWES the service). No
effect on Capital yet.

Goods Withdrawn for Owner takes goods (Stock) from the business for himself. Effect: Stock (Asset) ↓,
Personal Use Capital ↓ (treated exactly like Drawings, at COST price).

Goods Given as Charity / Effect: Stock (Asset) ↓, Capital ↓ (treated as an expense/loss, at COST price).
Free Samples

Goods Lost by Fire/Theft Effect: Stock (Asset) ↓, Capital ↓ (full amount is a loss since nothing will be
(Uninsured) recovered).

Goods Lost by Fire (Insured, Effect: Stock (Asset) ↓ by the FULL cost of goods lost; a new Asset ‘Insurance Claim
claim admitted by insurer) Receivable’ ↑ by the amount ADMITTED by the insurer; Capital ↓ only by the
UNRECOVERED portion (the loss actually suffered).

EXAM TIP — Adjustments

★ Whenever an expense is created without paying cash → a Liability is created AND Capital falls.
★ Whenever income is earned without receiving cash → an Asset is created AND Capital rises.
★ Interest on Capital & Interest on Drawings — remember the special ‘net effect is NIL on total Capital’ rule; it is a
favourite trick question!
★ For goods lost by fire — always split the loss into the INSURED part (becomes an asset — claim receivable) and the
UNINSURED part (pure loss reducing Capital).

7. Second Solved Illustration (with Credit Sale & Discount)

Illustration 2: Prepare the Accounting Equation from the following transactions of Ravi:
1. Ravi started business with cash ₹80,000 and furniture ₹20,000.
2. Purchased goods for cash ₹30,000.
3. Sold goods costing ₹20,000 to Mohan on credit for ₹28,000.
4. Received cash ₹27,000 from Mohan in full settlement (discount allowed ₹1,000).
5. Paid salary ₹2,000.
6. Charged depreciation on furniture ₹1,000.

Tr. Cash +Stock +Furn. +Debtors = Capital

1 80,000 — 20,000 — = 1,00,000

2 –30,000 50,000 +30,000 30,000 20,000 — = 1,00,000

3 50,000 –20,000 10,000 20,000 +28,000 28,000 = +8,000 1,08,000

4 +27,000 77,000 10,000 20,000 –28,000 0 = –1,000 1,07,000

5 –2,000 75,000 10,000 20,000 0 = –2,000 1,05,000

6 75,000 10,000 –1,000 19,000 0 = –1,000 1,04,000

Final 75,000 10,000 19,000 0 = 1,04,000

Check: Total Assets = 75,000 + 10,000 + 19,000 + 0 = ₹1,04,000 = Capital ₹1,04,000 (no other liability here). ✔
Balanced!
Note: Discount allowed of ₹1,000 is a LOSS/expense to the business (we received less than what was owed), so it
reduces Capital, even though it did not reduce any specific asset amount beyond what was received.

8. CBSE Exam-Pattern Questions with Answers

A. Multiple Choice Questions (1 Mark each)

Q. The Accounting Equation is based on which accounting concept? (a) Going Concern (b) Dual Aspect (c) Accrual
(d) Consistency [1 Mark]
Ans. (b) Dual Aspect Concept
Q. Capital + Liabilities is equal to: (a) Drawings (b) Expenses (c) Assets (d) Net Profit [1 Mark]
Ans. (c) Assets
Q. If total assets of a business are ₹1,50,000 and capital is ₹1,00,000, the liabilities will be: (a) ₹2,50,000 (b)
₹50,000 (c) ₹1,00,000 (d) Nil [1 Mark]
Ans. (b) ₹50,000 (Liabilities = Assets − Capital = 1,50,000 − 1,00,000)
Q. Purchase of furniture for cash will: (a) Increase total assets (b) Decrease total assets (c) Not change total assets (d)
Increase capital [1 Mark]
Ans. (c) Not change total assets (one asset increases, another decreases by the same amount)
Q. Outstanding salary is shown in the accounting equation as an increase in: (a) Asset (b) Liability (c) Capital (d)
Revenue [1 Mark]
Ans. (b) Liability

B. Very Short Answer Questions (1 Mark each)

Q. State the Accounting Equation. [1 Mark]
Ans. Assets = Liabilities + Capital.
Q. What is meant by Capital? [1 Mark]
Ans. Capital is the amount invested by the owner in the business; it is what the business owes to the owner.
Q. On which concept is the Accounting Equation based? [1 Mark]
Ans. It is based on the Dual Aspect (Duality) Concept, which states every transaction has two effects.
Q. What is the effect of ‘further capital introduced’ on the equation? [1 Mark]
Ans. Both Assets (Cash) and Capital increase by the same amount.
Q. Give the new form of the equation to find Liabilities. [1 Mark]
Ans. Liabilities = Assets − Capital.

C. Short Answer Questions (3–4 Marks each)

Q. Explain the Dual Aspect Concept with the help of an example. [3-4 Marks]
Ans. The Dual Aspect Concept states that every business transaction has two effects — a giving aspect and a
receiving aspect — and both must be recorded. For example, when a business purchases goods for cash ₹5,000: it
RECEIVES goods worth ₹5,000 (Stock increases) and GIVES UP cash worth ₹5,000 (Cash decreases). Because of
this dual recording, total Assets always remain equal to total Liabilities + Capital, which is the foundation of the
Accounting Equation and of the entire double entry system of book-keeping.
Q. Explain any three effects of transactions on the Accounting Equation, with examples. [3-4 Marks]
Ans. (i) Increase in one asset, decrease in another asset — e.g., furniture bought for cash: Furniture ↑, Cash ↓, total
assets unchanged. (ii) Increase in asset and increase in liability — e.g., goods bought on credit: Stock ↑, Creditors ↑.
(iii) Decrease in asset and decrease in capital — e.g., rent paid in cash: Cash ↓, Capital ↓ (because rent is an expense).
Q. What is the effect of ‘interest on capital’ and ‘interest on drawings’ on the Accounting Equation? Explain. [3-4
Marks]
Ans. Interest on Capital is an expense for the business but income for the owner, so it increases Capital (as it belongs
to the owner) and simultaneously decreases Capital (as it is a business expense) — the net effect on total Capital is
NIL, unless actually paid in cash (in which case Cash and Capital both fall). Interest on Drawings works the opposite
way: it is income for the business (increases Capital) but is added to Drawings, which reduces Capital by the same
amount — again, the net effect on total Capital is NIL.

D. Numerical / Long Answer Question (6 Marks) — Solve Yourself First!

Practice Question: Develop the Accounting Equation from the following transactions:
1. Started business with cash ₹50,000 and goods ₹10,000.
2. Sold goods costing ₹4,000 for ₹5,500 on credit to Suresh.
3. Purchased goods for cash ₹8,000.
4. Paid wages ₹500.
5. Received ₹5,500 from Suresh in full settlement.
6. Goods costing ₹1,000 given as charity.
7. Depreciation charged on goods (loss by fire, uninsured) ₹500.
(Try solving this on paper using the table method shown in Illustration 1 & 2 before checking the answer key below.)

✔ Answer Key
Tr. Cash +Stock +Debtors = Capital

1 50,000 10,000 — = 60,000

2 50,000 –4,000 6,000 +5,500 5,500 = +1,500 61,500

 Tr. Cash +Stock +Debtors = Capital

3 –8,000 42,000 +8,000 14,000 5,500 = 61,500

4 –500 41,500 14,000 5,500 = –500 61,000

5 +5,500 47,000 14,000 –5,500 0 = 61,000

6 47,000 –1,000 13,000 0 = –1,000 60,000

7 47,000 –500 12,500 0 = –500 59,500

Final 47,000 12,500 0 = 59,500

Check: Total Assets = 47,000 + 12,500 + 0 = ₹59,500 = Capital ₹59,500 (no liabilities in this problem). ✔ The
equation is balanced.
Note on Tr.7: ‘Depreciation charged on goods (loss by fire, uninsured)’ simply means goods worth ₹500 were
destroyed with no insurance recovery — the full amount is a pure LOSS, so Stock falls and Capital falls by ₹500.

Quick Revision Summary (For Last-Minute Reading)

● Accounting Equation: Assets = Liabilities + Capital (also: Capital = Assets − Liabilities)
● Based on the Dual Aspect / Duality Concept — every transaction has two effects.
● Assets = things OWNED; Liabilities = amounts OWED to outsiders; Capital = owner's own investment
(owed to owner).
● Income/Profit → Capital increases. Expense/Loss/Drawings → Capital decreases.
● Cash purchase of an asset → only asset-side change, totals stay the same.
● Credit transactions create Debtors (asset, business will receive) or Creditors (liability, business will pay).
● Outstanding expense → Liability ↑, Capital ↓. Accrued income → Asset ↑, Capital ↑.
● Interest on Capital / Interest on Drawings → net effect on total Capital is NIL (unless cash is actually
paid/received).
● After every transaction — without exception — Total Assets MUST equal Total Liabilities + Capital.