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The accounting equation and double entry: Class 11 Accounting
What accounting is, the accounting equation, how transactions change it, the rules of debit and credit, journal entries and the trial balance.
Key points
Accounting is the process of identifying, measuring, recording, summarising and communicating the financial information of a business so that users can make decisions. The users include owners, managers, banks, tax authorities and suppliers.
The accounting equation shows the financial position of a business:
- Assets = Liabilities + Capital (owner's equity).
- Assets are the resources owned by the business, such as cash, stock, equipment and money owed by customers.
- Liabilities are the amounts the business owes to others, such as loans and amounts owed to suppliers.
- Capital is the owner's claim on the assets, which is what is left after liabilities are deducted.
Every transaction changes the equation but always keeps it in balance. If the owner puts Rs 100,000 into the business, assets (cash) and capital both rise by Rs 100,000. If goods are bought on credit, assets (stock) and liabilities (amount owed to the supplier) both rise. If a loan is repaid from cash, assets and liabilities both fall.
The double entry system records every transaction in two accounts, one debited and one credited, for equal amounts. The reason is that every transaction has two aspects, something received and something given.
Rules of debit and credit:
- An increase in an asset is debited and a decrease is credited.
- An increase in a liability or in capital is credited and a decrease is debited.
- An expense is debited, because it reduces capital.
- Income (revenue) is credited, because it increases capital.
A transaction is first written in the journal, which has columns for the date, the accounts debited and credited, the amounts and a short narration. Entries are then posted to the ledger accounts. At the end of the period a trial balance is prepared by listing all the ledger balances. If the total of the debit balances equals the total of the credit balances, the books are arithmetically correct. A trial balance that agrees does not prove that no errors exist, because some errors do not affect the totals.
Study tip: Before writing a journal entry, ask which two accounts change and whether each one increases or decreases. Then apply the rule for each.
Definitions and flashcards
Say the meaning first, then open the card to check.
Accounting
The process of recording, summarising and communicating the financial information of a business.
Asset
A resource owned by a business.
Liability
An amount that a business owes to others.
Capital
The owner's claim on the assets of the business.
Debit
The left side of an account.
Credit
The right side of an account.
Journal
The book in which transactions are first recorded.
Ledger
The book of accounts to which journal entries are posted.
Trial balance
A list of ledger balances used to check that debits equal credits.
Formula sheet
| Name | Formula | What it means |
|---|---|---|
| Accounting equation | Assets = Liabilities + Capital | Always true after each transaction. |
| Capital | Capital = Assets − Liabilities | The owner's claim. |
| Double entry | Total debits = Total credits | For every transaction. |
Short questions with model answers
These are the kind of questions asked for 2, 3 and 5 marks. Try each one before opening the answer.
Define accounting. (2 marks)
Accounting is the process of identifying, recording, summarising and communicating the financial information of a business so that users can make decisions.
State the accounting equation. (2 marks)
Assets = Liabilities + Capital.
What is double entry bookkeeping? (3 marks)
In double entry bookkeeping every transaction is recorded in two accounts. One account is debited and the other is credited for the same amount, because each transaction has two aspects.
State the rules of debit and credit for assets, liabilities and capital. (3 marks)
An increase in an asset is debited and a decrease is credited. An increase in a liability or in capital is credited and a decrease is debited.
What is a trial balance? What does it show? (3 marks)
A trial balance is a list of the debit and credit balances of all the ledger accounts at a date. If the totals agree, the books are arithmetically correct, but some errors may still be present.
How does buying goods on credit affect the accounting equation? (3 marks)
Assets (stock) increase and liabilities (the amount owed to the supplier) increase by the same amount, so the equation stays in balance.
Numericals with worked steps
A business has assets of Rs 500,000 and liabilities of Rs 200,000. Find the capital.
- Capital = Assets − Liabilities.
- = 500,000 − 200,000.
Answer: Rs 300,000
The business in the previous example repays Rs 50,000 of its loan from cash. Show the new position.
- Cash falls by 50,000, so assets fall to 500,000 − 50,000 = 450,000.
- The loan falls by 50,000, so liabilities fall to 200,000 − 50,000 = 150,000.
- Capital is unchanged at 300,000.
- Check: 450,000 = 150,000 + 300,000.
Answer: Assets Rs 450,000, liabilities Rs 150,000, capital Rs 300,000
Write the journal entry for this transaction: the owner starts a business with Rs 100,000 in cash.
- Cash (an asset) increases, so debit Cash.
- Capital increases, so credit Capital.
Answer: Debit Cash Rs 100,000. Credit Capital Rs 100,000.
Write the journal entry: goods worth Rs 20,000 are bought for cash.
- Purchases (stock) increase, so debit Purchases.
- Cash decreases, so credit Cash.
Answer: Debit Purchases Rs 20,000. Credit Cash Rs 20,000.
Common mistakes
- Reversing the rules and debiting an increase in capital or a liability.
- Writing the journal entry with unequal amounts of debit and credit.
- Treating drawings by the owner as an expense. Drawings reduce capital.
- Saying that an agreeing trial balance proves there are no errors.