The whole concept of accounting is based on accounting equation. It forms a base to finalize books of accounts and to prepare profit & loss account and Balance Sheet.
The Accounting Equation is:
Assets = Liabilities + Capital
Assets Means Property owned the business
Liabilities means money to be paid to outsiders
Capital means money invested by the owner of business
Let us understand the accounting equation.
Any business requires resources to operate and these resources are provided by someone. The resources possessed by the business are called assets and some of the resources are introduced by the owner of the business called capital. If all the assets are provided by him then asset must equal to capital.
Then accounting equation will become:
Assets = Capital
For example Mr. A starts a business with Rs. 5 Lacs. Form these Rs. 5 lacs, he purchased Assets ( Computers, furniture etc) of Rs. 2 Lac and rest Rs. 3 Lac is with in Bank Account. So here Capital i.e. Rs. 5 Lac is equal to Assets i.e. Rs. 5 Lac.
On the other side, some investment may also be made by persons other than owner. The business indebtness for these resources brought by outsiders are called liabilities.
Hence now the accounting equation becomes:
Assets = Liabilities + Capital
The two sides are now equal. On one side it shows resources possessed and on other side it shows sources from which these resources are obtained.
The value of assets, liabilities and capital may change according to growth of the business but the accounting equation must always be true.
The equation is based on the principle that accounting deals with property and rights to property and the sum of the properties owned is equal to the sum of the rights to the properties. The properties owned by a business are called assets and the rights to properties are known as liabilities or capital of the business.
You can also modify the accounting equation, like:
Capital = Assets – Liabilities
Or
Liabilities = Assets – Capital
Rules of accounting Equation
For Assets: Increase in assets are debit and decrease in assets is credit
For Liabilities: Increase in liabilities are credits and decrease in liabilities are debits.
For Capital: Increase in capital is credit and decrease in capital is debit.
Hope you have understand the concept of accounting equation, you can also comment to ask any query on accounting equation.
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