Q.The capital of a business firm is ₹1,00,000, Reserve and Surplus ₹40,000 and external liability ₹25,000. Total Assets of the business are
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The Accounting Equation: The Foundation of Double-Entry Bookkeeping
Imagine you start a small business. You put in ₹1,00,000 of your own money. The business now has ₹1,00,000 in cash. But where did that cash come from? It came from you, the owner. So the business owes you ₹1,00,000. That's the core idea: everything the business owns (assets) is matched by a claim against it (liabilities or owner's equity).
The Precise Meaning
The accounting equation states:
Assets = Liabilities + Owner's Equity
This is not a suggestion — it is an identity. It must always hold true, after every single transaction, without exception. Let's break it down:
- Assets are resources the business controls (cash, inventory, machinery, buildings, debtors).
- Liabilities are claims of outsiders (creditors, bank loans, outstanding expenses).
- Owner's Equity (also called Capital) is the owner's claim on the business. It equals the amount the owner originally invested plus any profits retained, minus any withdrawals.
The equation is always in balance. Every transaction affects at least two accounts, and the equation remains true. This is the entire point of double-entry bookkeeping.
Why It Matters
The accounting equation is not just a theory — it is the practical tool that tells you whether a transaction has been recorded correctly. If you ever prepare a trial balance and it doesn't tally, the equation is the first place you look. It also helps you understand the financial position of a business at a glance.
For example, if a business has total assets of ₹5,00,000 and liabilities of ₹2,00,000, then the owner's equity must be ₹3,00,000. That tells you the net worth of the business from the owner's perspective.
Accounting Treatment: Debit and Credit
Every transaction affects the equation. The rules are simple:
- Increase in an asset → Debit that asset account
- Decrease in an asset → Credit that asset account
- Increase in a liability → Credit that liability account
- Decrease in a liability → Debit that liability account
- Increase in owner's equity → Credit the capital account
- Decrease in owner's equity → Debit the capital account
Let's see this with a few common transactions.
Transaction 1: Owner invests cash into the business
The business receives cash (asset increases) and owes the owner more (capital increases).
| Account | Debit (₹) | Credit (₹) |
|---|---|---|
| Cash A/c | 1,00,000 | |
| To Capital A/c | 1,00,000 |
Effect on equation: Assets (+₹1,00,000) = Liabilities (no change) + Owner's Equity (+₹1,00,000). Balanced.
Transaction 2: Purchase machinery on credit
The business gets machinery (asset increases) and creates a liability to the supplier.
| Account | Debit (₹) | Credit (₹) |
|---|---|---|
| Machinery A/c | 50,000 | |
| To Creditors A/c | 50,000 |
Effect on equation: Assets (+₹50,000) = Liabilities (+₹50,000) + Owner's Equity (no change). Balanced.
Transaction 3: Pay rent in cash
The business pays rent (expense), which reduces owner's equity (profit decreases). Cash also decreases.
| Account | Debit (₹) | Credit (₹) |
|---|---|---|
| Rent A/c | 10,000 | |
| To Cash A/c | 10,000 |
Effect on equation: Assets (-₹10,000) = Liabilities (no change) + Owner's Equity (-₹10,000). Balanced.
Expenses and drawings reduce owner's equity. Revenues and gains increase owner's equity. That is why expenses are debited (they reduce equity, which is normally credited) and revenues are credited.
The Expanded Accounting Equation
For a more complete picture, especially when dealing with revenues, expenses, and drawings, the equation expands to:
Assets = Liabilities + (Owner's Capital – Drawings + Revenues – Expenses)
This is the same equation, just unpacked. It shows that profit (Revenue – Expense) increases owner's equity, and drawings decrease it.
A Practical Example: The Full Cycle …
Using Assets = Capital + Reserves & Surplus + External Liabilities, total assets = 1,00,000 + 40,000 + 25,000 = 1,65,000. …
Total Assets = Capital + Reserve & Surplus + External Liabilities = 1,65,000.
The accounting equation can be expanded as: Assets = Owner's Equity + External Liabilities, where Owner's Equity includes Capital and Reserves & Surplus.
| Item | Rs |
|---|---|
| Capital | 1,00,000 |
| Reserve & Surplus | 40,000 |
| External Liability | 25,000 |
| Total Assets | 1,65,000 |
| … |
Showing the 12 most recent of 15 on this concept.
- CBSE 2026Set ANNUAL1 markMCQQ.Mohan has assets of Rs. 25,000 and liabilities of Rs. 18,000, the capital is -(a) Rs. 7,000(b) Rs. 8,000(c) Rs. 25,000(d) Rs. 18,000
›Reveal solutionSolution
Correct option: (a) Rs. 7,000.
By the accounting equation, Capital = Assets - Liabilities = 25,000 - …
- CBSE 2026Set ANNUAL1 markQ.Fill in the blank: Rent paid will ________ capital.
›Reveal solutionSolution
Answer: decrease.
Rent paid is an expense of the business. Expenses reduce the owner's capital, so rent paid will decrease ( …
- CBSE 2025Set MARCH1 markMCQQ."Bought goods on credit". The effect of this transaction is :(a) Asset increases, Asset decreases(b) Asset increases, Liability increases(c) Asset increases, Liability decreases(d) Asset decreases, Liability increases
›Reveal solutionSolution
The correct answer is (b) Asset increases, Liability increases.
Buying goods on credit means the firm receives goods now but will pay later. Applying the accounting equation (Assets = Liabilities + Capital):
Element Effect Purchases / Stock (asset) Increases Creditors (liability) Increases … - CBSE 2025Set ANNUAL1 markQ.Fill in the blank: Accounting equation is based on ________ concept.
›Reveal solutionSolution
Answer: Dual aspect concept.
The accounting equation (Assets = Liabilities + Capital) is based on the dual aspect concept, which states that every transaction has two aspects - a debit and an eq …
- CBSE 2022Set ANNUAL1 markMCQQ.The liabilities to a third party of a business are Rs. 50,000 and the capital is Rs. 80,000. The total assets of the business are(a) Rs. 30,000.(b) Rs. 1,30,000.(c) Rs. 50,000.(d) None of these.
›Reveal solutionSolution
Using Assets = Capital + Liabilities = 80,000 + 50,000 = Rs. 1,30,000, the answer is (b).
The fundamental accounting equation states:
Item Rs. Capital 80,000 Add: Liabilities to third parties 50,000 - CBSE 2022Set ANNUAL1 markMCQQ.The excess of assets over liabilities is called(a) Capital.(b) Profit.(c) Debtors.(d) Creditors.
›Reveal solutionSolution
Assets minus liabilities equals the owner's equity, i.e. capital. The answer is (a).
From Assets = Capital + Liabilities, rearranging gives Capital = Assets - Liabilities. Thus the excess of assets over liabilities is the owner's capital (also called net worth).
- (a) Capital — correct. …
- CBSE 2018Set ANNUAL1 markMCQQ.Which of the following is correct?(a) Assets = Capital + Liability.(b) Assets = Liability – Capital.(c) Assets = Capital – Liability.(d) Assets = Capital + Reserve and Surplus.
›Reveal solutionSolution
The fundamental accounting equation is Assets = Capital + Liabilities.
Every resource (asset) of a business is funded from two sources: the owner's contribution (capital, including retained profits) and amounts owed to outsiders (liabilities). Hence Assets = Capital + Liabilities. This equality always holds because of the dual-aspect concept of double entry.
…
- CBSE 2018Set ANNUAL1 markMCQQ.The capital of a business firm is ₹1,00,000, Reserve and Surplus ₹40,000 and external liability ₹25,000. Total Assets of the business are(a) ₹1,15,000.(b) ₹35,000.(c) ₹1,65,000.(d) ₹1,40,000.
›Reveal solutionSolution
Total Assets = Capital + Reserve & Surplus + External Liabilities = 1,65,000.
The accounting equation can be expanded as: Assets = Owner's Equity + External Liabilities, where Owner's Equity includes Capital and Reserves & Surplus.
Item Rs Capital 1,00,000 Reserve & Surplus 40,000 External Liability 25,000 Total Assets 1,65,000 … - CBSE 2018Set ANNUAL1 markMCQQ.When closing capital is less than opening capital, it denotes(a) Profit.(b) Loss.(c) Deficit.(d) Surplus.
›Reveal solutionSolution
Closing capital less than opening capital denotes a loss (other factors unchanged).
In the net-worth (statement of affairs) method used with incomplete records, profit for the period = Closing Capital + Drawings - Additional Capital - Opening Capital. If, ignoring drawings and fresh capital, the closing capital is lower than the openin …
- CBSE 2018Set ANNUAL1 markMCQQ.Opening capital ₹1,50,000, Closing capital ₹2,75,000, Drawing ₹25,000, Further Capital introduced ₹45,000. What is Gross Profit?(a) ₹55,000.(b) ₹1,95,000.(c) ₹1,05,000.(d) ₹1,75,000.
›Reveal solutionSolution
Profit by the statement of affairs method = 2,75,000 + 25,000 - 45,000 - 1,50,000 = 1,05,000.
When records are incomplete, profit is found by comparing capitals, after adjusting drawings and fresh capital.
Item Rs Closing Capital 2,75,000 Add: Drawings 25,000 Less: Additional Capital introduced (45,000) Less: Opening Capital (1,50,000) Profit for the year 1,05,000 … - CBSE 2018Set ANNUAL1 markMCQQ.Single entry system is a system of(a) Single entry.(b) Double entry.(c) Mixed entry.(d) Mixture of single, double and non-entry.
›Reveal solutionSolution
Single entry system is really a mixture of single entry, double entry and no entry.
The so-called 'single entry system' is an incomplete and unscientific method of book-keeping. In practice: personal accounts and the cash book are usually kept under full double entry; many nominal accounts are recorded only one-sidedly (single entry); and real accounts such as fixed assets are often not recorded at all (no …
- CBSE 2018Set ANNUAL1 markMCQQ.For a year opening and closing balances of creditors are ₹1,50,000 and ₹2,70,000 respectively, paid to creditors ₹1,30,000. The credit purchase in that year is(a) ₹10,000.(b) ₹1,20,000.(c) ₹2,50,000.(d) None of these.
›Reveal solutionSolution
Credit purchases = Closing creditors (2,70,000) + Paid (1,30,000) - Opening creditors (1,50,000) = 2,50,000.
In incomplete records, credit purchases are the balancing figure of the Total Creditors Account.
| Total Creditors A/c | Rs | | Rs |
|---|---|---|---| …
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