The accounting equation is Assets = Capital + Liabilities. It is the starting point for every later topic, because each transaction is simply a change to one or more of these three groups, with both sides still equal afterwards.
This lesson belongs to accounting model and transactions. You need only basic addition and subtraction, but you do need to read each transaction slowly.
What does each part of the equation mean?
Assets are resources the business owns, such as bank, equipment and inventory. Liabilities are amounts the business owes to outsiders, such as a supplier. Capital is what the owner has put in, adjusted later for profit and drawings.
Think of a business as a jug of water with two labels on where the water came from. Assets show what the business holds.
Capital and liabilities show who has a claim on it. The two always match.
How do you work through a transaction?
- Name the two items affected. A transaction always touches at least two.
- Classify each one as an asset, a liability or capital.
- Decide the direction: does each item go up or down?
- Update a running table, then check that assets still equal capital plus liabilities.
Worked example
Faris starts Faris Bike Repairs. All amounts are in RM.
- Faris pays RM20,000 into a new business bank account.
- He buys tools (equipment) for RM3,000, paid from the bank.
- He buys spare parts (inventory) for RM2,000 on credit from a supplier.
- He pays the supplier RM800 from the bank.
| After | Bank | Equipment | Inventory | Assets total | Payables | Capital | Liabilities + Capital |
|---|---|---|---|---|---|---|---|
| 1 | 20,000 | 0 | 0 | 20,000 | 0 | 20,000 | 20,000 |
| 2 | 17,000 | 3,000 | 0 | 20,000 | 0 | 20,000 | 20,000 |
| 3 | 17,000 | 3,000 | 2,000 | 22,000 | 2,000 | 20,000 | 22,000 |
| 4 | 16,200 | 3,000 | 2,000 | 21,200 | 1,200 | 20,000 | 21,200 |
Step 1: bank (asset) up 20,000 and capital up 20,000.
Step 2: equipment up 3,000 and bank down 3,000. One asset swapped for another, so the total stays at 20,000.
Step 3: inventory up 2,000 and payables (a liability) up 2,000. Assets and liabilities both grow.
Step 4: bank down 800 and payables down 800. Assets and liabilities both shrink. Capital has not moved at any point after step 1.
The mistake to watch for
A common slip is to record only the asset side of a credit purchase.
Mistaken working for step 3: inventory up 2,000, and nothing else. Assets become 22,000 but capital plus liabilities is still 20,000.
The equation is out by RM2,000, which means a second effect has been left out.
The correction is to ask “who or what provided the 2,000?”. The supplier did, by allowing credit, so a liability of 2,000 must be added.
Another version of this slip is treating the payment in step 4 as a cost that reduces capital. Paying a supplier only settles a debt, so capital stays at 20,000.
Check yourself
Use RM and a running table if it helps.
1. Nisha starts a business with RM10,000 in the bank and a van worth RM15,000. Show the equation.
Show answer
Assets are 10,000 + 15,000 = 25,000. Capital is 25,000, so 25,000 = 25,000 + 0.
2. Nisha then receives a bank loan of RM5,000 into the business bank. What are the new totals?
Show answer
Bank rises by 5,000, so assets are 30,000. The loan is a liability of 5,000. Capital stays 25,000. Check: 30,000 = 25,000 + 5,000.
3. She buys equipment for RM4,000, paid from the bank. What happens to total assets?
Show answer
Equipment rises by 4,000 and bank falls by 4,000. Total assets stay at 30,000, and capital and liabilities are unchanged.
Where this leads next
Next, sort real items into the three groups in distinguishing assets, liabilities and capital. The double-entry and ledger trainer lets you test your own transactions, and the module practice set mixes every skill.
Some students follow each example in class but lose the thread when a question changes the wording. That is the pattern our teachers look for in online one-to-one Accounting tuition.