Accounting Equation & Double Entry

Learning Objective: Apply the accounting equation and record transactions using double entry

Imagine you open a small stationery shop in Lalitpur with Rs. 2,00,000 of your own savings and borrow Rs. 1,00,000 from a bank. Your shop now has Rs. 3,00,000 in resources. But where did that money come from? The accounting equation answers exactly this question.

The Accounting Equation

The foundation of all accounting is this simple equation:

Assets = Liabilities + Owner's Equity

• Assets: What the business owns (cash, furniture, stock, building)
• Liabilities: What the business owes to others (bank loans, creditors)
• Owner's Equity (Capital): What the owner has invested in the business

Using our stationery shop example:

• Assets = Rs. 3,00,000 (cash in hand)
• Liabilities = Rs. 1,00,000 (bank loan)
• Owner's Equity = Rs. 2,00,000 (your savings)

Rs. 3,00,000 = Rs. 1,00,000 + Rs. 2,00,000 -- the equation always balances!

The Double Entry System

Every business transaction affects at least two accounts. This is called the double entry system. For every debit, there must be an equal credit.

Rules of Debit and Credit:

| Account Type | Increases With | Decreases With | |-------------|---------------|----------------| | Assets | Debit | Credit | | Liabilities | Credit | Debit | | Capital/Equity | Credit | Debit | | Expenses | Debit | Credit | | Revenue/Income | Credit | Debit |

T-Accounts Explained

A T-account is a visual representation of a ledger account. It looks like the letter "T":

        Cash Account
  ──────────────────────────
  Debit (Dr.)  | Credit (Cr.)
  ─────────────|────────────
  Rs. 2,00,000 | Rs. 50,000
  (Capital)    | (Rent paid)

Worked Example

Sita starts a tailoring business in Bhaktapur:

1. She invests Rs. 1,50,000 cash (Capital increases -- Credit; Cash increases -- Debit)
2. She buys a sewing machine for Rs. 40,000 cash (Machine increases -- Debit; Cash decreases -- Credit)
3. She takes a loan of Rs. 50,000 from a friend (Cash increases -- Debit; Loan/Liability increases -- Credit)

After these transactions, the equation is:

• Assets: Cash Rs. 1,60,000 + Machine Rs. 40,000 = Rs. 2,00,000
• Liabilities: Loan Rs. 50,000
• Capital: Rs. 1,50,000
• Rs. 2,00,000 = Rs. 50,000 + Rs. 1,50,000 -- balanced!

Key Term: Double Entry means every transaction has two equal and opposite effects, keeping the accounting equation in balance at all times.

Summary

• The accounting equation (Assets = Liabilities + Equity) must always balance.
• The double entry system ensures every transaction is recorded in at least two accounts.
• Debits increase assets and expenses; credits increase liabilities, equity, and revenue.
• T-accounts provide a simple visual way to track debits and credits.