The foundation of the whole double-entry system is the accounting equation. It states that what the business owns (assets) must equal the sources that funded them — the claims of outsiders (liabilities) and the claim of the owner (owner's equity).
Key idea
Assets = Liabilities + Owner's Equity. Expanded form: Owner's equity = Capital + Net profit − Drawings.
Effect of Transactions
Every transaction touches at least two accounts so that the equation always stays in balance. For example:
- Owner injects cash capital — asset (cash) up, equity (capital) up.
- Buy furniture for cash — one asset up (furniture), one asset down (cash).
- Buy inventory on credit — asset (inventory) up, liability (creditor) up.
- Pay a creditor in cash — asset (cash) down, liability (creditor) down.
Worked Example
Example
Ms Lina starts a business with cash capital of RM50,000. Assets (cash) = RM50,000; Equity = RM50,000. She buys a vehicle for RM30,000 in cash: cash falls to RM20,000, vehicle RM30,000. Assets stay at RM50,000. She then takes a loan of RM10,000: cash rises to RM30,000, liability RM10,000. Now Assets RM60,000 = Liabilities RM10,000 + Equity RM50,000. Balanced.
Why the Equation Always Balances
The equation always balances because of the business entity concept and the double-entry system. Every transaction has two effects of equal value but in opposite directions, so both sides of the equation change by the same amount. The business entity concept means the business is treated as separate from its owner; that is why capital is regarded as the owner's claim on the business and sits on the right-hand side of the equation. Grasping this relationship lets a student analyse the effect of a transaction before recording it in the ledger, and it is the foundation for later preparing a trial balance that agrees.
Remember
Net profit increases owner's equity; drawings and net loss reduce it. The equation must balance after every transaction.