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Financial Accounting · Double-entry bookkeeping principles including the maintenance of accounting records

Accounting Equation and Types of Accounts Explained

Updated 11 October 2026 · Fact-checked

The accounting equation says assets = capital + liabilities. Every transaction changes at least two items but keeps both sides equal. To solve questions, classify each item as asset, liability, capital, income or expense, decide whether it rises or falls, then check the equation still balances. Income and expenses change capital through profit.

Understand Accounting Equation and Types of Accounts

A business owns things, owes things, and belongs to its owner. The accounting equation captures this in one line: assets = capital + liabilities. Assets are resources the business controls, such as cash, inventory and equipment. Liabilities are amounts owed to others, such as loans and payables. Capital is the owner's claim on the business.

The equation always balances because every transaction has two sides. If you buy inventory for cash, one asset rises and another falls. If you buy it on credit, an asset rises and a liability rises. This two-sided effect is the idea behind double-entry bookkeeping.

Capital is not fixed. It rises when the owner pays in money or when the business makes a profit. It falls when the owner takes drawings or when the business makes a loss. Profit is income minus expenses. So the extended equation is: assets = opening capital + capital introduced + income − expenses − drawings + liabilities.

Accounts are grouped by type. Asset accounts, liability accounts and capital accounts make up the statement of financial position. Income accounts and expense accounts make up the statement of profit or loss. At year end, income and expenses are closed off into profit, which moves into capital.

You may also meet the older labels. Personal accounts are for people or organisations, such as receivables and payables. Real accounts are for assets, such as cash and equipment. Nominal accounts are for income, expenses and sometimes capital. The exam mainly uses asset, liability, equity, income and expense, but you should recognise the older terms.

Key formulas to remember

Basic accounting equation
Assets = Capital + Liabilities
Must hold after every transaction. Also written as Capital = Assets − Liabilities.
Extended accounting equation
Closing capital = Opening capital + Capital introduced + Profit − Drawings
Profit = Income − Expenses. A loss is subtracted instead.
Profit from capital movement
Profit = Closing capital − Opening capital − Capital introduced + Drawings
Used in incomplete records questions where no income or expense figures are given.
Normal balances
Debit: assets, expenses, drawings. Credit: liabilities, capital, income
Increase an account on its normal side; decrease it on the opposite side.
Account types
Personal = people or organisations; Real = assets; Nominal = income, expenses
Older classification. Capital is sometimes treated as personal (the owner).

How to solve Accounting Equation and Types of Accounts questions

Use this method for any question on the equation or on classifying accounts.

  1. 1Read each item and label it: asset, liability, capital, income or expense.
  2. 2Write down the equation: assets = capital + liabilities. Put the known figures in.
  3. 3For a transaction, identify the two accounts affected and whether each rises or falls.
  4. 4Update the totals. Income raises capital, expenses lower it, and drawings lower it.
  5. 5Find the missing figure by rearranging the equation, for example capital = assets − liabilities.
  6. 6Check that assets still equal capital plus liabilities.
  7. 7Re-read the question to confirm you answered what was asked, such as profit, capital or total assets.

Quickest way: Two-effects check

When to use it: Use for multiple choice questions asking how a transaction affects the equation or what type of account something is.

  1. Ask: what two things changed?
  2. Label each as asset, liability, capital, income or expense.
  3. Mark each up or down.
  4. If the effect is only on the asset side, or only within liabilities and capital, totals do not change.
  5. Eliminate any option where the equation would no longer balance.

Common mistakes in Accounting Equation and Types of Accounts

  • Treating drawings as an expense.

    Both reduce the owner's wealth, so they feel similar.

    Fix: Drawings reduce capital directly and never appear in profit or loss. Expenses reduce profit.

  • Classifying a prepayment as an expense or an accrual as an asset.

    Students focus on the word expense rather than who owes what.

    Fix: A prepayment is a current asset (the business has paid ahead). An accrual is a current liability (the business owes money).

  • Thinking buying an asset with cash changes capital.

    Money leaves the business, so it feels like a loss.

    Fix: Cash falls and the new asset rises by the same amount. Capital is unchanged.

  • Saying a bank overdraft is an asset.

    It appears in the bank account.

    Fix: An overdraft is a liability because the business owes the bank.

  • Confusing debit with increase.

    Everyday language links debit to decrease.

    Fix: Debit increases assets and expenses but decreases liabilities, capital and income. Learn the normal side of each type.

  • Mixing up real, nominal and personal accounts.

    The names do not describe their content.

    Fix: Personal means people, real means assets, nominal means income and expenses. Use the type labels asset, liability, income and expense where the question does.

Worked examples

Example 1

A sole trader starts with assets of $48,000 and liabilities of $18,000. During the year the owner introduces $5,000 more capital, takes drawings of $9,000 and makes a profit of $14,000. Calculate closing capital.

Show the solution
  1. Opening capital = assets − liabilities = $48,000 − $18,000 = $30,000.
  2. Add capital introduced: $30,000 + $5,000 = $35,000.
  3. Add profit: $35,000 + $14,000 = $49,000.
  4. Deduct drawings: $49,000 − $9,000 = $40,000.

Answer: Closing capital is $40,000.

Example 2

A business has assets of $60,000, liabilities of $25,000 and capital of $35,000. It buys equipment costing $8,000 on credit, then pays $3,000 of that creditor in cash. What are total assets, total liabilities and capital afterwards?

Show the solution
  1. Buying equipment on credit: assets rise by $8,000 to $68,000; liabilities rise by $8,000 to $33,000.
  2. Paying the creditor: cash (an asset) falls by $3,000 to $65,000; liabilities fall by $3,000 to $30,000.
  3. Capital is unchanged at $35,000.
  4. Check: $65,000 = $35,000 + $30,000. It balances.

Answer: Assets $65,000; liabilities $30,000; capital $35,000.

Exam tips

  • Write the equation at the top of your rough paper and update it line by line for each transaction.
  • In multiple response questions, count how many options you must select before you start choosing.
  • In number entry questions, check the sign and the units. Profit and drawings move capital in opposite directions.
  • Watch for items that look like expenses but are assets or liabilities, such as prepayments, accruals and drawings.
  • If a figure is missing, rearrange the equation rather than guessing.

Practice questions from Double-entry bookkeeping principles including the maintenance of accounting records

Accounting Equation and Types of Accounts in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Accounting Equation and Types of Accounts: frequently asked questions

What is the accounting equation?

It is assets = capital + liabilities. It shows that everything a business owns is funded by the owner or by outsiders. It holds after every transaction.

Where do income and expenses fit in the equation?

They fit inside capital. Income increases capital and expenses decrease it. The net result is profit or loss, which is added to or deducted from capital.

What is the difference between real, nominal and personal accounts?

Personal accounts relate to people or organisations, such as receivables and payables. Real accounts relate to assets. Nominal accounts relate to income and expenses.

Is capital an asset?

No. Capital is what the business owes the owner, so it sits on the same side as liabilities. It equals assets minus liabilities.