Accounting Equation and Rules of Debit and Credit

Understand Accounting Equation and Rules of Debit and Credit

Key rules to remember

Accounting equation

Assets = Capital + Liabilities

Also written Capital = Assets − Liabilities. It holds after every transaction.

Expanded equation

Assets = Liabilities + Capital + Income − Expenses − Drawings

Use this when the question includes profit items or drawings during the year. Capital here means opening capital.

Personal account rule

Debit the receiver; Credit the giver

Applies to persons, firms, companies, and the owner's capital and drawings accounts.

Real account rule

Debit what comes in; Credit what goes out

Applies to cash, bank, stock, furniture, building, machinery and other assets.

Nominal account rule

Debit all expenses and losses; Credit all incomes and gains

Applies to rent, wages, discount, commission, interest and similar items.

Effect of debit and credit

Assets and expenses: Dr increases, Cr decreases. Liabilities, capital and incomes: Cr increases, Dr decreases

This is the modern approach and gives the same answer as the golden rules.

How to solve Accounting Equation and Rules of Debit and Credit questions

1. 1Read the transaction and underline the two accounts affected. Every transaction affects at least two.
2. 2Classify each account as asset, liability, capital, expense or income.
3. 3Decide whether each account increases or decreases.
4. 4Apply the rule: for an asset or expense, an increase is a debit. For a liability, capital or income, an increase is a credit. Decreases are the opposite.
5. 5Cross-check with the golden rule for the account type (personal, real or nominal).
6. 6For equation questions, write the new values of Assets, Liabilities and Capital after each transaction.
7. 7Verify that Assets = Capital + Liabilities and that total debit equals total credit.

Quickest way: Two-question shortcut

Common mistakes in Accounting Equation and Rules of Debit and Credit

• Treating debit as always meaning increase and credit as decrease.

  Bank statements use credit to mean money added, so the everyday meaning sticks.

  Fix: In accounting, the effect depends on the account type. Debit increases assets and expenses; credit increases liabilities, capital and income.

• Classifying outstanding rent or prepaid insurance as nominal in every case.

  The name contains an expense, so students stop reading.

  Fix: Outstanding expense is a liability (personal). Prepaid expense is an asset (real). The expense itself stays nominal.

• Treating drawings as an expense and debiting it to the Profit and Loss Account.

  Drawings feel like money spent.

  Fix: Drawings reduce capital. Debit the Drawings account and never show it as a business expense.

• Calling the owner's capital account a real account.

  Capital sounds like money or property.

  Fix: Capital is a personal account, because it is owed to the owner. The business is a separate entity from its owner.

• Showing a loss as an asset reduction without changing capital in the equation.

  Students forget that expenses reduce capital.

  Fix: When an expense is paid, assets fall and capital falls by the same amount. Both sides stay equal.

• Applying the personal rule to goods bought from a supplier instead of the real rule for goods.

  Both a person and goods are involved.

  Fix: Apply each rule to its own account: debit Purchases (or goods coming in) and credit the supplier, who is the giver.

Worked examples