Fundamentals of Financial and Cost Accounting · Accounting Principles, Concepts and Conventions

Accounting Equation and Systems of Accounting Explained

Updated 10 October 2026 · Fact-checked

The accounting equation says Assets = Liabilities + Capital. Every transaction changes it but keeps both sides equal. Cash basis records money when received or paid; accrual basis records income and expenses when earned or incurred. Double entry records two effects of every transaction; single entry is incomplete. Solve by finding the effect on each element.

Understand Accounting Equation and Systems of Accounting

Every business owns things and owes money. The things it owns are assets: cash, stock, machinery, debtors. What it owes to outsiders are liabilities: loans, creditors, bills payable. What is left for the owner is capital (also called owner's equity).

This gives the accounting equation: Assets = Liabilities + Capital. It always balances because every rupee of assets is funded either by outsiders or by the owner. Each transaction has a dual effect. It changes at least two items, and the equation stays in balance. This is the logic behind double entry.

Now the basis of accounting. Under the cash basis, you record a transaction only when cash is actually received or paid. Under the accrual basis, you record income when it is earned and expenses when they are incurred, whether or not cash has moved. Accrual gives a truer profit. It is the basis on which the accrual and matching concepts operate. Cash basis is simple and is used by small professionals and non-profit bodies for some items.

Next, the system of recording. In the double entry system, every transaction has two aspects: one account is debited and another credited for the same amount. Personal, real and nominal accounts are all kept, and since every debit has an equal credit, a trial balance can check arithmetic accuracy. In the single entry system, records are incomplete. Usually only cash book and personal accounts of debtors and creditors are kept, with no proper nominal or real accounts. Profit is found by comparing opening and closing capital.

So the three ideas fit together: the equation is the rule, double entry is the method that keeps the rule true, and the accrual basis decides when each item enters the books.

Key formulas to remember

Accounting equation: Assets = Liabilities + Capital; Must hold after every transaction. Capital = Assets − Liabilities.
Expanded equation: Assets = Liabilities + Opening Capital + Profit (or − Loss) + Additional Capital − Drawings; Profit increases capital; drawings and losses reduce it.
Profit from capital (single entry / statement of affairs): Profit = Closing Capital − Opening Capital + Drawings − Additional Capital; Used when only assets and liabilities are known.
Accrual vs cash adjustment: Accrual expense = Cash paid + Outstanding at end − Prepaid at end (ignoring opening balances); Opening outstanding or prepaid amounts also need adjusting if given.
Double entry rule: Total debits = Total credits for every transaction; Basis of the trial balance check.

How to solve Accounting Equation and Systems of Accounting questions

Use this method for equation problems and for theory questions on bases and systems.

1Read the question and note whether it asks for a number (equation) or a concept (basis or system).
2For numbers, list each item as an asset, a liability or capital before calculating.
3For each transaction, decide which two items change and whether each rises or falls.
4Check that the equation still balances after the change. Assets change on one side only if another asset or a liability or capital changes too.
5Treat drawings and losses as reductions of capital, and profit and fresh investment as increases.
6For basis questions, ask: is the item recorded when cash moves or when it is earned or incurred?
7For system questions, ask: is the record complete with both aspects (double entry) or incomplete (single entry)?
8Match your result to the options and eliminate any that break the equation.

Quickest way: Solve for the missing element

When to use it: When the question gives two of assets, liabilities and capital, or a list of transactions with changes.

Write A = L + C at the top.
Fill known values and find the missing one by simple arithmetic.
For a transaction, write only the change, such as +₹10,000 on A and +₹10,000 on L.
If a change occurs on one side only, it must be an exchange within that side, so totals stay the same.
For basis or system theory, remember: cash basis equals cash movement; accrual equals earned or incurred; double entry equals two aspects.

Common mistakes in Accounting Equation and Systems of Accounting

Treating drawings as an expense.
Money leaves the business, so it feels like a cost.
Fix: Drawings reduce capital directly. They never appear in the profit calculation.
Writing Capital = Assets + Liabilities.
Students mix up the sides of the equation.
Fix: Remember Capital = Assets − Liabilities. Capital is what is left after outsiders are paid.
Thinking accrual basis means no cash is ever recorded.
The word accrual is linked to credit transactions.
Fix: Accrual still records cash items. It simply also records items earned or incurred but not yet settled.
Calling single entry a system with no records at all.
Students read incomplete as absent.
Fix: Single entry usually keeps a cash book and personal accounts. It lacks full real and nominal accounts.
Assuming a trial balance proves all accounts are correct under double entry.
Equal totals look like proof of accuracy.
Fix: It proves only arithmetic agreement of debits and credits. Some errors, such as wrong account or omission, remain hidden.
Adding credit purchases of goods to assets only.
The liability side is forgotten.
Fix: Credit purchase raises stock (asset) and creditors (liability) by the same amount.

Worked examples

Example 1

Rohan starts a business with cash ₹5,00,000. He buys furniture for ₹1,00,000 in cash and goods for ₹2,00,000 on credit. What are total assets, liabilities and capital after these transactions?

Show the solution

Start: cash ₹5,00,000. Capital ₹5,00,000. Assets ₹5,00,000.
Furniture for cash: cash falls by ₹1,00,000, furniture rises by ₹1,00,000. Assets remain ₹5,00,000.
Goods on credit: stock rises ₹2,00,000 and creditors rise ₹2,00,000.
Assets = cash ₹4,00,000 + furniture ₹1,00,000 + stock ₹2,00,000 = ₹7,00,000.
Liabilities = ₹2,00,000. Capital = ₹7,00,000 − ₹2,00,000 = ₹5,00,000.

Answer: Assets ₹7,00,000; liabilities ₹2,00,000; capital ₹5,00,000.

Example 2

Under the accrual basis, a firm pays rent of ₹60,000 in the year. Rent of ₹5,000 is still outstanding at year end and ₹8,000 of the amount paid is for next year. Ignoring opening balances, what rent is charged to the profit and loss account? Options: (a) ₹57,000 (b) ₹60,000 (c) ₹63,000 (d) ₹73,000

Show the solution

Accrual expense = cash paid + outstanding − prepaid.
= ₹60,000 + ₹5,000 − ₹8,000.
= ₹57,000.
Wrong options: (b) ₹60,000 ignores both adjustments (cash basis); (c) ₹63,000 comes from applying the adjustments the wrong way round, adding prepaid and subtracting outstanding (₹60,000 + ₹8,000 − ₹5,000); (d) ₹73,000 adds both outstanding and prepaid instead of subtracting prepaid.

Answer: (a) ₹57,000

Exam tips

Questions often give two of the three elements. Do the subtraction or addition first and skip the long working.
Know the one-line differences between cash and accrual basis, and between single and double entry. These appear as direct theory MCQs.
For transactions, check whether the answer shows an exchange within assets (total unchanged) or a change in both sides (total changes).
Watch for the words drawings, additional capital and loss in equation questions; each one moves capital.
With no negative marking, eliminate impossible options and always answer every question.

Practice questions from Accounting Principles, Concepts and Conventions

Accounting Equation and Systems of Accounting 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 Systems of Accounting: frequently asked questions

What is the accounting equation with an example?

It is Assets = Liabilities + Capital. If a business has assets of ₹8,00,000 and liabilities of ₹3,00,000, the capital is ₹5,00,000. Any transaction keeps both sides equal.

What is the difference between cash basis and accrual basis of accounting?

Under cash basis, items are recorded only when cash is received or paid. Under accrual basis, income and expenses are recorded when earned or incurred, even if cash comes later. Accrual gives a truer profit for the period.

What are the main features of the double entry system?

Every transaction has two aspects, a debit and a credit of equal amount. Personal, real and nominal accounts are all maintained. A trial balance can be prepared to check arithmetic accuracy.

Is single entry a proper system of accounting?

It is an incomplete method, not a full system. Usually only a cash book and personal accounts are kept. Profit is often estimated by comparing opening and closing capital.