The accounting equation and business transactions
Every transaction keeps Assets = Liabilities + Equity true. Each one changes at least two items, so the equation always balances.
The five elements
Assets are present economic resources the business controls as a result of past events; each has the potential to bring economic benefits: cash, inventory, equipment, amounts owed by customers. Liabilities are present obligations to transfer an economic resource (to pay or deliver) as a result of past events: a bank loan, amounts owed to suppliers. Equity (the owner's capital) is what is left for the owner: assets minus liabilities. Income increases equity, other than capital put in by the owner (sales, fees). Expenses decrease equity, other than drawings (rent, salaries). Drawings are what the owner takes out for personal use; they reduce equity but are not expenses.
Transaction or not?
The business entity concept keeps the owner's private dealings out of the business books.
Worked layout: Nimal Mobile Centre, Kandy (Rs.)
| No. | Transaction | Cash | Inventory | Equipment | Payables | Capital |
|---|---|---|---|---|---|---|
| 1 | Nimal invests cash | +500,000 | +500,000 | |||
| 2 | Buys equipment for cash | −150,000 | +150,000 | |||
| 3 | Buys goods on credit | +80,000 | +80,000 | |||
| 4 | Sells goods costing 30,000 for 45,000 cash | +45,000 | −30,000 | +15,000 (profit) | ||
| 5 | Pays the supplier | −50,000 | −50,000 | |||
| 6 | Pays rent | −12,000 | −12,000 (expense) | |||
| 7 | Takes cash for personal use | −8,000 | −8,000 (drawings) | |||
| Balances | 325,000 | 50,000 | 150,000 | 30,000 | 495,000 |
Worked example: prove that the equation balances
Using the Nimal Mobile Centre table, prove that assets equal liabilities plus equity after the seven transactions.
- Cash: 500,000 − 150,000 + 45,000 − 50,000 − 12,000 − 8,000 = 325,000.
- Inventory: 80,000 − 30,000 = 50,000. Equipment: 150,000.
- Total assets: 325,000 + 50,000 + 150,000 = 525,000.
- Payables: 80,000 − 50,000 = 30,000.
- Capital: 500,000 + 15,000 − 12,000 − 8,000 = 495,000.
- Liabilities + equity: 30,000 + 495,000 = 525,000.
Assets Rs. 525,000 = Liabilities Rs. 30,000 + Equity Rs. 495,000. The equation balances.
Worked example: find the profit from capital figures
At 1 April 2025 Dilani's capital was Rs. 600,000. At 31 March 2026 her business had assets of Rs. 1,200,000 and liabilities of Rs. 350,000. During the year she added Rs. 50,000 of capital and withdrew Rs. 90,000. Find her profit for the year.
- Closing capital = assets − liabilities = 1,200,000 − 350,000 = 850,000.
- Closing capital = opening capital + additional capital + profit − drawings.
- 850,000 = 600,000 + 50,000 + profit − 90,000.
- 850,000 = 560,000 + profit, so profit = 850,000 − 560,000 = 290,000.
- Check: 600,000 + 50,000 + 290,000 − 90,000 = 850,000.
Profit for the year = Rs. 290,000.
Every sale at a supermarket checkout, every loan a bank gives a three-wheeler owner and every rent payment by a Pettah shop changes at least two items of the accounting equation, and the books stay in balance.
Short answer: “State the accounting equation.” Assets = Liabilities + Equity (owner's capital).
Structured question: “Show the effect of the following transactions on the accounting equation.” Draw a table with a column for each asset, liability and capital; enter + and − for each transaction; total the columns and prove A = L + E.
A = L + E. Income adds to E; expenses and drawings take away from E. If your table does not balance, a transaction has only one side recorded.