4 Financial Accounting · 4.1 Accounting basics: concepts, conventions and the accounting process
4.1.2 The accounting process: accounting equation, double entry, types of accounts and rules of debit and credit
Every transaction has two equal sides (double entry), so Assets = Liabilities + Capital always holds; each side is a debit or a credit in some account, decided by the type of account and its rule.
- APPSC Paper I
- Advanced level
- 9 min read
- Free
Core facts
- Accounting process (cycle): identify the transaction (with a voucher) → journal (book of original or prime entry) → ledger (posting, the book of final entry) → balancing → trial balance → adjustments → final accounts (trading account, profit and loss account, balance sheet) → closing entries.
- Accounting equation: Assets = Liabilities + Capital (A = L + C). Hence Capital = Assets − Liabilities and Liabilities = Assets − Capital.
- Capital grows with profit and fresh capital; it falls with losses and drawings.
- Double entry: every transaction affects at least two accounts, one debited and one credited, by the same amount. Total debits always equal total credits.
- Debit (Dr) = left side of an account; Credit (Cr) = right side.
- Traditional (British) classification:
- Personal: natural (Ram, Sita), artificial (SBI, a company, a club), representative (outstanding salary, prepaid rent, accrued interest, income received in advance). The owner's capital and drawings accounts are also personal accounts.
- Real: tangible (cash, building, machinery, furniture, goods) and intangible (goodwill, patents, trademarks).
- Nominal: expenses, losses, incomes and gains (rent, wages, salary, discount, commission, interest, bad debts, depreciation).
- Golden rules:
- Personal: debit the receiver, credit the giver.
- Real: debit what comes in, credit what goes out.
- Nominal: debit all expenses and losses, credit all incomes and gains.
Explained
Modern (American, accounting-equation) approach. Accounts are grouped into five kinds; an increase is entered on the side shown.
| Account type | Increase | Decrease | Normal balance |
|---|---|---|---|
| Assets | Debit | Credit | Debit |
| Expenses and losses | Debit | Credit | Debit |
| Liabilities | Credit | Debit | Credit |
| Capital | Credit | Debit | Credit |
| Revenue and gains | Credit | Debit | Credit |
Drawings reduce capital, so drawings are debited. Both approaches give the same entry.
Example 1 (effect on the equation). Arun's transactions:
- Starts business with cash ₹1,00,000.
- Buys furniture for cash ₹20,000.
- Buys goods on credit from Ravi ₹30,000.
- Sells goods costing ₹20,000 for ₹28,000 cash.
- Pays salary ₹3,000.
- Pays Ravi ₹25,000.
- Withdraws ₹2,000 cash for personal use.
| After | Assets (₹) | Liabilities (₹) | Capital (₹) |
|---|---|---|---|
| 1 | 1,00,000 | 0 | 1,00,000 |
| 2 | 1,00,000 | 0 | 1,00,000 |
| 3 | 1,30,000 | 30,000 | 1,00,000 |
| 4 | 1,38,000 | 30,000 | 1,08,000 |
| 5 | 1,35,000 | 30,000 | 1,05,000 |
| 6 | 1,10,000 | 5,000 | 1,05,000 |
| 7 | 1,08,000 | 5,000 | 1,03,000 |
Working. Final assets: cash 1,00,000 − 20,000 + 28,000 − 3,000 − 25,000 − 2,000 = 78,000; furniture 20,000; stock 30,000 − 20,000 = 10,000; total ₹1,08,000. Liabilities: creditor Ravi ₹5,000. Capital 1,00,000 + profit 5,000 (8,000 − 3,000) − drawings 2,000 = ₹1,03,000. Check: 5,000 + 1,03,000 = 1,08,000. Note that transaction 2 only changes the form of an asset (cash to furniture), so totals do not move.
Example 2 (applying the rules).
| Transaction | Debit | Credit | Rule used |
|---|---|---|---|
| Paid rent ₹5,000 | Rent a/c (nominal) | Cash a/c (real) | Expense Dr; what goes out Cr |
| Sold goods to Suresh on credit | Suresh a/c (personal) | Sales a/c | Receiver Dr; goods go out Cr |
| Bought machinery from Lakshmi & Co. on credit | Machinery a/c (real) | Lakshmi & Co. a/c (personal) | Comes in Dr; giver Cr |
| Received commission ₹1,200 | Cash a/c (real) | Commission a/c (nominal) | Comes in Dr; income Cr |
| Deposited cash in SBI | SBI (bank) a/c (personal, artificial) | Cash a/c (real) | Receiver Dr; goes out Cr |
| Owner took goods for home | Drawings a/c (personal) | Purchases a/c | Owner receives Dr; goods go out Cr |
Example 3. Total assets ₹5,00,000, outside liabilities ₹1,80,000. Find capital. Solution. 5,00,000 − 1,80,000. Answer: ₹3,20,000
Goods account. Goods are a real account, kept in parts: purchases, sales, purchases returns (returns outward) and sales returns (returns inward). Goods taken by the owner or given as charity are credited to purchases, not sales.
Deeper
- Profit from the equation (capital comparison). Profit = closing capital − opening capital + drawings − additional capital introduced. This is the basis of the statement of affairs method for single entry.
Example 4. Opening capital ₹2,00,000, closing capital ₹2,60,000, drawings ₹30,000, fresh capital ₹40,000. Find the profit. (a) ₹60,000 (b) ₹50,000 (c) ₹90,000 (d) ₹1,30,000 Solution. 2,60,000 − 2,00,000 + 30,000 − 40,000. Answer: (b) ₹50,000
Example 5. A firm's total assets are ₹3,50,000. It buys goods for ₹1,50,000 on credit and then pays creditors ₹1,20,000 in cash. What are the total assets now? Solution. Credit purchase raises assets: 3,50,000 + 1,50,000 = 5,00,000; paying liabilities lowers assets: 5,00,000 − 1,20,000. Answer: ₹3,80,000
- Four kinds of transactions on the equation:
- both sides rise (credit purchase, capital brought in);
- both sides fall (paying a creditor, drawings);
- one asset up, another down (cash purchase of an asset): totals unchanged;
- one liability up, another down (bill accepted for a creditor; the creditor becomes bills payable): totals unchanged.
- Advantages of double entry: complete record, arithmetical check through the trial balance, profit and financial position can be found, fraud is harder to hide.
- Limits: the trial balance agreeing does not prove accuracy; errors of complete omission, commission (wrong person, same side and amount), principle and compensating errors do not disturb it.
- Bases of recording: source documents (cash memo, invoice, debit and credit notes, receipt, vouchers) support each journal entry.
- Debit balance or credit balance? Assets, expenses, drawings: debit balance. Liabilities, capital, incomes, provisions: credit balance. A bank overdraft (owed to the bank) is a credit balance in the bank account.
Common traps
- ✗ "Capital = Assets + Liabilities." ✓ Capital = Assets − Liabilities.
- ✗ "Drawings are credited because they reduce capital." ✓ Drawings are debited (a decrease in capital is a debit).
- ✗ "Outstanding salary is a nominal account." ✓ It is a representative personal account; salary itself is nominal.
- ✗ "Bank account is a real account like cash." ✓ The bank is an artificial person: personal account.
- ✗ "Goods taken by the owner are credited to sales." ✓ Credit purchases account (at cost); debit drawings.
- ✗ "The ledger is the book of original entry." ✓ The journal is the book of original entry; the ledger is the book of final entry.
- ✗ "Buying furniture for cash increases total assets." ✓ One asset replaces another; totals are unchanged.
- ✗ "Goodwill is a nominal account." ✓ It is an intangible real account.
Quick revision
- Cycle: voucher → journal → ledger → trial balance → final accounts.
- A = L + C; capital = assets − liabilities.
- Personal: debit receiver, credit giver.
- Real: debit what comes in, credit what goes out.
- Nominal: debit expenses and losses, credit incomes and gains.
- Modern: assets and expenses rise on debit; liabilities, capital, revenue rise on credit.
- Drawings: debit; reduce capital.
- Bank, company, outstanding and prepaid items: personal accounts.
- Goodwill, patents: intangible real.
- Profit = closing capital − opening capital + drawings − fresh capital.
Go deeper: Mains writing (beyond what APPSC Paper I usually asks)
Mains writing Mains writing
- Frame: the accounting equation is the dual aspect concept in numbers; double entry is how it is kept true transaction by transaction.
- Points: the cycle from voucher to balance sheet; the traditional and modern rules give the same entries; the trial balance is an arithmetical, not a complete, check.
- Illustration: take three transactions, show the entry and the equation after each.
- Close: computerised accounting (Tally, ERP) automates posting and balancing but still rests on the same debit and credit logic.
Practise this topic. Questions on Accounting concepts, conventions & process, with answers explained.
All Accounting basics: concepts, conventions and the accounting process notes · APPSC Paper I syllabus · APPSC Paper I Mock 1 with answers · Start free
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