How Profit or Loss Affects Capital in Double Entry Accounting (With Examples)

📘 Learning Outcomes

🧭 This is Part 1 of a two-part series.
In this article, we’ll cover the first half of the learning outcomes listed below. Stay tuned for Part 2, where we’ll dive into T-accounts, debits and credits, and owner’s drawings.

1. Calculate profit by comparing revenue with expenses.
2. Use the accounting equation to show how changes in assets and liabilities affect capital.
3. Understand why separate accounts are used for each type of expense and revenue.
4. Explain why expenses are recorded as debits and revenues as credits.
5. Enter a series of expense and revenue transactions into the correct T-accounts.
6. Understand how to record business cash or goods used for personal (owner’s) use.

In Part 2, we’ll explore how to enter transactions into T-accounts, and understand debits and credits using clear examples

💡 Understanding Profit and Loss

Profit occurs when your revenue is greater than your expenses. If your costs exceed your revenue, the business makes a loss.

The terms "sales" and "revenue" are often used interchangeably. Let’s look at a simple example to understand this better:

🍭 Example: The Candy Shop

Imagine you run a small candy shop. On 29th June 2025, you sold candies worth $1,000. This amount is your revenue.

But before you could sell, you had to buy the candies from suppliers. Let’s say you paid $700 for the stock you sold that day.

Now let’s calculate your profit:

• Revenue: $1,000
• Cost of Goods Sold (COGS): $700
• Profit: $1,000 − $700 = $300

So your profit from the sales on 29th June is $300.

On the other hand it is possible for expenses to exceed the revenue.

• Revenue: $1,000
• Cost of Good Sold (COGS): $1,100
• Loss: $1,000 − $1,100 = ($100)

So your loss from the sales on 29th June is ($100).

Understanding how revenue and expenses impact profit is foundational in accounting. This concept also ties directly into the accounting equation and the double-entry system, which we’ll explore in the next sections.

📘 Question:

On 29th June 2025, a candy shop made total sales of $1,000. The owner purchased candies worth $1,100 from the supplier on the same day.
a) What is the cost of goods sold (COGS)?
b) Was there a profit or a loss? Show the calculation.
c) Explain why this result is important in understanding business performance.

✅ Answer:

a) The cost of goods sold (COGS) is $1,100.

b) There was a loss, because the cost of goods sold is higher than the revenue.

Calculation:
Revenue = $1,000
COGS = $1,100
Loss = $1,000 − $1,100 = ($100)

c) This result shows that the business spent more money buying stock than it earned from selling it. If this continues, the business won’t be sustainable. Understanding this helps the owner make better decisions about pricing, cost control, and inventory management. It also connects directly to how profit or loss affects the business’s capital in the accounting records.

📊 The Effect of Profit and Loss on Capital

The primary reason most businesses operate is to earn a profit and grow their capital. But how do capital and profit differ?

Let’s understand this using the accounting equation:

Assets = Liabilities + Capital

🧾 Opening Balances (1st July 2025)

A business has the following balances at the start of the month:

Assets:

• Furniture = $20,000
• Inventory = $15,000
• Bank = $4,000

Liabilities:

• Accounts Payable (A/P) = $3,000

We can calculate capital as:

Capital = Assets − Liabilities = (20,000 + 15,000 + 4,000) − 3,000 = $36,000

So, the opening capital on 1st July 2025 is $36,000.

💰 Profit Earned During July

During July, the business sold all its inventory for $20,000.

• Sales Revenue = $20,000
• Cost of Goods Sold (Inventory sold) = $15,000
• Profit = $20,000 − $15,000 = $5,000

This profit increases the capital of the business.

📘 Closing Balances (31st July 2025)

After selling all inventory, here’s the update:

• Inventory = $0
• Bank increases by the sale amount:
• Previous bank balance = $4,000
• Sales income = $20,000

New bank balance = $24,000

• Furniture remains unchanged at $20,000
• Liabilities (A/P) remain at $3,000
• Profit of $5,000 is added to capital

Let’s recalculate:

Assets:

• Furniture = $20,000
• Bank = $24,000
• Inventory = $0
• Total Assets = $44,000

Liabilities:

• Accounts Payable = $3,000

New Capital:

Capital = Assets − Liabilities = $44,000 − $3,000 = $41,000

✔ The capital has increased from $36,000 to $41,000, reflecting the $5,000 profit earned in July.

• We can say Old Capital + Profit = New Capital

This shows how profit increases the owner’s capital, which is clearly reflected in the accounting equation. If the business had made a loss instead, the capital would have decreased.

• Old capital - Loss = New capital

Profit is made when you sell goods or services for more than they cost you. On the other hand, a loss occurs when you buy something at a high price but sell it for less.

There are different types of profit, such as gross profit and net profit—but we’ll cover those in more detail later.

In real life, businesses don’t just use one expense account like “Cost of Goods Sold” or “Purchases.” Instead, each type of expense is recorded in its own separate account, depending on its nature.

Every company sets its own policy for categorizing expenses and assigns them to specific accounts. Here are a few common examples:

• Interest Expense Account
• Rent Expense Account
• Stationery Expense Account
• Management Expense Account

Similarly, revenue or income is recorded in different income accounts based on its source. For example:

• Rental Income Account
• Sales Account
• Royalties Income Account

💳 Debit vs Credit in Expenses and Income

In general:

• Expense accounts usually carry a debit balance
• Income (revenue) accounts usually carry a credit balance

However, this is not always the case. Sometimes, an expense account may show a credit balance, which usually means the expense has been overpaid, reversed, or recorded in advance (a prepaid or accrual situation).

It all depends on the nature of the transaction and the business context.

🔄 Let's Understand Debit and Credit (With a Little Joke First 😄)

Before we dive deeper into debit and credit, let me share a quick accounting joke.

A young intern had just joined a well-established accounting firm. He was inspired by an old, seasoned chartered accountant named Luther, who had decades of experience and the respect of everyone in the office.

The intern noticed something peculiar:
Every morning, Luther would quietly open his desk drawer, take out a small note, read it for a moment, and then put it back—before starting his day.

Curiosity got the better of the intern. He couldn’t gather the courage to ask Luther about it directly, but his mind kept wondering:
"What’s written on that note?"

One day, Luther was running late. The intern finally saw his chance. He rushed over to the desk, opened the drawer, and unfolded the mysterious note.

It read:

"The column by the window is Debit. The column by the door is Credit."

😂 Classic!

But don’t worry—you won’t need to tape notes to your desk. I’ve got you covered. Let’s break it down clearly and simply so that debit and credit become second nature.

👉 Next: Part 2: Debits and Credits Explained Using T-Accounts in Double Entry Accounting