Sunday, December 23, 2007

Debits Credits and The Accouting Equation

Why is accounting so powerful? It is because it is all based off of one simple accounting equation:

Assets-Liabilities-Stockholder's Equity = 0

Assets = Liabilities + Stockholder's Equity

Stockholder's Equity = Assets - Liabilities

Liabilities = Asset - Stockholder's Equity

Yes, all of these are one simple equation. Just a bunch of different variations, to say the same thing. Always in balance, always able to provide information. The accounting equation is able to provide tons of information. By breaking this equation out further accountants, financial analysts and banks come up with more complex ways to evaluate a company. For instance assets can be broken into current assets and long term assets. By breaking up key information the ability to to evaluate key financial measures like liquidity is extended. Liquidity ratios answer a simple question, "Does X Company have enough money to pay the bills?" A simple but vital question financial statements answer.

Now that you understand the power of the equation let's discuss debits and credits. To understand debits and credits focus on the equation when it is stated:

Assets - Liabilities - Stockholder's Equity = 0

Debit and credits ensure that the equation is always in balance. Most people think of a debit and credit as a positive or a negative a left or right. Before you know it your lefts and rights are all mixed up and you find yourself in a tangled mess. They are just two opposites that offset each other when on the same side of the equation. Debit and credit must always equal each other. This creates the balance, it is that simple. They allow the parts of the equation to change but the ultimate outcome is always zero.

Zero serves the function of a check figure. A credit always offset a debit creating no net affect. That is it. The numbers change but the balance remains. This dichotomy is how we keep track of the changes occurring in our business's financial picture. This whole process is referred to as dual entry accounting.

People generally get confused over a little accounting trick. Basically, it is how we develop an income statement. All accounting information is used to effect the balance sheet. The income statement is created by separating a portion of the entries into income and expense accounts. Since, the offsetting side to these accounts usually have an effect on an asset or liability. The culmination of these income sources and expenses are collected in retained earning at the end of the accounting period. The whole time being offset by assets and liabilities. The balance sheet account that collects the income and expense are often called current year retained earning which is equal to your net income and comprise the P&L.  So to summarize expense and income accounts are just a breakout of current year retained earnings.

This allows for balance and difference to co-exist. Obviously, you want to be able to tell what you've earned so take expenses from income and that positive number (hopefully) leftover is your profit. If your not running the business efficiently that negative number is the loss.  At the end of the day the credit to income eventually turns into a credit to retained earnings increasing what the owner's percentage of the balance sheet.

Bring accounting down to the level of simple concepts. Accounting is the documentation of a transaction that is it, don't over complicate the process.

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