THE ACCOUNTING EQUATION SIMPLIFIED
By Michael L. Russell
© 2008 All rights reserved. Mike Russell Bookkeeping & Tax Services, Inc.
Many people mistakenly shy away from learning accounting because they get confused with the explanation of Debits and Credits. I would like to unravel this mystery for you and make you aware of the fact that accounting is actually a financial language used all over the world. Once you learn this financial language, you could conceivably work anywhere in the world. All you would need to learn is the monetary system used by the country where you care to work.
The type of universal accounting work I am referring to is called a dual-entry system. There are many dual-entry accounting systems on the market today; however, in my opinion, QuickBooks is the easiest for the beginner to learn and operate. I believe, as of this writing, QuickBooks has about 70-80% of the market share for all small to medium sized businesses.
The dual-entry system of accounting is quite different from a single-entry system. An example of a popular single-entry system would be Quicken, another excellent product put out by Intuit. The single-entry system was basically designed to record income and expenses, and was originally thought of as an accounting system that would be used primarily by individuals to monitor their household budgets. The single-entry system has major limitations for businesses that want and need to produce better management information in order to run their businesses.
Our discussion will concentrate on the dual-entry accounting system because it is by far the most accurate and once again, the universal language of finance. I learned in college that credit has been given to the Egyptians for the invention of the dual-entry accounting system. Hieroglyphics found in the pyramids, are believed to be the oldest evidence on record of anyone using a dual-entry accounting system. This dates back to around 1300 B.C. or earlier.
A dual or double-entry accounting system is based off what is called the “Chart of Accounts”. This chart of accounts is a listing of all the individual accounts in your companies set of books. This is not a fixed list by any means. You always have the ability to add, edit, delete or make inactive from this list as the need arises. If you were to go to your bank and start up a new savings account you can easily come back to your QuickBooks program and set up a new savings account in the Chart of Accounts. Generally speaking, as your business grows so will your Chart of Accounts.
The Chart of Accounts in a double-entry accounting system is defined by only 3 major categories. These categories are; Assets, Liabilities and Equity. This also happens to be the infamous accounting equation.
Assets = Liabilities + Equity
Let’s define some of these terms so that we have a clear understanding of their meaning. You have probably heard all of these words used before so they are not new.
Assets are those things you own in your company. Namely; bank accounts, accounts receivable, tools & equipment, inventory, autos & trucks, undeposited funds, etc. These asset accounts are broken down further in QuickBooks to include; other current assets, fixed assets and other assets.
Liabilities are those things you owe to others from your company. For example; accounts payable and credit cards. Liability accounts can be further broken down into; other current liabilities and long-term liabilities.
Equity is the difference between what you owe to others and what you own in your business. As I like to say to my students, “ If you were to stop all business as of today and collected all the money all your customers owed to you and then paid out what you owed to everyone else, the difference or what is left over is your equity”. Equity accounts for sole-proprietors are normally their Capital and Drawing accounts. In a Partnership, each partner will have a Capital account and a Drawing account. Corporations call their equity account Retained Earnings.
These 3 major categories Assets, Liabilities and Equity refer to one of the main financial statements known as the Balance Sheet. The other main financial statement we will concern ourselves with is called the Profit & Loss Statement, or Income Statement. Now let’s define some of the terms we will find on a typical Profit & Loss Statement.
Income is the money you derive from the sale of services or products to your customers.
Cost of Goods Sold is where a business combines all of its’ direct job costs needed to produce its’ products or services.
Expenses can be for various business purposes, but they must be necessary expenses incurred during the production of income.
Other Income is that amount of money your company receives from others but is not your main source of business income. Like Workman’s Compensation Dividends or Material Discounts.
Other Expense is that amount of expense that is not a part of your normal business operation. Like Federal & State Corporate Taxes.
Now that we have defined the categories of accounts we are dealing with I can explain where all the confusion over debits and credits comes from. You will see in the following diagram that sometimes you will debit an account to increase it and sometimes you might credit an account to increase it. How do we know what to do and when?
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ASSET ACCOUNTS |
LIABILITY ACCOUNTS |
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DEBIT TO |
CREDIT TO |
DEBIT TO |
CREDIT TO |
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EXPENSE ACCOUNTS |
CAPITAL OR EQUITY ACCOUNTS |
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DEBIT TO |
CREDIT TO |
DEBIT TO |
CREDIT TO |
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COST OF GOODS SOLD ACCOUNTS |
INCOME INCOME |
|||
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DEBIT TO |
CREDIT TO |
DEBIT TO |
CREDIT TO |
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OTHER EXPENSE |
OTHER INCOME |
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|
DEBIT TO |
CREDIT TO |
DEBIT TO |
CREDIT TO |
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All of the accounts listed on the left are increased by debiting them and decreased by crediting. Just the opposite is true for the accounts listed on the right hand side of the page. All of these accounts are increased by crediting them and decreased by debiting. This is how the accounting equation stays in balance.
When I show this to my students in the class invariably a couple of students will immediately say that this cannot be correct because when they go to their bank they see a sign at the drive-up window that says “All deposits received after 4PM will be credited to your account on the following business day”.
The students ask, “How can your chart say that when I deposit money it is suppose to be a debit but the bank says they are going to credit my account”. This is the main reason most people get frustrated with accounting.
You have to remember that first, the chart I have laid out showing what to debit and credit to increase and decrease is correct and should be memorized. Second, when businesses talk about accounting they are more than likely talking about their set of books and not yours. What the bank means when they say they will credit your account, is that, in their books they will debit their cash account, to show they received the money and then credit a liability account to show that the money is owed back to you. In your books, when you deposit money, you will debit your bank account for the amount deposited and then credit an income account if the money was received from a customer or undeposited funds in QuickBooks.
See how the use of the terms debit and credit can be confusing if you don’t consider whose set of books you are talking about. One of the aspects of accounting I enjoy the most is knowing that the above chart will never change. When I write a check out of my checking account it will always be a credit to that account and when I put money into that bank account it will always be a debit.
When banks first came out with debit cards I believe they might have been originally designed only for making deposits into your account. This language works because when you deposit money to your account it is a debit in your books. It also happens to be a debit in the bank’s books. But when you use your debit card to withdraw money you are actually crediting your account. The language that banks, television and movies use have thoroughly confused the general public about accounting terms to the point that most folks get it backwards. Now that you know how this terminology is misused. You can listen for it on television and in the movies. Listen for all the accounting terms that are used in crime dramas or trials when they are,” following the money trail”.
To summarize, you should memorize what accounts you debit and credit to increase and decrease. This is not a waste to time, it will never change. There are very few absolutes in the world but this is one of them. Also recognize that accounting is considered more of an art form than a science. Just think of the Enron scandal. When you are recording information in your set of books you want to be consistent in the way you record income and expenses. I hope you are no longer confused by what to debit or credit. At least now you have a chart to refer to for the right answer. Keep it next to you when you are working in QuickBooks. Hopefully, you will no longer be confused by that sign at the bank.
