Sunday, January 27, 2008

Basic Accounting Equation

Today I will continue with my review of basic accounting. There is an essential equation in accounting which forms the foundation for the entire system. This equation states that the sum of Liabilities and Owners' Equity equals the sum of Assets. This equation is the bridge between accounts and explains why a double-entry accounting system is necessary. For every entry made to a debit, an equal amount must be applied as a credit somewhere else. All Debit columns must be able to be added and have their sums equal the total of the credit columns. Also, if there is a change to an asset account, an equal change must be made to a liability or owners' equity account.

Let me give you two or three examples and hopefully this will become a little more clear for you:

Owners invest $70,000 in company in exchange for stock.
The $70,000 is added (via debit) to the Assets. At the same time, to maintain the equality in the accounting equation, there is also $70,000 added to the Owners' Equity (via credit).

Pay $500 in cash to pay wages.

This time there is a decrease in Assets (via credit) and an accompanying decrease (via debit) to the Owners' Equity Account.

Receive $1,200 cash from customer for services.I think you are starting to get the idea! You had an increase in assets (via debit) when you received the money, and an equal increase in the Owners' Equity (via credit). If take a look, the accounting equation remains true and the debits equal the credits.

Paid $2,000 cash to a vendor for new equipment.
This time you are merely exchanging one asset for another, so there is no change to the Liabilities or to the Owners' Equity.

Declare a $6,000 dividend
In this final example, the company has made an obligation for itself which must be recorded. There is a decrease in the Owners' Equity (via debit) and a corresponding increase in the Liabilities (via Credit).

These are just a few simple examples. There are many, many, many more possible. It is my hope that you will take the time to seek them out for yourself to learn more. Stop back to my blog again soon. Next time I will introduce and discuss the Accounting Cycle.
--------Sincerely, Trevor Stasik
To return to initial post in my Accounting Review Guide, click HERE.

View Trevor Stasik's profile on LinkedIn

Post a Comment