Before you can understand debits and credits, you’ll need a little background on the structure of accounting. It all starts with the Accounting Equation. The Accounting Equation is the foundation of double entry accounting. It categorizes accounts into different account types. Those account types determine how debits and credits will be used to increase and decrease accounts.
Let’s dig into the Accounting Equation so you have the start of a solid foundation!
What is the Accounting Equation?
The Accounting Equation is the basis of double-entry accounting and it used to record changes (transactions) in a business. Those transactions include buying goods, selling products, and owner’s investments and withdrawals. The Accounting Equation provides the framework for tracking the changes. The Accounting Equation shows the relationship between Assets (what a company owns), Liabilities (what a company owes to vendors or banks, and Equity (what a company owes to its owners.)
What is the Basic Accounting Equation?
Assets = Liabilities + Equity (also known as Capital)
The Accounting Equation looks at what a company owns and compares it to what a company owes. The difference between the two is called equity. Let’s use a delivery van for a florist shop as an example to explain.
The florist shop purchases a delivery van for use in delivering flowers to customers. The florist shop paid $20,000 for the van. It purchased the van for a cash down payment of $5,000 and took out a loan for $15,000.
The delivery van is an asset. It’s something the company owns that has value and will be used to make revenue for the business. The company has an Asset that cost $20,000.
Assets = $20,000 [Assets increased by the value of the delivery van we purchased.]
The company made a downpayment of $5,000 cash. Cash is also an Asset. It’s something the company owns that has value and will be used to make revenue for the business. Because the company paid out the cash, the asset value has decreased. We no longer have that $5,000 in the bank account.
Assets = $20,000 – $5,000 = $15,000 [Assets increased by the $20,000 delivery van and assets decreased by the amount of cash we spent.]
The company also took out a $15,000 loan to pay for the delivery van. That loan is a liability. A liability is an obligation to pay based on whatever terms were decided between the company and the lender.
Liabilities = $15,000 [Liabilities increased by $15,000, the amount of the loan for the delivery van.]
Coming back to the Accounting Equation, now we have:
Assets = Liabilities + Equity
$15,000 = $15,000 + 0
Equity is zero because for every dollar of assets we have, we have a dollar of liability. It’s the same as the bank giving you a 100% mortgage (liability) for a house purchase. You have no equity in the house, the bank essentially owns all of it until you start to make payments.
Asset (house) = Liability (mortgage) + Equity (zero)
Obviously, that’s not a great financial position to be in!
Back to our florist shop.
Let’s say the company had $50,000 in cash to start with and only used $5,000 for the purchase of the van. The Accounting Equation changes:
Assets = Cash ($50,000 – $5,000) + Delivery Van ($20,000) = Liability ($15,000) + Equity ($50,000)
Total Assets $65,000 = Liability $15,000 + Equity 50,000
The difference between Assets and Liabilities is Equity.
As transactions occur, the Accounting Equation changes. Accounts increase and decrease, and as that happens the Accounting Equation is continually changing. The Owner’s Equity is continually changing. Accounting is all about tracking those changes!
When we track the changes in the Accounting Equation, we use the three basic accounts (Assets, Liabilities, and Equity). But it wouldn’t make sense to just put all of our Assets in a big pile and dump all our Liabilities in a bucket. We need more detail than that.
We need to know of our Assets, how much is Cash, how much is Delivery Van, how much is Inventory. We need to know of our Liabilities, how much is the delivery van loan, how much is the mortgage. The Accounting Equation helps us do that by giving us a foundation we can build on.
You can learn more about how the Accounting Equation works by watching this video:
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