November 15, 2016

Finance 101: Understanding the accounting equation

A picture is worth a thousand words

I have spent a long time studying accounting and am still learning. I love that accounting is both a science and an art form. In my final year in my bachelors degree in Accounting I came home one day and announced to my wife that I finally understood the accounting equation. Granted this was after studying accountancy in high school, earning an associates in business and certificate in accounting and having worked in an accounting office for several years.

The accounting equation, in theory, is rather simple:

Assets = Liabilities + Equity

Assets are everything you own or are owed.
Liabilities are everything you owe.
Equity is made up of all the contributions and withdrawals of the shareholders as well as the current and retained earnings of the business.

The books always have to balance. We use debits and credits as a double entry system to keep the accounting equation in balance.

Debits = Credits

When you want an asset account to go up — you record a debit. When you want a liability or equity account to go up — you record a credit.

At the end of the day, the objective is to create a relevant and reliable picture which contains immense value to the stakeholders involved in the business. If your only objective is to create reports useful to the tax man — as a business owner you are missing out in understanding a huge side to your business. The picture we create is capable of telling a very detailed story about how a business is being operated. The details allow us to see operational deficiencies, strategy shortcomings, or massive opportunities and strengths to capitalize on.