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Accounting Fundamentals: The Accounting Equation
Often times the first thing you’ll learn in a college Accounting course…
and many would say it’s the most important concept in Accounting (hence the name)
But what’s so special about it?
Let’s dive in.
➡️ What the idea?
This equation summarizes how a business can be interpreted using a report called a “Balance Sheet”.
It introduces the concept of “double entry” accounting, where every transaction in a business affects 2 items in a balance sheet, and atleast 1 of these section.
➡️ What exactly does it mean?
Let’s do a quick set of definitions…
Assets → Items of economic value that the business owns or substantially controls (cash, receivables, inventory)
Liabilities → amounts that you owe to creditors (credit cards, loans, deferred revenue)
Owners Equity → amounts that the owners are owed (IE: what’s left after you subtract liabilities from assets)
So the accounting equation explains that all of your assets came from either amounts funded by creditors (liabilities) or owners (owners equity)
➡️ What’s so special about that?
Well…a lot.
1️⃣ It all balances
Net Income is calculated on your P&L by taking all income accounts less all expense accounts...
and that feeds into your owners equity via an account called retained earnings.
So when net income goes up, your owners equity goes up…
when net income goes down…your owners equity goes down.
Since Assets must always = liabilities + owners equity, you know that the must be a corresponding effect in your assets or liabilities.
2️⃣ Debits & Credits
Debits & Credits are the mechanism you use to showcase the movements of account balances in your general ledger.
So however they work for Assets, is the complete opposite for how they work for Liabilities and Owners Equity.
ex:
Assets: ⬆️ Go up with a Debit, ⬇️ Go down with a credit
Liabilities + Owners Equity: ⬆️ Go up with a credit, ⬇️Go down with a debit
Now you know your debits & credits
3️⃣ Cash flows
If you understand the accounting equation, you can prepare a statement of cash flows under the indirect method
See…Assets = Liabilities + Owners equity
Which means the net change of Assets from one period to another…
is equal to the net change of Liabilities + Owners equity from one period to another.
So if we flip the calculation on one side of the equation, and add up the net change in all accounts, we’ll get to 0.
Like this:
Last months Assets - This Months Assets
+
This Months Liabilities - Last months Liabilities
+
This months owners equity - last months owners equity
= 0
Great! So if we do that now for all accounts EXCEPT for cash…that becomes our plug for how much our cash went up or down
Now you know how to create a statement of cash flows
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