A Basic Introduction to Accounting

Double-entry accounting at its simplest is the accounting equation:

Assets = Liabilities + Equity

Accounts are created that fall under one of these three categories in addition to revenue and expense accounts. Asset accounts normally¹ carry a debit balance while liability and equity accounts normally carry a credit balance. In simple terms, debiting an asset account will raise its balance while crediting it will lower its balance. On the opposite side of the equation, crediting a liability or equity account will raise their balances and debiting them will lower their balances. Revenue accounts carry a credit balance, and expense accounts carry a debit balance. These two accounts flow into the accounting equation above, but we'll save that discussion for later.

Each account has its own ledger to book detailed transactions, and each ledger flows into a general ledger that summarizes the individual ledgers. Every transaction that is booked in a ledger must balance by issuing debits and credits that equal on each side of the accounting equation. Think of it like Newton's third law of motion:

To every action, there is always opposed an equal reaction; or, the mutual actions of two bodies upon each other are always equal, and directed to contrary parts.

Take Cash as an example. Cash is normally considered an asset account. Suppose you receive $10 in Cash temporarily from financing but you have an obligation to pay it back in the future. That obligation can be represented by a liability account called Accounts Payable. When receiving the cash, the following entry should be booked:

Cash $10
  Accounts Payable $10

Here we have debited $10 to the Cash account and credited $10 to the Accounts Payable account. Both accounts balance. Revisiting the accounting equation, we can see how it still balances:

Assets = Liabilities + Equity
10 = 10 + 0

Now if we dive into the Cash account at a deeper level, we can represent it with a t-chart (aka t-account), which is named for its "T" shape. We add the debit on the left side to reflect the asset account's positive balance. Naturally, the amount is booked on the left side of the t-chart, which matches how asset accounts are on the left side of the accounting equation:

  Cash
---------
10  |

Similarly, we book the increase to the Accounts Payable (A/P) balance by adding a credit to the right side of the t-chart, matching how liabilities are on the right side of the accounting equation:

   A/P
---------
    |  10

Both Cash and Accounts Payable carry a balance of $10. Since Cash is an asset account that carries a debit balance, we represent it in t-chart form by adding 10 to the left side of the t-chart (matching up with assets being on the left side of the accounting equation). Accounts Payable carries a credit balance since it is a liability account, so we represent it by adding the 10 to the right side of the account (matching up with liabilities being on the right side of the accounting equation).

Next, let's look at what happens when we pay back $5 of our obligation. First, we book the following entry:

Accounts Payable $5
  Cash $5

Now we have debited Accounts Payable and credited Cash, which are the opposites of the balance types their respective account types normally carry. This reduces the balance of both accounts, as demonstrated by their updated t-charts:

  Cash
---------
10  |
    |   5

   A/P
---------
    |  10
 5  |

The accounting equation is now:

Assets = Liabilities + Equity
5 = 5 + 0

Finally, let's look at an equity account. Suppose when the business was formed, we gave it $10 of widgets (Inventory asset account) in exchange for equity in the business:

Inventory $10
  Equity $10

Inventory
---------
10  |

 Equity
---------
    |  10

Pretending that the founding equity has now been introduced (because it would have normally been the first entry in the company's books), the accounting equation is updated as so:

Assets = Liabilities + Equity
15 = 5 + 10

Now suppose we receive $20 in cash from the sale of all of our widgets valued at $10. Our business was formed to sell these widgets, so the sale is revenue. Revenue is an equity account. The sale would be booked with the following entry:

Cash $20
  Inventory $10
  Revenue   $10

Since Revenue is an equity account, we have increased its balance by crediting it $10, which is the difference between the cash received and the value of the widgets we sold. The t-charts for the account balances in the transaction are the following:

  Cash
---------
10  |
    |   5
20  |

Inventory
---------
10  |
    |  10

 Revenue
---------
    |  10

What do you think the accounting equation looks like at this point? Think on it for a second.

Let's close out our accounts before answering that question.

Assets

  Cash
---------
10  |
    |   5
20  |
---------
30  |   5
---------
$25
=========

Inventory
---------
10  |
    |  10
---------
$0
=========

Total: 25 + 0 = $25

Liabilities

   A/P
---------
    |  10
 5  |
---------
       $5
=========

Total: $5

Equity

 Revenue
---------
    |  10
---------
      $10
=========

 Equity
---------
    |  10
---------
      $10
=========

Total: 10 + 10 = $20

At this point, the accounting equation remains perfectly balanced still:

Assets = Liabilities + Equity
25 = 5 + 20

From here, we could create a Balance Sheet (B/S), which is a look at the balances of our accounts at a point in time.

---------------
 Balance Sheet
---------------

Assets
---------------
Cash         25
Inventory     0
---------------
Total       $25
---------------

Liabilities
---------------
A/P           5
---------------
Total        $5
---------------
Net Assets: $20
===============

Equity
---------------
Equity       10
R/E          10
---------------
Total       $20
===============

We can see a shift of the accounting equation on the B/S with the Net Assets (Assets - Liabilities) equaling the Equity.

Hold on. Where did R/E come from? That stands for Retained Earnings and represents the net profit at the end of the period as measured by the Income Statement (I/S). The I/S handles revenues and expenses. When the accounting period ends, net profit flows into Retained Earnings². Similarly, the movement of Cash during the period is accounted for in the Statement of Cash Flows (C/F) with the ending cash position flowing into the Cash balance on the B/S.

Accounting is more complex in reality of course, but I hope this provides a demonstration of how double-entry accounting works and how accountants think when performing bookkeeping functions. It's really sort of a fun practice in a geeky way. It's all about the flow of balancing things. Everything is accounted for, and these practices demonstrate how business resources are used.