Unit
- Accounting equation: The foundational framework Assets = Liabilities + Equity must always balance after each transaction. This equation underpins double-entry bookkeeping and ensures that every financial event affects at least two accounts, preserving the integrity of the financial records.
- Double-entry system: Every transaction records debits and credits in equal amounts. Debits increase asset and expense accounts, while credits increase liability, equity, and revenue accounts. This dual effect maintains the accounting equation and provides a self-checking mechanism for errors.
- Asset accounts: These represent resources owned by the entity, such as cash, accounts receivable, inventory, equipment, and buildings. Assets are recorded on the left side of the balance sheet and normally carry a debit balance, meaning increases are debited and decreases are credited.
- Liability accounts: These represent obligations to outsiders, including accounts payable, notes payable, accrued expenses, and deferred revenue. Liabilities appear on the right side of the balance sheet and normally have credit balances, so increases are credited and decreases are debited.
- Equity accounts: Owner's or stockholders' equity represents the residual interest in the assets after deducting liabilities. It includes contributed capital and retained earnings. Equity increases with credits (e.g., from revenues) and decreases with debits (e.g., from expenses or dividends).
- Revenue recognition: Revenues increase net income and thereby increase equity. When a company earns revenue, it credits a revenue account and debits an asset (typically cash or accounts receivable). This aligns with the principle that revenues are recorded when earned, not necessarily when cash is received.
- Expense recording: Expenses decrease net income and reduce equity. They are recorded as debits to expense accounts and credits to either asset (if paid) or liability (if accrued) accounts. The matching principle requires expenses to be recognized in the same period as the revenues they help generate.
- Normal balances: Assets and expenses normally have debit balances; liabilities, equity, and revenues normally have credit balances. Understanding this rule helps in analyzing account balances and preparing trial balances. A trial balance lists all accounts with their debit or credit balances to verify that total debits equal total credits.
- Example transaction: A company purchases equipment for $5,000 cash. The entry is a debit to Equipment (asset increase) and a credit to Cash (asset decrease). Both sides of the equation change, but the equation remains balanced: Assets increase by $5,000 (Equipment) and decrease by $5,000 (Cash), so total assets are unchanged, while liabilities and equity remain unaffected.
Financial Formula
Accounting Equation
Assets = Liabilities + Equity
Assets = Liabilities + Equity
Where:
- Assets: Economic resources controlled by the entity (e.g., cash, inventory, property).
- Liabilities: Obligations arising from past transactions (e.g., loans, accounts payable).
- Equity: Residual interest after liabilities, including owner contributions and retained earnings.
This equation must always hold true after each transaction. It is the foundation for double-entry accounting and ensures that the balance sheet is always balanced.
Quick Revision
- The accounting equation Assets = Liabilities + Equity must balance after every transaction.
- Double-entry accounting requires each transaction to have equal debits and credits.
- Assets and expenses normally have debit balances; liabilities, equity, and revenues have credit balances.
- Revenues increase equity, while expenses decrease equity, affecting the equation indirectly.