Learning About Accounting
First (simplest) Cycle:
Assets are things in your possession (things you own) such as cash,
cars, land, buildings, etc.
Liabilities are bills, debt…anything you owe to others.
If you add everything you own, and then you subtract everything you owe,
what’s left over is what you are worth. In other words:
Assets — Liabilities = Capital (Capital has many names such as
Worth or Equity or Proprietorship)
Another way of looking at it would be to tell a story:
That is: Everything you have, is either owned by you, or you owe someone for it
or a combination of both.
This story is called the Fundamental Bookkeeping Equation:
Assets = Liabilities + Capital
The story is told on a Balance Sheet
…named so because the two sides are equal.
Note: the Balance sheet is a “snapshot” of the
items on one particular day…things change from day to day.
Let’s say that you have a car which you bought for $7,500 and paid $500 down.
The rest you borrowed from Ace Bank.
The story goes like this. You have a $7,500 car to drive which is your Asset.
You owe the bank $7,000, and therefore, what’s left over is your worth or your
claim on the car. The liability of $7000 would be the bank’s claim on your asset.
Your Balance Sheet on this day would look like this:
ASSETS = LIABILITIES + CAPITAL
Car $7,500 Ace Bank $7,000 My Worth $500
Notice the Assets on the LEFT equals the Liabilities and the Capital on the RIGHT.
At this point, you should know:
An Asset is:
A Liability is:
The Fundamental Bookkeeping (or Accounting) Equation is:
Which side are the assets on?
Which side are the liabilities on?
Which side is the Capital on?
Classify the following: (tell if they are an Asset, Liability, or Capital)
$5 you borrowed from your brother
an IOU from me to you for $20
WHY are the assets on the left, and WHY are the liabilities and capital on the right?
Answer: Just because we set it up that way! It could have been done the other way around,
but it make sense this way, since we read from left to right to list our possessions
first and then list the claims on those assets second.
OK, lets talk about Income and Expenses
In the beginning…when Adam started his accounting system,
he had only the three classifications: Assets, Liabilities, and Capital.
One day, he sold his apple for $5 cash which he had only paid $3 for.
So cash goes up $5
Apple (an asset) goes down $3
But where does the other $2 go?
It isn’t an asset, nor does he owe it so it’s not a liability. Therefore, it has to go into Capital.
This $2 is called INCOME. DO YOU LIKE INCOME? YES!
Why do you like income? Because it increases your worth!
The more income you have, the more you are worth.
Aha, do you like expenses? Nope!
WHY don’t you like expenses? Because the more expense I have, the less I’m worth!
So In the beginning income and expenses were recorded in the CAPITAL account.
Income increases Capital …so it increases on the right side.
Expenses decrease Capital …so they increase on the left side.
Here is a diagram showing which side of an account is the increase side..
(Obviously the opposite side from + is the subtraction side.)
___Assets_____ = ___Liabilities____ + ___Capital____
| | |
+ | | + | +
| | |
You must know and understand the above diagram completely! (memorize at first, if necessary)
It is the basis for the rest of your course!
What side do Assets increase? WHY? (left)
What side do Liabilities increase? WHY? (right)
What side does Capital increase? WHY? (right)
What side does Income increase? WHY? (right)
What side do Expenses increase? WHY? (left)
The Why’s are most important! If you can’t tell why, go back and read again!
Did you know that accountants are greedy, clever people?
They figured out a way to charge people more money and confuse them by:
instead of saying LEFT, they say DEBIT. Instead of saying RIGHT, they say CREDIT.
So now you know the secret: DEBIT MEANS LEFT (or left hand side) and
CREDIT MEANS RIGHT (or right hand side).
If I say to debit an account, I mean to place the amount on the left hand side of that account,
and to credit an account means to place the amount on the right hand side of that account.
And that is ALL debit and credit mean: Left or Right.
***(You must use the diagram above to figure out whether you have an increase or decrease in the account.)