Phoenix Arizona CPA | Arizona Tax Accountant | Arizona Income Tax

Why is accounting so powerful? It is because it is all based off of one simple accounting equation:

Assets-Liabilities-Stockholder’s Equity = 0

Assets = Liabilities + Stockholder’s Equity

Stockholder’s Equity = Assets - Liabilities

Liabilities = Asset - Stockholder’s Equity

Yes, all of these are one simple equation. Just a bunch of different variations, to say the same thing. Always in balance, always able to provide information. The accounting equation is able to provide tons of information. By breaking this equation out further accountants, financial analysts and banks come up with more complex ways to evaluate a company. For instance assets can be broken into current assets and long term assets. By doing this the greater the ability to to evaluate key financial measure like liquidity. Liquidity ratios answer a simple question, “Does X Company have enough money to pay the bills?” A simple and vital question to answer.

Now that you understand the power of the equation let’s discuss debits and credits. To understand debits and credits focus on the equation when it is stated:

Assets - Liabilities - Stockholder’s Equity = 0

Debit and credits ensure that the equation is always in balance. Most people think of a debit and credit as a positive or a negative a left or right. Before you know it your lefts and rights are all mixed up and you find yourself in a tangled mess. They are just two opposites that offset each other when on the same side of the equation. Debit and credit most always equal each other. This creates a balance of the equation. They allow the parts of the equation to change but the result to be the same, zero.

Zero serves the function of a check figure. A credit always offset a debit creating no net affect. That is it. The numbers change but the balance remains. This is how we keep track of the changes occurring in our business’s financial picture. This whole process is referred to as dual entry accounting.

People generally get confused over a little accounting trick. Basically, it is how we develop an income statement. All accounting information is used to effect the balance sheet. The income statement is created by separating a portion of the entries into an income and expense accounts. Since, the offsetting side to these accounts usually have an effect on an asset or liability.

The culmination of these income sources and expenses are collected in retained earning at the end of the accounting period. The whole time being offset by assets and liabilities. The net effect of all the entries made to expense and income accounts relates to the amount put into retained earnings, which is in balance with assets and liabilities.

This allows for balance and difference to co-exist. Obviously, you want to be able to tell what you’ve earned so take expenses from income and that positive number (hopefully) leftover is your profit. The difference. In the end of the day the credit to income eventually turns into a credit to retained earnings increasing what the owner’s portion of the balance sheet.

Bring accounting down to the level of simple concepts. Accounting is the documentation of a transaction that is it, don’t over-complicated the process.

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