Finally everything clicked so I want to share this with you.
If you are like me and you ever tried, or are now trying, to learn Accounting, please read this if you want to Understand.
TL;DR Summary(1) Equity = Assets - LiabilitiesThe figure of interest in the Actual Accounting Equation (1) is owner's position or Equity, defined as Assets minus Liabilities, viewed at an instant in time (statically). To view a position's changes over a period of time (dynamically), we also separately track and summarize Income minus Expense events or transactions within the period, then apply those also to the position.
(2) Equity = (Assets - Liabilities) + (Income - Expenses)Balance is made evident, and signs are specified, by setting one side of the equation to zero and giving Equity a positive sign on the other side. Rearranging (2), then, we have:
(3) 0 = Equity - Assets + Liabilities - Income + ExpensesThus arranged, to reveal Balance and assert positive Equity, the profession defines "Dr" or "debits" as amounts applied to any account which increase the right hand side of (3), while "Cr" or "credits" are defined as amounts which decrease the RHS of (3). Thus debits result in expansions in equity, liabilities, or expenses, and contractions in assets or income, while credits are the opposite.For example, for an increase in Assets balanced by an increase in Equity, the Asset change is in the Cr column which by expanding the (negative) Asset column decreases the sum in the RHS of (3), while an equal Equity change is recorded in the Dr column, increasing the sum, so that Dr balances Cr, and (3) remains zero. Conveniently, symmetric reasoning solves every such accounting puzzle. Happily, almost all subtraction is eliminated from such a system -- excepting only at the highest level in summarizing using (3) or (2) or (1). Hence for all categories Equity, Asset, etc., T-accounts that show debits on the left and credits on the right will only have positive numbers in them, and for any transaction it can be locally seen by examining only the affected accounts, whether balance is obtained, by seeing that the Dr's equal the Cr's. The idea of Double Entry Accounting is this balance requirement, that any transaction or transaction summary if it increases the RHS of (3) must at the same time and in equal amount decrease the RHS of (3), so that the total sum remains zero. If even the smallest transaction is written down in a balanced form, meaning its sum view through equation (3) is zero, then any summary sum of such transactions, each individually being zero, will also jointly sum to zero. Thus balance in all transactions automatically yields balance within any summary no matter how encompassing. "Accountant" may be defined as a person who keeps (3) in their head, including all its positive and negative components. Then, mapping to Dr and Cr accordingly -- and hiding this mystery of their simple meaning -- is both efficient work practice and a high barrier to entry, providing excellent job security.
The MathAccounting is WAY simpler than what is universally presented and taught. Let me bring you down the sweet and easy path to understanding the mysteries of Accounting. Ready to start? Here we go!
On The Classification of NumbersNow, can you remember all the signs for those categories in (H)? That's your whole entire job, that's what separates the accounting department from sales or production. Once you get that, you can put the price on the whole enterprise and sell it or buy it to make money, and everybody swings from your little finger. So now go memorize (H).Memorize what is positive, and what is negative in the equation which adds everything to Zero and in which Equity is Positive!)
I'll make it easier for you. Hint, hint! Suppose the things that pull out of the company are positive, and the things that the company has in hand to be pulled from, are negative. So the Owner can pull out their Equity, and Liabilities to lenders are just their right to pull money out of the company in the future, and Expenses are pulling money out of the company immediately, and those are all positive. Pull is Positive. Whereas the negatives are the solid basis, the held-in-hand resources from which there is something to be pulled, those are the Assets and in the current period also the Income. So this equation sets the positive direction to mean in the direction of pulling stuff up and out of the company, and negative being back down towards balance at zero. You can think of it that way if you want, and everything falls out consistently.Should I cheat and skip ahead to the next secret? Only when you're ready and if you want to, go ahead. Did you remember the positives and negatives in (H) yet? Quiz yourself and then come back here. Now quiz yourself again and then come back here. Don't cheat! It only cheats yourself. Sorry, this is about to get a little bit uglier. Can you hold on for another complication? Well maybe you were already wondering. See it turns out, of course, that every one of those categories in H can be made larger or smaller (by adding to it or subtracting from it). Even the negatives like assets and income can be made larger (farther from zero) or smaller (closer to zero). And of course, the positives like equity, liability, and expenses can also be made smaller or larger. So plus and minus are no longer a simple matter because there is adding to a negative category and subtracting from a positive category, and we have to be sure the right things go up and down in the end, especially Equity. But there's really only two directions here, up and down, ultimately. So what we really need is a concept of what we might call ultimate plusses and ultimate minuses, which we can label every balancing number with, whether within a single transaction, or summed across a whole period of lots of transactions. Because if all the ultimate plusses and all the ultimate minusses each add up to the same number, then they will cancel each other when they are summed up ultimately in (H). How can we do this? For every category in equation (H) we might find increases as well as decreases in that category, so we'll need two columns for each one, to collect them together separately. It's a holy mess. How do we classify all of them? Answer: Methodically. Let's look at the different combinations, starting from the obvious cases.
So, what we want is to be safe and comfortable, I mean, every step we take should keep us safe and comfortable. Not letting things get all out of control and then just hoping and crossing our fingers that it turns out right in the end. No, we want to maintain balance the whole time. We want, in short, a system that works when the whole picture gets put together at the end, and also works for every single transaction taken in isolation. At the micro or transaction level and the macro or summary level: Both. We could say we just want the "In"s to equal the "Out"s, but as you see income above has opposite sign from equity and both are nice numbers that we want to be positive, so it's a little confusing. "In" to who? Income is "in" to the business, Equity is "in" to the Owner -- therefore "out" from the Business. How can we keep track? What I personally find confusing is, I want my Equity to grow, and stay in the Company, and keep on getting bigger and bigger so I'm worth more and more, it's not an Out number to me, it's an In number: stay In there and keep on Growing. If I was to liquidate it and have the money, instead, well, money is subject to inflation and it becomes worth less and less, whereas a nice performing Company grows and grows and even changes its prices to follow and outgrow inflation, so thinking of Equity as something I (could) take Out is not the way I like to think about it. Because unfortunately, I identify with my company.Anyhow you see we are struggling for some terms here for the Ultimate Plusses and Ultimate Minusses to tag our (temporarily all positive) entries with, so that we can add them up separately and show they are equal. We could say Giver and Reciever like the inventor of double entry said but since he was Italian and doesn't make 100% sense to us we use Italian words, "dare" (to give) and "credere" (to believe), or "Dr" and "Cr" (yes properly trained CPAs do use Dr/Cr for this), or Debit and Credit. That's where it came from. We could use anything so long as they are opposite and we can point them either direction according to (H). The truth is, these words have no meaning outside of equation (H). But we do need some words like this, like "ultimate positives" (Credits) and "ultimate negatives" (Debits), that will be understandable in the right way if you are following equation (H), and so that the values will cancel in the right way, both with each other within a transaction and across the big equation so that the whole equation stays true at every step as all kinds of transactions go on. So we will invent these two words in order to keep track of the balancing that we require. So the principle is, we require that debits equal credits in every transaction. This handles the micro level balancing, at the level of each tiny transaction, so we can feel comfortable when the debits equal the credits in any transaction. And when we add and subtract (or compare) the columns at the end using the formula (H), it will also make it work at the macro level, for the whole system altogether after any given period of time. It works because the ins and the outs, the Gives and Recieves, whatever you want to call them, they are organized to come together following (H). What we say is: The credits are positive for the positive accounts in equation H. (What follows are negatives and double negatives, based on that.) So: Debits are negative values or reductions that come into the positive accounts in (H). Debits are also positives or increases in the negative accounts in (H). And using the double negative, credits are also those negatives or reductions applying to the negative accounts in (H). See? That's it. So yes, sorry, you now have to memorize what accounts are positive credit/negative debit, and which ones are the opposite. Actually you aleady did, with the Normalized Accounting Equation (4) above. And now you know why. It's all because Equity is what we want to calculate and because we use an equation with the sum equal to Zero. That's really it! Now you understand debits and credits and double entry and balance and owner's equity and every mystery of Accounting. Go snow 'em! If you agree that now you do understand it, please will you share it with others? Yes! Any comments are much appreciated. |