Brain Dead Simple!

Accounting Concepts
Susan D. Tiner
Brain Dead Simple! Financial Organizing
Cover image of Luca Pacioli from Wiki Commons
(http://commons.wikimedia.org/wiki/File:Luca_Pacioli_(Gemaelde).jpeg#file)
Introduction
You do not need to wade deeply into accounting theory just to understand the basic
principles well enough to manage your own personal and small business bookkeeping.
The basic principles developed in this document are:

• the accounting equation

• the purpose of accounting
• accounts and balances
• debits and credits
• financial statements

The Accounting Equation

There is one equation that lies at the heart of the accounting model and it’s called the
accounting equation. Most people intuitively understand this equation by thinking about
the familiar example of buying a house.

Accounting Equation

Assets Liabilities Owner Equity

Assets Liabilities Owner Equity

You know intuitively that the equity of your home is its fair market value less the
outstanding mortgage amount. Well, that’s the accounting equation! Look at the first
equation shown you’ll see that it’s written just the way you typically understand it. In this
case, the asset is your home’s fair market value, the liability is your outstanding
mortgage, and owner equity is the equity you have in your home. This is the wealth
you’ve accumulated in your home due to payments reducing the mortgage and market
appreciation increasing its fair market value.

The first equation makes a lot of sense, but the problem is that this equation is normally
written in the second form shown. These two equations are equivalent equations, but you
might not find the second equation quite as intuitive because of the way it’s written. You
might wonder why it’s written in a counterintuitive way, and there is a reason for it, but
that discussion is beyond the scope of this document.

The best way to deal with the unfamiliar form is to convince yourself you can move the
parts around and the equation is still true. For example, once you’ve figured out your
home equity, however you calculated it in the first place, you must agree that if you take
the amount of your home equity and add to it the outstanding mortgage amount, this
equals the fair market value of your home.

The accounting equation is actually more general than the home example above. Let's
generalize to personal finances first, then switch to business entities.

Another way of thinking of the above equation, in more generalized form, is

the value of all your personal assets (e.g., house, car, furniture) - the balance of all your
liabilities (e.g., mortgage, car loan, bills due) = your personal net worth

Cleaning this up a bit we have:

personal assets - personal liabilities = personal net worth (or personal equity)

This is nearly equivalent to the formal accounting equation:

assets - liabilities = owner equity

In the personal case, the owner is you. In a business entity, the owner might be you or
stockholders—but let's hold off on discussing the business case for now.

The Purpose of Accounting

The accounting equation:

assets - liabilities = owner equity

is usually abbreviated

A - L = OE

In the personal context, consider the following scenarios:

• Assets going down in value, e.g., a decline in housing prices making your home
worth less,
• Savings, i.e., what’s left over after you subtract all your expenses from your
income,
• Taking out a home equity loan to remodel your house.
As you think of each situation, do you understand how your net worth increases or
declines as a result?

Double-entry bookkeeping formalizes our intuitive understanding of what happens to our

net worth as a result of changes to our assets and liabilities.

To put this into an historical context, the Italian monk Luca Pacioli (pictured on the
cover) published in 1494 what became the first widely read description of double-entry
bookkeeping. Pacioli himself gave credit for originating the method to Benedetto
Cotrugli, who had earlier published a manuscript describing features of double-entry
bookkeeping. Both Pacioli and Cotrugli addressed the needs of the “trader” in
determining his financial position. Pacioli's work specifically aimed to give “the trader
without delay information as to his assets and liabilities.”

At a high level, the purpose of double-entry bookkeeping is to:

a) give a business entity an ability to compute its equity position, i.e., the difference
between what the entity owns and what the entity owes, and
b) give a business entity information on the transactions that affect equity—income
and expenses.

Consider the transaction:

• Assets going down in value, e.g., a decline in housing prices making your home
worth less.

Suppose your house, when you bought it, was worth $1,000,000, your mortgage was
$800,000, and your equity—in this case the down payment—was $200,000. So you had

A = $1,000,000
L = $800,000
OE = $200,000

Since A - L = OE must hold true, let’s see if the above numbers work:

$1,000,000 - $800,000 = $200,000

They do!

But now your house has gone down in value to $850,000.

$850,000 - $800,000 = $50,000

The asset going down in value makes the equity go down by an equal amount. This is the
fundamental principle of accounting—the equation A – L = OE must always hold true.
This means that a change in one term must always be balanced by an equal change to
another term such that A – L = OE is still true.

This balancing of one change with another change of equal amount means that every
single transaction creates two changes. This is where the term double comes from in
double-entry bookkeeping.

The practice of accounting is all about figuring out the equity or net worth of individuals
and businesses. Accountants examine transactions and fit them into the equation

A - L = OE

so that the equation stays in balance.

Why is it so important to compute net worth? Banks care because they secure loans based
on equity. Individuals care, because in order to retire they need to increase net worth over
time to the point where it’s possible to live off of the savings. In the case of business
entities, e.g., corporations, shareholders care because they want stockholder equity to
increase.

When accounting is done properly, net worth is calculated accurately. When accounting
is manipulated, e.g., Enron, the results are disastrous. In a sense the entire world economy
depends on accounting being done properly because faith in financial markets is based on
everyone following the same core accounting rules.

QuickBooks forces the above equation to hold true. This means if you change a value of
one of the terms, you'll have to change the value of another by an equal amount to keep
the equation in balance.

Accounts and Balances

Before examining more transactions, it’s important to understand accounts. The elements
of the accounting equation are not actually terms but accounts.

Accounts are things that have balances that go up and down. There are three types of
accounts:
1. assets,
2. liabilities,
3. equities.

We've been talking about a house as an asset. If you put your house as an asset into a
personal accounting program like Quicken it will have a balance reflecting its current
market value. If you were to login to www.zillow.com and see that your house value has
gone up, you'd increase the balance of the house account in Quicken. The mortgage is
also an account, in this case a liability account. Your net worth is also an account, but you
don't change its balance—Quicken changes it automatically based on the balances of all
your asset and liability accounts.
Getting back to the example of your house going down in value:

A (house value goes down by 150k) – L (mortgage stays the same) = OE (goes down by
150k)
$850,000 - $800,000 = $50,000

The balance in the house account is 150k smaller and the OE account balance is also
150k smaller.

Now you want to remodel, so you take out a 10k home equity loan.

A (stays the same) – L (goes up by 10k for equity loan) = OE (goes down by 10k)

$850,000 - $810,000 = $40,000

How does savings affects your net worth. What is savings anyway?

Savings is what’s left over from your income after you pay for all of your expenses. If the
result is positive, you’re a little richer. If it’s negative, you’re a little poorer. When you
get paid, your checking account—an asset—goes up and your equity goes up. When you
pay a bill or expense, your checking goes down and your equity goes down.

Debits and Credits

Just when you got used to the standard form

A - L = OE

we have to switch it because the form below is the one used on the financial statement
called the Balance Sheet and it’s also the form that’s best for understanding what’s going
on with debits and credits:

A = L + OE

Now you know that these terms are really accounts, e.g., asset accounts, liability accounts
and equity accounts. Every time you make the balance of one account go up or down you
must make another account go up or down by that same amount to keep the above
equation in balance. Double-entry bookkeeping was set up such that the first transaction
is defined to be a debit to an account, and the second transaction is defined to be a
balancing credit to another account. For every debit there is a matching credit such that
the sum of all debits equals the sum of all credits. The main accounting equation stays in
balance after every single pair of transactions. The convention is to record the debit first,
then the credit.
Let’s take the example of paying a $50 check to a vendor for a telephone bill. The
checking account is an asset account (A), typically classified as cash. The vendor bill is
recorded in a liability account (L) called accounts payable.

accts payable (L)

(dr -) (cr +)
50 350

300

Cash Checking (A)

(dr +) (cr -)
3000 50

2,950

Since cash is an A (asset), it’s on the left side of the equation A = L + OE. The
convention for the left side is that debits increase the account balance and credits
decrease the balance. For L and OE accounts on the right side of the “=” sign the
convention is that credits increase the balance and debits decrease the balance.

In our example, accts payable starts with a $350 balance, then you record a debit of $50
to pay the telephone bill. The color red means the balance is going down. The ‘T’ looking
diagram is just that. It’s the way to represent an account and it’s called a “T” account
because it looks like the letter ‘T’. Notice that debits always go on the left and credits
always go on the right regardless of whether they make the account go up or down.

So we record the of $50 to pay the telephone bill and that action makes the accts payable
decrease to $300. Now we have to matching a matching credit. In this cash the action of
paying the bill makes the checking acct balance go down by $50. In this case checking
has a beginning balance of $3000, then we record a $50 credit and now the balance is
$2,950.

Going back to A = L + OE we see that it’s still in balance:

A (goes down by $50) = L (goes down by $50) + OE (doesn’t change)

To recap, for every debit there is a matching credit. Suppose you create a table with two
columns—one for debits and one for credits, and list one account per row. If you record
the debit or credit balance per account the total amount of debits should equal the total
amount of credits.
Financial Statements
The balance sheet shows asset, liability and equity account balances on a specific date.
Dec 15, 07

ASSETS
Current Assets
Checking/Savings 90,695.84
Accounts Receivable 81,798.70
Other Current Assets 87,869.36
Total Current Assets 260,363.90

Fixed Assets 407,291.13

Other Assets 1,041.85

TOTAL ASSETS 668,696.88

LIABILITIES & EQUITY

Liabilities
Current Liabilities
Accounts Payable 54,405.04
Credit Cards 5,127.62
Other Current Liabilities 12,585.62
Total Current Liabilities 72,118.28

Long Term Liabilities 77,447.18

Total Liabilities 149,565.46

Equity 519,131.42

TOTAL LIABILITIES & EQUITY 668,696.88

The profit and loss (or income) statement shows the net of income less expenses that will
increase (or decrease) equity.
Oct 1 - Dec 15,
07

Ordinary Income/Expense
Income
Construction
Labor 37,769.25
Materials 69,039.51
Miscellaneous 4,560.55
Subcontractors 57,207.01

Total Construction 168,576.32

 Total Income 168,576.32

Cost of Goods Sold

Cost of Goods Sold 8,541.37

Total COGS 8,541.37

Gross Profit 160,034.95

Expense
Automobile
Insurance 712.56
Fuel 231.10
Automobile - Other 10.60
Total Automobile 954.26

Bank Service Charges 47.50

Freight & Delivery 139.60
Insurance
Disability Insurance 300.00
Liability Insurance 2,100.00
Work Comp 1,650.00
Insurance - Other 297.66
Total Insurance 4,347.66

Interest Expense
Loan Interest 288.05
Interest Expense - Other 651.77
Total Interest Expense 939.82

Job Expenses
Equipment Rental 1,000.00
Job Materials 38,059.07
Permits and Licenses 700.00
Subcontractors 44,166.00
Total Job Expenses 83,925.07

Payroll Expenses 29,513.77

Professional Fees
Accounting 250.00
Total Professional Fees 250.00
 Rent 1,200.00
Repairs
Building Repairs 175.00
Computer Repairs 45.00
Equipment Repairs 0.00
Total Repairs 220.00

Tools and Machinery 1,160.00

Utilities
Gas and Electric 277.08
Telephone 100.71
Water 61.85

Total Utilities 439.64

Total Expense 123,137.32

Net Ordinary Income 36,897.63

Other Income/Expense
Other Income
Interest Income 93.42
Other Income 37.50

Total Other Income 130.92

Net Other Income 130.92

Net Income 37,028.55