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
Because I've never been able to get any CPA, Accountant or
Bookkeeper, Consultant, Investor, or Teacher to admit what
I'm saying is true. They all say, teach, and apparently
think, that you just have to memorize all these account
categories and a bunch of made up terms that have nothing to
do with anything, and there's no such thing as actually
understanding it. BS. I hate that. So I'm going to tell
you how it really works, and why. And you are going to
really understand it, or tell me why not! Okay? Okay.
by Tom Veatch
Accounting is WAY simpler than the "memorize-this" BS that 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!
A) Everything is for the Owner. You, right? It is indeed all about
B) So you, the Owner, basically only want to know one thing, how much do
you own here, what is your position, what is your Equity.
Sometimes it's obvious, really it's only obvious if you own all your
Assets outright and you have no Liabilities, no debt. Then add up
your assets, and that's it. Yes, that would be right, if you could do
it, and it's a good idea to go with a strong simple idea sometimes
(Dave Ramsey made his career on this) but we want to cover
everybody here. So we have to deal with Liabilities, too. Even with
Liabilities in the picture, the idea is still obvious, even if you
don't know what the amounts all are, so as to be able to calculate
C) The Accounting Equation:
Equity = Assets - Liabilities
It means, You get the leftovers.
Imagine it this way: Sell all your assets (A), use that to
pay all your liabilities (L), and then the rest is how
much is really yours, we call that owner's Equity. The
leftovers. Because if you have liabilities, then other
people have first dibs. You get the leftovers.
Now the Accounting Equation is usually written E + L = A, with all the
numbers positive, but since you know arithmetic, you know that's the
same thing as E = A - L, just subtract L from both sides. I say start
with E = A - L in the first place, because that is intuitive to me,
and it answers the Owner's question. But, a lot goes into being
organized about subtracting, in accounting, because people have a Hard
Time with it. So do I. Unless you're an accountant, so do you, and
that is the whole driver of the mystery we are going to unpack here.
We will see more about it in a second. But for now, it's all about
D) So, Equity: this curious beast, this fascinating, most desireable
and least fathomable number. It is what wildly fluctuates around as
assets and liabilities come and go. It is the invisible number.
Equity is the derivative value, what is left over, and what you want
to know about, as the owner. You have to add and subtract everything
else that's actually real, the debts and purchases and inventory and
everything and it's the unobservable left over amount that's what we
actually care about. It added up differently? You Lose! Or Win!
It's all about keeping track of Equity. (Just my opinion. Okay if
I'm the Owner then my opinion is the only one that matters. Hah!
E) I'm sure you noticed that things are always in balance, right?
Balance is a basic principle in accounting. Things are in balance,
things happen in equal amounts in different places: balanced. More
Assets: more Equity. More Liability: less Equity. Even transactions
that cancel without an effect on equity, like when you buy some job
material, cash goes out/inventory comes in, those are in balance
according to their value, which needs to be the same. And remember
Equity: we want to know their effect on Equity, which is well defined
as a zero effect, we see the different effects, money goes out,
product comes in, we see they have the same value, they cancel out, we
see there's no effect, great, that's satisfying. Balance.
Balance says: ....
Did you guess it yet? I know you are close!
Balance says: Double entry. If you have a number here, it also needs
to be over there, so it can be in balance. Sounds like double entry
to me. This is what lets you keep track of Equity as you account for
all the activity. Stuff sells, cash comes in, the stuff didn't cost
that much, so poof some profit appears in Equity. Actually that's
triple entry: cash, inventory, and equity. The number, "two" (or is
it "duo"), as in duoble entry, is not the point, there could probably
be quadruple entry transactions or more. (Wow, then which ones would
have to add up, that would be a mess. Soon this will all suddenly
become clear; meanwhile, patience, grasshopper!) The point we start
from, and stay on, is: balance.
F) Okay, now: Observing this balance of effects everywhere, keeping
track of positive and negative is the core organizing problem. Nobody
wants to use negative numbers. -1 is way too complicated for most
people. Seriously, me too, that's why we are walking slowly up behind
this one. Sneaking up on it! So okay, let us resolve to make them
all positive and put them in separate columns, and add up the columns
as positive numbers so you can do just one summary subtraction at the
end, when we can think about it properly. Then you can mostly avoid
negative numbers (though you might still need to be able to subtract,
in the end, or at least compare two numbers to see if they are the
same, which is a way to say, subtract and get zero as the
G) Finally we come to the really big technical idea. We will rewrite the
accounting equation as a sum starting with Zero Equals, and with
Equity as a *positive* number.
We make the arbitrary choice for Equity to be positive: Why? Because
as I have been saying, Equity is what it's all about, Equity drives
the whole picture. How? By being positive in this equation.
Everything else gets whatever sign happens to fall on it, plus or
minus, just so long as Equity is positive.
And Zero, zero is a way to talk about the balance. Zero means any
change anywhere has to immediately cancel out with a balancing
opposite change elsewhere, otherwise it won't add up to zero. Zero
emphasizes the balance aspect here. So:
H) 0 = Equity + Liabilities - Assets - Income + Expenses
Now, just try to keep track of positive and negative with that mess of
signs! (That's what we are about to do!) A dollar profit coming in as
Income has to balance a dollar Equity increase. How? By having
increases in Income be negative to balance the corresponding increase
in Equity. Because it balances. Because they add together to make
zero. That's why income is negative in (H). Get some positive
income, okay add that to Income so Income is bigger, now that makes
the "- Income" in (H) a bigger negative number, which cancels out a
bigger positive number in Equity, because you put some over there too,
to balance. Perfect. Ditto for everything else. Assets up, equity
up, why? Because in (H), an increase in E balanced with an increase in
A cancels each other out because of the minus sign in (H) on A, so the
total still equals zero.
The Classification of Numbers
Now, can you remember all the signs for those categories in (H)? That's
your whole 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). What is
positive, and what is negative? (When it adds up to Zero and Equity
Hint: the things that pull out of the company are positive,
and the things that the company has to be pulled from, are
negative. So you can pull out equity, and liabilities are
potentially pulling money out of the company in the future,
and expenses take money out immediately, and those are all
positive. Whereas the opposites are the solid basis 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 out of the company, and negative being back
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.
So now what we want is a way to group all the ultimate
plusses and all the ultimate minuses separately, whether
within a single transaction, or summed across a whole period
of lots of transactions. Because if they add up to the
same number, then they will cancel each other in
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 to collect them together separately.
It's a holy mess. How do we classify all of them? Answer:
Methodically. Let's just start from the obvious cases.
Now we are really done with the hard part. There's more to talk
about, but you know everything now, even if you don't know that you
know. So settle in and let me talk a little bit, you'll be surprised
- One thing is really obvious: We could add all the plusses in
the plus columns (like additions to or increases in
Equity, Liabilities, or Expenses) and put them together.
Those obviously pull the sum in the same (positive)
direction in (H), right? + + = +.
- But we could use the double negative concept too, and put the
minusses in the minus columns (such as reductions on
Income (e.g., discounts), or reductions of Assets (e.g.,
"shrinkage")) also over here with these ultimate
positives. Because − − = +. Together with
the previous + + group, that would be all the increases
in (H) that will need, on the other side, to be balanced
by a pile of decreases.
- So then we have to find all the decreases in (H) to
balance them, and if THAT sum comes out the same, then
they are in balance.
- So obviously some of the decreases in (H) are the
minuses in the plus columns (like decreases in Equity
(like when there is a loss in the business), or
decreases in Liabilities (like when a loan is paid off),
or or decreases in Expenses (like when a vendor gives a
discount)). − + = −.
- But some of the other decreases in (H) are
the plusses in the minus columns (like increases in
Assets or Income). + − = −.
- Both of those piles are single negatives, so they are
ultimately negatives in their influence on the sum in
(H). So now if you add up this pile of ultimate
negatives, it should end up to the same as the other
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 for every transaction,
and works when the whole picture gets put together at the end also.
At the micro or transaction level and the macro or summary level.
We could say we just want the ins to equal the outs, but as you see
income above is opposite from equity and both are nice numbers we want
to be positive, above.
For me, anyhow, 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 think about
it. Others think otherwise, that's fine.
Anyhow you see we are struggling for some terms here. 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 flip their meaning the right
way following equation (H), 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), to make it
work at the macro level, for the whole system altogether after any
given period of time.
It works because the ins and 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 F.
(Everything else follows as negatives and double negatives from
there:) 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? Then the debits can be in any account and the credits in any
other account, even in the same account, but if the debits and credits
balance within the transaction, then the sum will balance for the
whole equation at the end. That's the point.
So yes, sorry, you now have to memorize what accounts are positive
credit/negative debit, and which ones are the opposite. But at least
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.