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.

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. Baloney! 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. Sweet.

Sweet Accounting.

by Tom Veatch

The Math

Accounting 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!

  • A) Everything is for the Owner. You, right? It is indeed all about you. Yes!

  • 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, but really it's only very 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 it:

  • C) The Actual 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 Standard Accounting Equation is usually written E + L = A, with all the numbers positive (as if a Liability is positive), but since you know arithmetic, you know that's the same thing as E = A - L, just subtract L from both sides. Standard and Actual are the same, 100% equivalent to each other, but I say start with E = A - L in the first place, because that is intuitive to me, and it answers the Owner's question, which is the whole point. 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 Equity.

  • 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! Right?)

  • 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 result).

  • G) Finally we come to the really big technical idea. We will rewrite the accounting equation in Normalized Form, as a sum starting with Zero Equals, and with Equity as a *positive* number.

    Why 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.

    Why is Equity positive? Subtract it from both sides, it could be negative on the other side instead; why do we make the arbitrary choice for Equity to be positive? 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.

  • H) The Normalized Accounting Equation:
    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. Balance.

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 is Positive!)

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 (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 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.

  • 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 since we have put together all the increases, then next 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 pile, the pile of ultimate positives.

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 and happy.

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.

So, did you understand it? Then, will you share it with others? Please do!


Copyright © 2018, Thomas C. Veatch. All rights reserved.
Modified: January 11, 2018