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
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.
by Tom Veatch
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
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, 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
actually cover everybody here. So we have to deal with Liabilities,
too. Even with Liabilities in the picture, the idea is still obvious,
if you look at it the right way. Not the Standard way, but the Actual
way, in which it actually makes sense.
C) The Actual Accounting Equation:
Equity = Assets - Liabilities
The actual point of all accounting is, the Owner gets
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 subtraction. 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
actually 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, when cash goes out and 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 in this
case is well defined as a zero effect. Thus we see the different
effects, money goes out, product comes in, we see they have the same
value, they cancel out, we know nothing else is affected, great,
that's satisfying. Balance.
Balance says: ....
Did you guess it yet? I know you are
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 a
system where everything we write down is positive in its particular
column, and where we can add them all up safely, using a sum of
positive numbers for everything in a column or category, and then
after almost all is done, at the end, we can do just one or two
summary subtractions at the very end, when we can think about it
properly. This way we 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, which is to write
the accounting equation in Normalized Form, that is, 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 the total won't add up to zero.
Zero emphasizes the balance aspect here.
Why is Equity positive? We could instead decide to subtract it from
both sides, so 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 so? 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 is balanced by 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). If you 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 have to put some over there too,
to balance. Perfect. Ditto for everything else. For example, 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).
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
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 or smaller. 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.
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.
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 everything that contributes an ultimate increase to the
result in (H). (Of course it will need, on the other side, to be
balanced by a pile of decreases.)
- Now that we have put together all the increases, the next step
would be to find all the decreases in (H) to balance them out,
and if the sum of these decreases put together 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.
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 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 is opposite from equity and both are nice numbers that we
want to be positive.
What I 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
think about it. Others think otherwise, that's fine.
Anyhow you see we are struggling for some terms here for the Ultimate
Plusses and Ultimate Minusses to tag our entries with. 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 have their meaning 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), 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 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
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?