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 a CPA, Accountant or
Bookkeeper, Consultant, Investor, or Teacher to admit what
I'm saying is true. They seem to 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.
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 that is taught
and doesn't make sense nor the Normalized way that I'll get to later,
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. We are honorable and honest here, and
you do actually owe what you owe, so first pay off what
you owe, and then whatever's left is what you keep,
which might be nothing. Because if you have
liabilities, then other people have first dibs. You get
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. (We'll try to avoid, or at least minimize,
the subtracting bit.) I have a hard time with it, too, and 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 Lost! Or Won! 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, then 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; patience!) The point we start from, and stay on, is:
- 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 just like a way
of subtracting and getting zero as the result).
- G) Finally we come to the really big technical idea,
which is going to be to write the accounting equation in Normalized
Form, that is, as a sum starting with Zero Equals, and with Equity as
a *positive* number, and everything else lands however Arithmetic
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.
On The Classification of Numbers Now, 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
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.
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.
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 that in the end there is balance.
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 is opposite from equity and both are nice numbers that we
want to be positive.
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. Still, I could take my Equity out, so that's how we
account for it.
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
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.
That's 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 do understand it, please will you share it with
others? Yes! Also your comments are appreciated!