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The fundamentals of accounting (in particular double-entry bookkeeping) are simple, but they're often presented or understood as a series of unconnected facts t
by rahimnathwani 3y ago
The fundamentals of accounting (in particular double-entry bookkeeping) are simple, but they're often presented or understood as a series of unconnected facts that must be memorized.
It doesn't have to be this way!
Start with this identity:
Equity = Assets - Liabilities
This is self-evident: the owners of the company have a claim on the company's assets, but only after any liabilities (like debts to other companies) have been subtracted.
That identity can be rearranged:
Assets = Equity + Liabilities
This tells us that for everything the company owns, it also owes something. It has debts to some other entity (liabilities) and anything left over is owed to shareholders (equity).
Accounting transactions are made when something happens in the business. Each transaction changes the balance sheet. The balance sheet is made up of the three items in the identity, but there's more granularity. For example Assets might have a 'cash/bank' account and also an 'inventory' account
Any accounting transaction touches one or more than one of these three accounts.
Got some new equity funding? It increases Assets (cash in the bank) but also increases Equity (paid up share capital) by the same amount. So the identity is preserved.
Sold a product and collected some cash? Assets go up: yes, inventory decreased $10, but cash went up $15. So now Equity (retained earnings) goes up by $5 and the identity still holds.
The P&L (aka Income Statement) shows how the balance sheet changed between two points in time. Profit is the change in Equity between those two points (after removing any increase decreased from share issuance or buybacks).
If you've read this far and want some intuition about debits and credits, I wrote a brief post here: https://www.encona.com/posts/debits-and-credits https://www.encona.com/posts/debits-and-credits
- zellyn 3y agoIn my high school in South Africa, we were made to take accounting for a time. The entirety of what I remember of the experience can be summed up thusly: A. Equity = Assets - Liabilities B. Test time! Here's something we've never talked about before: try to guess which side it goes on!
- rahimnathwani 3y agoIf you want a gentler introduction to B, you could spend 5 mins on this, which I created ~5 years ago: https://www.oppia.org/explore/pepGU0qbyoUm https://www.oppia.org/explore/pepGU0qbyoUm
- scythmic_waves 3y agoI enjoyed that, thank you.
- TeeWEE 3y agoIsn’t the balance sheet changes between two points in time the cash flow statement? The P&L is based on transactions on Income accounts. The balance sheet is a point in time view of BalanceSheet accounts. For example: CASH is balance sheet. However REVENUE is an income account type. The income statement is the changes between to points in time of all balances of Income accounts.
- rahimnathwani 3y agoThe balance sheet's components each capture distinct aspects of a company's finances. While you've mentioned 'income accounts', these actually fall under the Equity section. A balance sheet has three primary segments, corresponding to the accounting equation: - Assets - Liabilities - Equity Specifically, you seem to be focusing on: --Assets: Cash and cash equivalents-- This indicates a company's liquid position. To understand cash flow changes over a given period, compare the differences in 'cash and cash equivalents'. -- Equity: Retained earnings–- This reflects accumulated income. To gauge profit changes over a time frame, observe the variations in Retained Earnings. (This is accurate provided no dividends were distributed during that period.)