Accounting is a subject that is taught everywhere in the world in different disciplines of studies. In addition, in every corporate firm, concepts of accounting are used for bookkeeping, reporting, internal controlling, and preparing management accounts. As a result, the importance of this subject is seen as high by all lecturers and students.
However, this does not mean that understanding the concepts of accounting is difficult. Accounting is one of the easiest subjects in the world if you grasp its principles properly. Most students find accounting difficult because of the fact that they have not been shown the similarities of many different components that appear in different stages of accounting concepts.
The easiest way of understanding the principles of accounting is by tapping on into the accounting equation. In the 15th and 16th centuries, when the global economy was really simple, there were no complex transactions. As a result, the earliest form of the accounting equation was in the below form.
Assets = Liabilities
In this equation, the left-hand side consists of only Assets and the right-hand side consists of only Liabilities. In the earlier ages, Assets were left-hand entries, and Liabilities were right-hand entries. The Italian mathematician Luca Pacioli, who is widely recognized as the Father of Accounting denoted one type of accounting entry to the left-hand side, and all the other entries to the right-hand side.
He named the left-hand entries as "Debits" and right-hand entries as "Credits". Therefore, the first thing to know in accounting is the Debits and Credits mean nothing but the things at your left and the things at your right.
Debit entries and Credit entries are connected by the equals sign (=). At all times, this equality must be maintained. This gives us the second principle of accounting. That is, if you perform any adjustment to your left, you need to perform an equal (value) adjustment to your right (and vice versa) to maintain the equality of the accounting equation.
When the value of an asset entry is increased, it is considered a debit entry. Similarly, when the value of a liability is increased, it is considered a credit entry. On the contrary, a dip in the value of an asset is considered a credit entry, and a dip in the value of a liability is considered a debit entry.
Example:
Assume that Company A obtained a Bank Loan of $100,000 to fund a new project. This loan is an obligation the company has towards the bank. Therefore, the loan value of $100,000 should be considered a liability in the company's books. Liabilities are entered on the right side of the accounting equation.
Similarly, the disbursement of this loan increases the company's bank balance by $100,000. Bank balance (cash) is considered an Asset. The increase of the Asset balance as a result of the loan disbursement will be recorded on the left side of the accounting equation.
Now, when you try to reconcile the two sides of the equation, you will notice the below.
Increase in Cash ($100,000) = Increase in Liabilities ($100,000)
Eureka! The equation balances. This means we have recorded this transaction correctly.
In the double-entry system, this transaction will be recorded as follows.
Dr: Cash - $100,000
Cr: Loan Liability - $100,000
Notice of the credit entry is right indented to demonstrate that the credit items are recorded on the right end.
The paid version of this article will contain the below topics.
- Modifications to the basic accounting equation
- How to perform double entries with the modified accounting equation
- How to recognize the category of an item when you see it for the first time
- Examples and practice questions with worked answers
If you are interested in getting that, send an email to [email protected].
