Learn about the golden rule of how accountants keep track of assets, liabilities, and equity.
- All of accounting is governed by the golden rule, the accounting equation. Simple name, simple equation, lots of implications. You'll generally see it written as assets equals liability plus owners' equity. It can also be re-arranged to say that owners' equity equals assets minus liabilities. It's fairly common to see it both ways. You know that assets are resources, such as cash, inventory, and equipment.
They're things that will produce benefits in the future. Liabilities are obligations that need to be paid, such as loans and accounts payable. These are generally accrued because a business needs to raise money to buy assets or pay employees. The owners' equity portion of the equation accounts for capital contributed by owner's and also retained earnings. Let me give you an example of how this works. I can pull the balance sheet for LinkedIn on Google. In Q3 of 2016, LinkedIn showed total assets of 7.56 billion.
The company also showed total liabilities of 2.68 billion. So you can assume that the equity is around 4.88 billion. If I look at the balance sheet I see that it's 4.87 billion. That's close enough. Probably a difference of significant figures somewhere. I could teach you a whole course on the accounting equation, however I want to point out something pertinent to this particular course and move on. When it comes to accounting, you'll deal with debits and credits. You know about this.
You may either have a credit or a debit card or both. When you use a credit card, you essentially borrow money to pay for goods. When you use your debit card, you pay for the purchase directly from your bank account. In a similar manner, the accounting equation also deals in debits and credits. When you debit an asset account, you increase its value. When you credit it, you decrease it's value. When you want to decrease the balance of a liability or an equity account, you debit that account. To increase their value, you can credit those accounts.
For example, imagine that you pay a supplier for merchandise that was previously purchased on a credit card. Well, you'd have to credit the cash account, which is an asset that decreased and debit accounts payable which is a liability that also decreased. So it's a zero-sum operation. You lost some asset, but you also fulfilled your obligation by paying the liability. I want to turn my attention to two very important components that I haven't explicitly talked about yet. Revenue and expenses.
These two categories sort of fall under the umbrella of equity, but are not the same thing. Revenue is the money that a business earns from selling a product or a service. Expenses are expenditures that allow a company to operate. Both of these accounts are nominal as they're reset to zero at the beginning of each new accounting period. Under accrual accounting, revenue can only be recognized when the goods or services are delivered. Expenses are recognized in the same period as the revenue that they helped generate.
To show increased revenue, you should credit that account. To show decreased revenue, you should debit it. The expense account is the opposite. Debit to increase and credit to decrease. Let's take a look at a scenario. Imagine that you own a sporting goods store and sell a ping pong paddle for $50. Your cost for the paddle is $10. That's a great margin. When you sell the product, you debit your assets account for $50. Cash increased your assets.
At the same time, you have to credit assets for $10, because you lost $10 worth of assets. What about liabilities? Well since the customer paid cash at the time of purchase, there's really no liability to worry about. Let's move to owner's equity and break it into revenue and expense. Notice that you generated revenue. You delivered the paddle to the customer, so you can credit revenue for $50. At the same time, you suffered an expense of $10, so you must debit expenses for that amount.
By the way, this expense is also known as cost of goods sold or COGS. Now take a look at the equation. Everything lines up. The change in assets equals a change in liabilities plus owners' equity.
- Explain the four different types of financial statements.
- Distinguish between the types of moving averages.
- Determine a seasonal adjusted trend.
- Break down pro-forma financial statements.
- Identify cash flows, and what increased liabilities and decreased earnings generally indicate.
- Tell what a regression is.
- Outline the naive approach.