Chapter Two

ACCOUNTING FORMULA

Truth never damages a cause that is just.

Mahatma Gandhi - 2 October 1869 – 30 January 1948) was the preeminent leader of the Indian independence movement.

Chapter 1 focused on the accounting cycle and this chapter will begin to gradually enhance and expand that basic concept.

This article is preparation for understanding on how transactions are recorded into the accounting system using double entry bookkeeping and T accounts.

In order to understand how transaction are recorded it is essential to have familiarity with the accounting formula.  We will now gradually build on what has already been presented and provide an overview of the Balance Sheet and the basic accounting formula.  The third chapter will expand the concept of double entry bookkeeping and T accounts.

REVIEW OF ACCOUNTING CYCLE

It would be helpful to read or reread chapter one, which gives a very brief overview of the accounting cycle.  The chapter will simplify the accounting cycle assuming the reader is not familiar with accounting or bookkeeping.  The overall accounting process will be expanded and explained gradually.

The following is a brief refresher on what was previously covered: REVIEW OF THE ACCOUNTING CYCLE:

Refer to Figure 1 and recall that the accounting cycle begins with a TRANSACTION.

Figure 1

• The JOURNAL entries are posted to similar accounts in the LEDGER
• TRIAL BALANCE is prepared using the LEDGER, which, among other things ensures that the debits equal the credits.
• The TRIAL BALALNCE is expanded into a TRIAL BALANCE WORKSHEET and used to close out the accounting cycle and finalize the FINANCIAL STATEMENTS especially the Balance Sheet.
• With this overview, we will proceed with an explanation of the basic accounting formula.

BASIC ACCOUNTING FORMULA

You may have heard the term “double entry” bookkeeping.  This means that every accounting entry requires a debit and a credit.  The easy way to understand the debit/credit mystery is to begin with the very basic accounting formula (A) Assets = (L) Liabilities + (Net Assets/Owners’ Equity).  Refer to Figure 2.

Figure 2

The accounting formula or equation is very straight forward, assets (things of value owned) equal the difference between the assets and (liabilities amount owed).  Net Assets (Owners’ equity) is the resulting balance.

ASSETS are things of value owned.  Examples of assets would be cash, land, buildings, any interest bearing investment accounts, land, and buildings.

LIABILITIES represent money owed for assets or services received but not paid for.

NET ASSETS/OWNERS EQUITY is simply the difference between what is owned and what is owed.

BALANCE SHEET

The Balance Sheet is a financial statement based on the accounting formula.  That is, assets equal liabilities plus net assets/owners’ equity.

One side of the balance sheet reflects assets and other side contains liabilities and plus net assets/owners’ equity.

See figure 3 for a simple example.

Figure 3