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Accounting Basics Part 1: Accounting Equation

Back on the subject of accounting today. My goal is to help you learn what you need to know about accounting to run your business, from basic to advanced. I feel it would be easier to learn through application and that there is no better way to apply these principles than through setting up and processing your business’ books in QuickBooks.

Last week I discussed QuickBooks as the preferred accounting software, and this week I would like to follow up on that with the first part of accounting basics – understanding the basic accounting equation. The accounting equation is the foundation for recording economic activity within a business and in QuickBooks, and an important concept to grasp before moving into the other aspects of accounting and bookkeeping for your business.

The idea behind the basic accounting equation is that economic activity in a business is an exchange of assets and/or claims to assets. The claims to assets are either claims by creditors such as a bank (liabilities), or claims by owners – you (stockholders’ equity). These assets and claims to assets relate to one another in the following equation:

Assets = Liabilities + Stockholders’ Equity

This means that at any given time in your business, the assets (cash, accounts receivable, inventory, fixed assets, etc) must equal the liabilities (accounts payable, unearned revenue, loans, credit cards, payroll tax liabilities, etc) and stockholders’ equity (capital contributions, retained earnings, common stock, etc).

This relationship is the basis for what is known as the Balance Sheet. The Balance Sheet is a financial statement that shows your financial position at a given date and will be one of the two main financial statements that you will use to manage your business. The relationship between assets and liabilities/equity in the accounting equation and expressed in the Balance Sheet is used to analyze the financial strength, liquidity, solvency, and overall value of your company. Banks and other creditors will be relying on these statements to analyze your business, so it is in your best interest to learn to do the same!

The other main statement that you will use to analyze your business is the Income Statement or Profit & Loss Statement. It is also important to understand how this statement relates to the accounting equation as expressed on the Balance Sheet.

Another concept to understand is the difference between permanent and temporary accounts, also known as real or nominal accounts. Permanent accounts are shown on the Balance Sheet and are considered permanent because the balances in these accounts do not relate to any one accounting period (year) but carry over into future accounting periods (years). Temporary accounts are the accounts shown on the Income Statement and only relate to a specific accounting period (year). These accounts are cleared out at the end of the period and the ending positive or negative balance (known as net income or loss for the period) is transferred to the balance sheet under stockholders’ equity as retained earnings.

This is also an important point because it goes to show that every transaction you make impacts one or both sides of this equation and is reflected as such. This is the basis for every transaction you will make in QuickBooks.

I hope this was a helpful little overview of the foundational principles behind accounting. The accounting equation is the basis for the financial statements and is how every transaction is filtered through and reflected in your books. Next week we will discuss some more about what you can expect when setting up your QuickBooks file, including an explanation of the Chart of Accounts and how what we have discussed today ties into all of this.

Please let me know if you have any questions about what was discussed here as I would be happy to delve a little deeper and explain further if necessary.

Keep Reaching!

Mark

One comment on “Accounting Basics Part 1: Accounting Equation

  1. Pingback: Accounting Basics Part 2: Chart of Accounts in QuickBooks

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