Accounting Equation
Last week on the blog, we talked about accounting being the language of business and that through accounting we can tell the story of a business. This week we are going to dive into the nitty gritty of the accounting equation. But before we do I want to talk about accounting entries.
Accounting entries or also called journal entries are just a fancy way to say the record of what happened. I think of these entries as the sentences that make up the story of the business. The financial statements we talked about in the last blog post are really a summary of all the sentences that make up a business. When an event happens in your business, there is usually an entry that goes along with it. For example, if you paid $100 in cash to receive 10 printed copies of your books to sign and then sell, that is an event which would trigger a journal entry. The simple entry is that cash decreased by $100 and book inventory increased by $100.
There are two ways to think about recording these entries. You either record them when cash was exchanged also known as cash basis OR you record them when business revenue and matching expenses when they are generated—not when money actually changes hands also known as accrual basis. For most small business, cash basis is the easiest way to go. The question you ask yourself when you are wondering if you need to record an entry is did cash change hands. If the answer is yes, then you would go ahead and make note of what happened. If you are curious if accrual accounting is right for you, send me an email and we can chat more. Most people reading are going to be on a cash basis.
If you heard all of that and are still with me and you are like OMG you told me that every time cash is exchanged, I need to be making an entry or a note of it and I have been in business for 6 months and I haven’t done that yet, don’t panic. We will go more into the logistics of making note of what happened in a future blog post. But if you are like Savannah, please give me something to start doing right now, then I would suggest opening a Google Sheet and writing down anything you have paid or received cash for. Write down what it was for and how much it cost. This will make your life easier when it comes to tax season to have records of your income and expenses.
Like we just talked about you will likely set your business up as cash basis. And that means anytime cash is exchanged we record an entry. The example we used is we spent $100 to buy 10 copies of books to sell after we sign them. This entry decreased cash and increased book inventory --- impacted two areas. This is called double entry accounting. When do one thing, something else is happening. Which leads right into the accounting equation.
The accounting equation is simple. Assets = Liabilities + Equity. Before we dive into how the equation works, which don’t panic because remember I am your accounting bestie and will explain it all to you, let’s explore what is an asset, liability, and equity.
Let’s first start with assets. The technical definition of an asset is anything with a current or future economic value to a company. The simple way to explain it is something that will bring your company value now or in the future. If you are like me, you will want examples of assets to make them make sense. The easiest example is cash. Cash bring your company value because you can go purchase more assets with it or pay for expenses. Another example is inventory. So, if you own a publishing house and you have 25 copies of your newest author’s book sitting in your bedroom ready to sell, that is an asset. If your company sells custom t-shirts, the t-shirts sitting in your closet ready to be decorated are inventory. But one you probably are not thinking about as an asset is the vinyl press machine you use to make those shirts. This would fall under equipment. An easy way to think about assets are the things in your business you can touch or hold.
Next let’s talk about liabilities. The technical definition of a liability is a debt or obligation a person or company owes to someone else. I think personal examples are a little bit easier for this so a personal liability would be your car loan. Or your student loans. Or your mortgage. Since most of you will be on a cash basis, there won’t be a ton of liabilities because generally when you purchase something you will pay for it right away. You won’t have a promise to pay in the future. You will have swiped your debit or credit card, and you will have exchanged the cash.
Lastly, let’s talk equity. The technical definition is the difference between assets and liabilities. But that is not a very good definition because that just explained the equation in a different way. I think of equity as how much you have put into the company – either from your hard work earning money for the company or from an investment in the company. For example, to get my business off the group I decided to put $1,000 in my business checking account so as I was paying for things like hosting my website or podcast, I had cash to pay for it. Well, there was an exchange of cash so there must be some sort of entry, but you are probably wondering what the entry is right. I bet you can get the first half. Cash increased by $1,000, right? Well, where does the other half of the entry go? It would go to equity. Specifically, an account called owner’s equity. Because if I were to close the business tomorrow and not have spent that $1,000, I would want the $1,000 back to me. The business owes me $1,000.
To recap, the accounting equation is simple. Assets = Liabilities + Owner’s Equity. Assets are the things that will bring your business future value or the things you own. Liabilities are how much you owe other people, and Owner’s Equity is how much money you put into the company. The accounting equation is helpful when we are trying to record what happened in our business because it must balance. If you increase assets, then you have three options of the other side of the entry: (1) you decrease another asset, (2) you increase liabilities, or (3) you increase owner’s equity.
If you are feeling like you need to take action after reading this blog post, I would suggest downloading our freebie linked here to help you start keeping track of all the journal entries (or remember accounting is the storytelling of business so think of this link sentences) related to your business. Any time you exchange cash - receive it or spend it – you have some journal entry you will need to record. Lastly, if you aren’t sure what the entry would be, simple write down a sentence or two of what you did. For example, I paid $100 for 10 T-shirts so I could have them on hand for when people order custom designed shirts. After all, accounting is just the storytelling of business.
Your Accounting Bestie,
Savannah