Business Law
A Very Brief Primer On Accounting

The Two Basic Accounting Equations

The first basic accounting equation is also the form of the Balance Sheet:

Assets = Liabilities + Equity

The second basic accounting equation is the key to the “double entry” accounting system:

Debits = Credits

In essence, this equation means that if you change something on the Balance Sheet, you must change something else to keep the equation balanced (i.e., “balancing the books”).

Accounts and Entries

Accounting information is broken down into separate accounts (e.g., the “cash account”). Asset accounts are natural debit accounts, while liabilities and equity accounts are natural credit accounts. Negative numbers are avoided since each transaction is recorded via at least two positive entries where the sum of debits equals the sum of credits.

Example: Borrowing money increases an asset (debit cash) and increases a liability (credit debt to bank) by the same amount — thus keeping the Balance Sheet balanced.

The Double Entry System

The system is essentially algebra with a twist, allowing clerks to follow a “recipe” without needing to understand the deeper meaning. It also enables easy error checking — for example, by adding all debits and credits to ensure they balance.

Ledger and Journals

Each transaction is entered in chronological order on the ledger: debit entries first, followed by indented credit entries. Each account has its own journal (e.g., “cash journal”), and reconciliation (such as comparing bank and company accounts) ensures accuracy.

Example Transaction

Financial Statements

Accounting provides financial information in useful formats, summarized in financial statements:

1. Balance Sheet

A snapshot of assets, liabilities, and equity at a point in time.

2. Profit and Loss Statement (P&L / Income Statement)

Summarizes changes to equity (excluding owner contributions or distributions) over a period. Income accounts are natural credit accounts; expense accounts are natural debit accounts.

Example: Mortgage Payment

The P&L’s bottom line (net income/loss) is carried into the Balance Sheet under equity, with prior period results shown as Retained Earnings.

3. Statement of Sources and Uses of Cash

Begins with beginning cash on hand, adds/subtracts net income, adjusts for non-cash items (e.g., depreciation), and includes other cash uses/sources (e.g., land purchases, borrowing). The bottom line shows ending cash on hand.

Capitalizing vs. Expensing

A common issue is whether expenditures should be capitalized (as assets) or expensed. For instance, fixing up a building might be a repair (expense) or improvement (asset). Principles include:

• If the expenditure creates an asset lasting more than one year → capitalize.
• Similar companies should be treated similarly (e.g., pre-opening restaurant costs should be capitalized).
• Post-opening expenses (like staff training) are operating expenses.

Methods of Accounting

Cash Method

Records income when received and expenses when paid. Easier to maintain, often defers taxable income, but omits accounts receivable/payable.

Accrual Method

Records income when earned and expenses when incurred. More accurate economically and always IRS-approved. Preferred for larger businesses.

GAAP

Generally Accepted Accounting Principles standardize reporting, primarily used for larger businesses’ financial statements.

Example: Depreciation

A $3,000 computer (debit computer, credit cash) should not be written off all at once. Under the straight-line method with a 3-year life:

• Each year: Debit depreciation expense $1,000, Credit computer $1,000.

Economic vs. Accounting Income

Economic income (true wealth increase) may differ from accounting income. Example: If Microsoft stock rises, Bill Gates’ net worth increases, but his books may still show the stock at its original cost basis.