First, the basics! Accounting is the structure used to keep track of stuff. In this case, it's money. There are four basic account types in Accounting: assets, liabilities, equity, and jelly beans. Okay, I made that last one up, but wouldn't the world be a better place if jelly beans had a larger part in it? Equity accounts can further be broken into expenses and revenues. What does this mean?
Assets are usually things you own, like a car, maybe, or a boat. Don't limit yourself to transportation, however. A house might be an asset. Or a computer, or a television, or three thousand vinyl albums are also assets. Perhaps you can think of an asset as anything you can sell. By this definition, chunky yogurt is not an asset.
Liabilities are commitments to pay money. If you have a car loan, you have a liability. Same with a home loan. Or a TV loan, or a loan on three thousand vinyl albums. You get the picture. If you are committed to paying for something over a period of time, it is a liability. A credit card is an excellent example of a liability that many people have.
Equity is somewhat odd in my book, because it is principly the same as an asset you owe to yourself. If you think of yourself as a giant corporation, equity is the part of the company you own. The assets of the company might be things like the office furniture or a manufacturing plant in Indonesia. If you sell the manufacturing plant, the money becomes a company asset. If you sell the company, the money you get is your equity. If that's clear, hopefully expenses and revenues are self-explanatory.
Think of each of your accounts as a giant T on a page. On one side, you will enter credits. On the other, debits. How do you know which side is which? Debit is the left side. Credit is the right side. It's the same with sailing, by the way. Port and Starboard don't mean anything but left and right, but sailors just won't shut up about port side this, and starboard side that. Accountants are the same way. So, Debits = Credits is basically saying: Lefts = Rights. Left side of what? That's where it gets confusing! Imagine your checking account as a big T on a piece of paper. Which side is the credit side? The side on the right of the stem of the T. Which side is the debit side? The area on the left of the stem. Let's draw a picture:
Checking --------+--------- | (debit) | (credit) | |Is there anything confusing about that? Not much. Okay, so maybe you'd like to think of credit as the left side. Well you can't. Credit means right side. I've thought of some easy mnemonics to remember this, but we're not there yet.
So far, we still haven't really linked all our accounts together. To do that, you must consider what type of accounts you have. Since your checking account is money in the bank, it is an asset. Your credit card, as I said earlier, is a liability. Since assets = liabilities + equity, your checking account goes on one side of the equation and your credit card on the other. Our accounts look like this:
Checking = Credit Card --------+--------- --------+--------- | | (debit) | (credit) (debit) | (credit) | | | |Mnemonic #1: Credit cards increase on the credit side.
Let's work a quick example to get the hang of this. Let's say you want to buy the latest Men Without Hats CD with your credit card. It costs $20. Since we can later sell that CD, we should probably consider it an asset. Here are the T-accounts:
Compact Discs = Credit Card --------+--------- --------+--------- | | 20 | 0 0 | 20 | | | |How did I know where to put what? As my convenient mnemonic intoned, I have to increase my credit card account on the credit side. As rule #2 states, though, credits = debits, so I needed to add the same amount to the debit side of my CD account. This tells us something important about the account types: Asset accounts increase on the debit side, which is opposite of the way liability accounts increase. This is a fundamental way in which accounting works to keep everything in balance.
Let's say you didn't have a credit card, though, and you bought the CD with a check. The T-accounts remain the same, as do all the rules. Since in the end, I know I'm still going to own the CD, I'll keep the debit side of my compact disc account the same. The checking has to decrease to keep everything in balance. Let's look:
Compact Discs = 0 --------+--------- | 20 | 0 | | Checking --------+--------- | 0 | 20 | |Easy right? And it tells us more about accounting. All asset accounts increase on the same side. all liability accounts also increase on the same side. One more example, and I think we'll call it a lesson. Let's say we did have a credit card on us to buy the CD, but we pay the credit card bill with a check at the end of the month. All we really need to do is combine the T-accounts:
Compact Discs = Credit Card --------+--------- --------+--------- | | 20 | 0 20 | 20 | | | | Checking --------+--------- | 0 | 20 | |The thing to notice about this is that the credit card company is now happy because we've paid them what we owe. Essentially, we've converted $20 of our checking account asset to $20 of Men Without Hats assets. Whether or not that is a good thing is up to your musical tastes. But notice that all the accounts stayed in balance throughout.
The problem arises with Equity's two subaccounts: Revenues and Expenses. Hopefully, a little reasoning clears up what to do with these two account types, but I don't find the explanation very satisfying. Still, in the interest of completeness, here goes.
Revenues increase Equity, so they increase on the side that would make Equity bigger. Since Equity increases on the credit (right!) side, Revenue accounts also increase on the credit side. Likewise, Expenses decrease Equity, so you might think they should increase in the opposite direction of Equity. It turns out that that is absolutely correct! This is where I think it all gets a little confusing, because now it sounds like Expenses and Assets work in the same way. And, honestly, they do. The difference is there is an equals sign that separates them, so even though they act the same way, they are completely opposite! Hopefully, this is satisfying for you. I'm still unconvinced, but trust me, even if you don't believe me, that's the way it works.
Remember, as long as you're consistent, you can fake a better understanding of accounting. Just look at some of the internet companies out there that are "fixing the books." One example I heard of was where a company was classifying shipping costs as a marketing expense. This is a problem because marketing is considered an elastic expense. That is, it can be reduced voluntarily, while shipping is probably not very elastic. So what? If they had classified shipping as an operating cost no one would have cared, because operating expenses are generally more static. The problem arises when your classification conflicts with someone else's and that someone else has the power to make you change yours. At your home, there probably aren't too many people with that kind of power. If you want to classify your Men at Work CD as a medical expense (I need to hear it or I'll die! Honest.), go right ahead. But you might have trouble getting a medical insurance company to reimburse you.