Understanding Accounting Basics (ALOE and Balance Sheets)

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In accounting, the math usually isn’t worse than multiplication. But accounting isn’t about math — it’s about concepts, and some had me confused. Accounting has simple and surprisingly elegant ways to track a business.

So What’s Accounting About, Anyway?

To be blunt, accounting is about tracking stuff (yes, there’s more to it, but hang with me). What kind of stuff can we track?

  • Assets: “Stuff” inside the company
  • Liabilities: “Stuff” that belongs to others
  • Owner’s Equity (aka Capital): “Stuff” that belongs to the owners

Simple enough. Now how are these related?

Assets = Liabilities + Owner’s Equity

In layman’s terms, everything the company has belongs to the owners or someone else. Think of the equation like this:

  • assets = liabilities + owner’s equity
  • stuff the company has = other people’s stuff + owner’s stuff

This formula (also called ALOE) might seem strange at first. Why do we add liabilities? Because we’re looking from the point of view of the company, not the shareholders. If the company has something, it could be owed to someone else.

From the owner’s point of view, owner’s equity = assets – liabilities. This equation looks more natural, but often we aren’t interested in the owner’s point of view. We want to know about the company.

What’s a balance sheet?

A balance sheet is a document that tracks a company’s assets, liabilities and owner’s equity at a specific point in time. As you know, if the company’s has something, it belongs to someone. The sides must balance. So let’s do an example.

Suppose we start a company with $100 cash:

Assets:
  Cash: 100
Liabilities:
  None
Owner's Equity:
  Stock: 100

The company has $100 in short-term investments, and the owners have $100 worth of stock (how ownership is represented in a company).

Now suppose we take a bank loan for $150. The balance sheet becomes this:


Assets:
  Cash: 250
Liabilities:
  Loans: 150
Owner's Equity
  Stock: 100

Now our company has $250, but $150 belongs to the bank and $100 belongs to the owners. Sorry guys — you can’t take out a loan and make your share of the company more valuable.

Next, let’s buy a building for $200:


Assets:
  Cash: 50
  Building: 200
Liabilities:
  Loans: 150
Owner's Equity
  Stock: 100

Buying a building doesn’t make our company more valuable: we re-arranged our assets. Instead of $250 in cash, we have $50 in cash and $200 in “building”. Our share of the company ($100) didn’t change a lick. And we still owe the bank $150.

That’s not how it really works, is it?

It is. Well, real accountants use fancier terms (“accounts receivable” vs “deadbeats who owe me”), and have a bigger, badder balance sheet. But the core idea is the same: show what the company’s worth, and who owns what.

Take a look at the balance sheet for a small internet company:

 

Assets are broken into short-and long-term categories; the company is worth about $18 billion on the books (as of Dec 2006). This is up from $10B in 2005.

There’s many, many reasons why assets may be over or under-valued on the books. How do you measure momentum? Employee morale? A brand? Customer loyalty?

Accountants try to quantify items like this with intangible terms like “Goodwill”, but it’s not easy. In reality, most companies are worth several times their reported assets; Google’s market cap is over 10x the book value (but read more about stocks to see why market cap is not quite right).

Now examine the other side of the equation, liabilities and owner’s equity:

Wow — Google doesn’t have many liabilities! Only $1.4B (of the total $18B) and there’s no long-term debt. What it does owe are “accounts payable” — the equivalent of a credit-card bill (usually paid within a short timeframe).

Now you can examine a company and see what it’s worth (on paper) and where the value lies. Google has no “inventory” (ever bought an off-the-shelf product from them?) but has a lot of cash, investments, and equipment. There’s very little debt and other liabilities, so it seems like a very stable company on paper; they won’t be going bankrupt anytime soon (there’s other documents that show how profitable the company is).

Blockbuster, for example, has 2.5B in assets but 1.9B is owed to others (saved balance sheet here). Shareholders aren’t left with much. In fact, it has 700M in “intangible assets”, so it actually has a negative amount of real, tangible assets. Not a good sign — if you liquidated the company today, it couldn’t pay off its debt.

The Rules of the Game

Accounting has many rules, but a basic one is this: use double-entry bookkeeping.

This fancy term means that all changes happen in pairs:

  • If assets go down, liabilities or owner’s equity should decrease also
  • If assets go up, liabilities or owner’s equity must increase as well

Every change to assets must have a corresponding change to keep the equation in balance. There’s a formal system of “debits and credits” that describes these changes, but the concept is simple: if you make a change to one side, you must make one on the other as well.

There’s More to Learn

There’s much more to accounting, but you’ve got an idea of the basics:

  • If a company has something, someone had better own it
  • A balance sheet lists assets, liabilities and owner’s equity at a point in time; everything must add up
  • Changes must be made in pairs: if assets, liabilities or owner’s equity changes, something else much change as well

Any system can be interesting (even “fun”) if you look at the reasons it was created and the problem it’s trying to solve. Could you have made a simpler way to report what a company is worth and who is owed what?

Enjoy.

Other Posts In This Series

  1. The Rule of 72
  2. Understanding Accounting Basics (ALOE and Balance Sheets)
  3. Understanding Debt, Risk and Leverage
  4. What You Should Know About The Stock Market
  5. Understanding the Pareto Principle (The 80/20 Rule)
  6. Combining Simplicity and Complexity
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57 Comments

  1. That was a nice quick summary.

    You might add that if assets and liabilities are stuff you either own or owe, then income and expense track the movement of stuff in or out of the company. Cash from a sale increases assets and the off-setting double entry is to income. But the sale might also reduce inventory which shrinks assets and that adjustment would be recorded as an expense. The difference in the two adjustments is your gross profit on the sale.

    Looking at a balance sheet shows you where a company stands financially at any given moment, the stuff they own and owe. Income and expense reports show movement and trends over time and break out the asset/liability changes into a variety of categories and types.

  2. I might also add that debits and credits are not pluses or minuses. They are simply two different categories that are associated with account types. Assets and expenses carry a debit balance. That means to increase them you make an entry in the debit column and to decrease them, a credit column entry. Liabilities, equity and income carry a credit balance. Credit column entries increase them and debit column entries decrease their value.

    No matter how long or convoluted an entry might be the only governing rule is that the debit column total and the credit column total must be the same. That is why assets=liabilities+equity is true. Quite literally, the only math in accounting is addition.

  3. Hi Jim, thanks for the great comments! Yes, it took a while to realize that debits weren’t always “bad” and credits weren’t always “good”. One confusion is the common terms (credit or debit balance) get confused with the more specific accounting ones. Appreciate the thoughts!

  4. Why doesn’t the balance balance? 15B$ Liabilities is less than 18B$ Assets… Where do the 3B$ benefits fit in?

  5. Banks and other financial institutions have sort of a reverse or at least non-intuitive usage of the terms debit and credit since they carry your deposit on their books as a liability, not an asset. The money does belong to you after all. That is why a deposit is “credited” to your account and why a debit card transaction reduces your balance. In your own books a deposit is a debit to a cash asset and a withdrawal a credit.

  6. @Jim: Thanks for the clarifications!

    @GUI Junkie: This example is a bit more complicated because Google reported “intangible assets” like Goodwill (things like brand recognition, etc.). As Jim said, their total reported assets, liabilities and equity add up.

    The 15B number is reported after intangible items have been removed.

  7. A “hypothetical” question: my wife has trouble keeping track of her spending. I’ve considered buying an accountant’s notebook and tracking spending (with her) there, but I don’t know how to do the double-entry bookkeeping. I know it’s not strictly necessary – basic add/subtract is easy enough to get right – but it seems that doing it more thoroughly might help her understand things better.

    How do I do that? I guess that’s basically asking how double-entry bookkeeping would work in a checkbook, eh?

  8. Hi Dan, good question. These double-entry accounting systems are more for financial reports than personal finance — when keeping track of your own expenses, a simple add/subtract will probably do the trick.

    One method is to keep all the receipts for a week (and write down any cash transactions) to see where the money is going. You can then check your credit card / debit card statements to make sure the amounts match. The simple dollar is a great finance blog and has more on this topic:

    http://www.thesimpledollar.com/2007/08/13/how-to-balance-your-checkbook-in-the-era-of-the-debit-card/

  9. it still amuses me from reading other posts here that one could claim to have 1B in the first year in OE and 3B in the fifth year yet the fifth year would be worth less due to inflation and competition.

    I happily await zero inflation – the physicists tunnelling.

  10. i’m in school to become an accountant i found this information to be helpful for my test in payroll and fundementals of accounting…

  11. Hi!

    I’ve got to say I am a sophomore in college and am taking my first accounting class. The first and second day of class, I was utterly confused I was almost in tears from frustration! LOL…I even started getting a headache from having to think too much!

    However after reading your tips, I’m feeling a little better. We’re currently working on “T” accounts and changing balance sheets (i think thats what its called) I’m feeling a little more confident know! THANK YOU!!! I was this close to dropping the class and trying again later!

  12. hi,
    One concept that my boss made me rote learn is ‘credit the giver, debit the receiver while you are making a posting’.

    But i can’t figure out whether credit,debit will be useful in single entry book keeping?

  13. The way accounting is explained in this passage make itthat muck easier to understand. Thanks for this website I fill I can do anything in accounting.

  14. I am at a point in my life where my career progress is stunted because i do not have a professional qualification in accounting. I found this website while looking for some simplified study tips .Thank you so much for this encouragement, i definitely feel i can give it a shot as I intend to go on to ACCA later. My college degree is in the arts but i enjoy maths and really like my job. Do you have any tips for someone like me? God bless you.

  15. i need to balance an account sheet within 3 days, but i don’t know how, i also need to know what is meant by account payable, withdrawable, etc. pls… help

  16. I am using a cash payment journal that has 3 special amount colums. Under what circumstances would there be a need for additional colums.

  17. I UNDERSTAND THAT ASSETS AND EXPENSE HAVE A DEBIT
    BALANCE BUT I DONT UNDERSTAND THE CONCEPT OF HOW
    TO BUT THEM ON THE BALANCE SHEET OR WHEN DO I CREDIT OR DEBIT AN ACCOUNT AND WHAT COMES FIRST
    THIS IS MY SECOND TIME TAKING THIS COURSE AND I JUST AVERAGING A D BARELY.HELP ME UNDERSTAND THIS ”

    45 YEAR OLD
    STUDENT

  18. Here is what I have read about that…
    The one giving in the transaction is the credit(or), and the one receiving in the transaction is the debit(or).

    i.e. Sell an hour of service, the the service revenue is the giver (so it’s credited), and the cash in the bank is the receiver (so cash is debited) and increased.

    Hope that helps you like it did me.

  19. This website info on accounts is SHORT, SWEET AND SIMPLIFIED. You successfully simplified and “funnified” a complex subject….accounts.

  20. @newby: Thank you! I really want to boil ideas into their bare essentials, and hopefully have some fun along the way :).

  21. To assist with (T) Accounts, I was taught to categorize the transaction in the following way
    - Personal (Accounts Receivable and Accounts Payables)
    As the name suggests it would be a person/company and the entry format is Debit the Receiver and Credit the giver
    - Real Account (Cash, Property,Buying and Selling of Goods and Services that directly affect your business)
    In this case Debit what comes in and Credit what goes out
    - Nominal Account
    (Debit all expenses (losses)
    Credit all income (revenue)
    Based on the above you can qualify what items go where.
    Nominal Accounts (transactions) are the ones that go into a Income Statement.
    The Real Accounts & Personal Accounts are the ones that go into the Balance Sheet
    Hope this helps

  22. As someone not versed in Accounting, this was a wonderful write-up, and a joy to read! This should be the benchmark of knowledge sharing, cos I learnt more in 5 minutes, than I probably would have in hours/days on a book or searching the web. Thanks for sharing! It truly was better explained. I shall be looking out for future articles of yours!

  23. Am a second year student now studying finance, and I still feel it really difficult over the course of 2 years now the basics of accounting slowly drifted away from me. But this really helped..

    I just wanted to know. I’m meant to help out a friend of mine who has a doctors surgery with her accounts.. Is there any tips you have in helping me go about it? Please it will be much appreciated :). This is the first time I had to step out of campus to actually put all my knowledge to use and I really just don’t know what to expect . And what’s expected of me ..

  24. I understand assets=libilities + onwers equity much better, but I’m still not sure of the balance sheet and how it works.

  25. I think its important if you are following the “debit the account that receives, credit the account that gives” rule to remember that you are talking about “value” not just money, although everything is expressed in money terms. This is something that is not always well explained in book keeping courses. I think this is why you use the word “stuff”.

    For example a debtor is someone, usually a customer, who has received value (not money) so he owes value in return (money). So you credit sales for giving value and debit the customer for receiving value. He now owes you and will pay you in money. Then you debit cash or bank, and credit the customer.

    A creditor is someone, usually a supplier, who has given value (not money) so he is owed value in return (money).

    An expense is (seemingly paradoxically at first until you think about it) a receiving of value by the business in the form of eg. Stationery, postage stamps, petrol, repair services. Value comes into the business.

    Items on the Profit and Loss account represent value given and received where there is no residual value at the end of the year. The stationery is used up, the stamps are licked, the petrol burned, etc. The goods that are sold go out and you don’t see them anymore. Goods purchased for resale are gone. (If any are unsold they go onto the balance sheet as stock in hand)

    So the Profit and Loss account is really historical information. At the end of the accounting year, all that historical information is cleared out and you start again with a clean sheet. All that is left is the profit that was earned and it is already on balance sheet.

    When you acquire an asset eg a motor vehicle the Motor Vehicles account is debited because it has received value. But that value is not (all) used up in the year. It stays on the balance sheet, and at the end of the accounting year the closing balance becomes next year’s opening balance because all those items still exist. The balance sheet tells you what you still have. It is a snap shot of the value of the business, of the stuff that is still there at the end of the year.

    So I think this one general rule can help you with any transaction.

  26. PS
    I meant to add that modern accounting systems make it easy because the debits and credits go on in the background. When you click “create a sales invoice”, it credits sales and debits the customer you choose. Etc.

  27. @YatharthROCK: Thanks!

    On the comments, I’ll have to check out my anti-spam plugin, it might be going haywire. I should also enable Markdown for comments, thanks!

  28. hey, can you please explain to me how balancing the books work. I don’t understand when an item fall under the debit or credit side.

  29. WOW! I read the comments after I posted my question. THANK YOU AMY, u saved me a whole lot of trouble. I really didn’t understand what was going on there, didn’t know what went where and when. Thanks a bunch.

  30. I’m a little confused with ref to the end of the year balance that l give to my accountant. Do l carry that balance over to the the start of the next business year, even though l still have to pay my corporation tax and accountant from it. If l do then how is it separated so that l do not pay corporation tax on the remaining balance ( after corporation tax ) the following year. I find this part confusing?

  31. I have a masters degree in finance and one of my early key insights into accounts was:

    “Debit” is derived from an Italian word which means “left”
    “Credit” simply means right.

    So if a thing is to be debited – you are writing it on the left column of a accounting table and writing it on right for things to be credited.

    Now this is nothing more than an agreed convention so that we all are on the same footing when reading a financial statement.

    Then over the periods these conventions solidified into rules like:

    If asset increases/ liability decreases – write it on the left (debit)
    Incur an expense – write it on the left (debit)

    Asset decreases/Liabitlity Increases – write on right (credit)
    Get an Income – write in or right (credit)

    Obviously nothing increases/decreases one-sided.

    If asset increases, you pay for that asset – so some other asset (cash) decreases – so we have to write one part in the debit side, another part in the credit side.

    The trouble with most new students is that they start assigning some meaning to ‘credit’ or ‘debit’ thinking one is good another bad or thinking one as increase, another as decrease.

  32. @Bhaskar: What you say may be true, except for your etymologies.

    Credit is derived from ‘credo’ — the Latin, “I believe”.

    Debit is derived from ‘debilitum’ — the Latin, “debt”.

    If they were derived from Italian, they would be reversed; after all, “dexter” being Latin for “right” and destro being the Italian descendant. “Sinister” and “sinistra” being Latin and Italian for “left”.

  33. Thanks so Much . This helped a great deal . New to Accounting . But after reading through . I’m enlightened

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