The Accounting Equation
This video introduces the accounting equation, which is the most important concept in accounting.
- This relationship between assets, liabilities and stockholders’ equity must always hold true. There are no exceptions to this rule.
After briefly defining the terms and walking through an illustrated example, the equation is expanded upon to introduce double-entry bookkeeping:
DOUBLE-ENTRY BOOKKEEPING: the system most commonly employed by businesses to record financial information. Double-entry bookkeeping requires that a change in one account be matched in another account.
- This is done by recording debits and credits. For every entry the sum of debits must equal the sum of credits.
- Please see video for an example and greater detail on this topic.
Debits and credits are difficult to grasp at first. The best way to approach this concept is to revisit the definition as your accounting vocabulary grows.
This definition is not included in the video, but can be found under “Reference” on the website. It can be helpful in better understanding debits and credits because it applies the concept to something everyone understands: cash.
The video continues to expand upon the accounting equation to show that…
- Stockholders’ equity is equal to the sum of contributed capital and retained earnings.
- Net income is equal to revenues less expenses.
These relationships are important in understanding how financial statements relate to one another and will be elaborated upon in future videos. The video concludes by pointing out that the balance sheet is simply a more formal presentation of the accounting equation. To demonstrate this the video organizes the components of the accounting equation vertically, and then details accounts that fall under assets, liabilities and stockholders’ equity.
Finally, the video points out that in every thorough financial model, for every accounting period, the balance sheet has a check to make certain that the accounting equation holds true (see blue arrow in the lower-right hand corner of the image above).