How to Classify Transactions

The accounting equation:  Assets = Liabilities + Capital/Equity

Where does it come from?

There are several records of people using double-entry bookkeeping dating as far back as the 11^th and 12^th centuries

in Korea during the Goryeo dynasty. As time passed, there were several others that used this system as well, but the one most commonly associated with double-entry accounting is Luca Pacioli under direction of Leonardo da Vinci. He was the first to codify the system, which has enabled all the rest of us to study and use this system as a way of explaining our business’s financial health.

What is the accounting equation?

To give you a simple description, it is simply Assets = Liabilities + Owner’s Equity

What exactly does that mean? Basically, everything recorded on the Assets side of the equation has to equal everything on the liabilities and Equity side of the equation. As a former math teacher, this makes perfect sense to me. If you do not like math or struggled with it in school, then this might be a little more nonsensical. My goal then is to break this down so that the common person can understand what is happening.

Probably everyone knows that all math equations must balance. This is the fundamental principle of Algebra. The tricky part is understanding how to keep it balanced. The first thing we have to do is throw out our normal understanding of debits and credits. In the world of finance, debits doesn’t necessarily mean we are subtracting and credits doesn’t necessarily mean we are adding.

Let’s break it down into the different accounts. Asset accounts have what is called a debit balance. That means that they increase in the debit column (left side) and decrease in the credit column(right side). Everything you own like cash, accounts receivable, supplies, prepaid insurance, equipment, etc. are considered assets and increases in these accounts are recorded as debits.

Liabilities (i.e. accounts payable and notes payable) and Equity/Capital (what belongs to the business owner) are credit balances meaning that any increase in these accounts are recorded on the credit column and decreases are recorded on the debit column. Confused yet?? It gets even better.

Lets talk now about what makes up the equity/capital account. This number comes from a separate equation which is Revenue – Expenses = Equity. How does this affect the debit and credit entries? Since these accounts are on the right side of the equation and all the action happens on the same side, then one must be a debit balance and the other must be a credit balance. If we continue with this logic, the right side of the equation has a normal credit balance which means to increase it we would need to record here. Revenue represents money coming in so it would have the credit balance. Our expenses represents money going out so that would be the opposite balance and would be a debit entry.

Example 1

You have a miscellaneous expense of some kind that you paid cash for and need to record it.

Accts Affected	Classification	Normal Balance	Changes in Balance	How Transaction is entered
Misc. Expense	Expense acct	Debit balance	Increases	Debit
Cash	Asset Account	Debit balance	Decreases	Credit

Explanation: Since our expense accounts fall on the right side of the equation and cash falls on the left side of the equation you would think that we would need to perform the same operation to keep things balanced. The problem with this is that the expense account is a part of another account under equity. The expense account increases which decreases equity so our cash must also decrease.

Example 2

Let’s say you buy supplies using cash. How would this be recorded?

Accts Affected	Classification	Normal Balance	Changes in Balance	How Transaction is entered
Supplies	Asset	Debit balance	Increases	Debit
Cash	Asset	Debit balance	Decreases	Credit

Explanation: This one is easier to understand. All the action is on the same side of the equation, which means the transactions need to cancel each other out to stay balanced. When we increase our supplies, our cash decreases.

Example 3

This time we buy equipment on account meaning we put it on a credit card. How would this be recorded?

Accts Affected	Classification	Normal Balance	Changes in Balance	How Transaction is entered
Equipment	Asset	Debit balance	Increase	Debit
Accts Payable	Liability	Credit Balance	Increase	Credit

Explanation: Both sides of the equation increased, so we must increase each of their normal balance columns. In this way we increase the Assets (debit balance) on the left and increase the Liability (credit balance) on the right.

I know this was all math and some of you may already understand all of this, but I think it is very fun and interesting. Although, as many of my former students have pointed out to me not everyone thinks math is fun, nor does everyone think math is easy and understandable. That is why I am here. If you need help, please feel free to contact me and schedule a consultation. My contact information is below.

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Bambi Samares – Epoch Bookkeeping

Website: https://epoch-bookkeeping.com

e-mail: bambi@epoch-bookkeeping.com

Cell: 936-697-5412