Financial Accounting/Session 1

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Accounting: Accounting is the art of interpreting, measuring and communicating the results of economic activities.

The Accounting Equation:

Assets = Liabilities + Owner's Equity

The resources owned by a business are its assets; for example, assets can consist of cash, inventory, land, and buildings. The rights, claims or obligations to creditors are the liabilities. The rights of the owners are called the owner's equity; the rights of the owners is the residual amount after deducting liabilities from assets.

All business transactions can be stated in terms of changes in the elements of the accounting equation. A useful way to conceptualize the accounting equation is that the left side (assets), "is what the Owner has" and the right side (liabilities + owner's equity) "is the method by which the Owner obtained the asset". For example, you have cash, inventory and buildings and you obtained it by using retained earnings(owner's equity), borrowing (liabilities), or raising capital (capital stock or contributed capital).

The Accounting equation can be re-arranged in the following ways:

Assets - Liabilities = Owner's Equity
Assets - Owner's Equity = Liabilities

Here's an example of a transaction to demonstrate the accounting equation. John has $1,000 and would like to purchase a vehicle. However, the vehicle he would like to purchase costs $10,000. So, John arranged a loan from the bank for $9,000. Thus, John is now able to pay for the vehicle for $10,000.

Now let's demonstrate the accounting equation from the economic activity from John's side. He has a vehicle worth $10,000, which is an asset on his books. However, he has a $9,000 loan which is now recorded as a liability. This liability is a obligation he owes to the bank. In addition, John contributed $1,000 towards the vehicle, creating an equity in John's books.

Therefore, the accounting equation is as follows:

10,000 Asset = 9,000 Liability + 1,000 Equity


Debits/Credits Rule This rule is based on the behaviour of accounts.

When a financial transaction is recorded, the Debits (Dr) and Credits (Cr) need to balance in order to keep the accounts in balance.

An easy rule to remember is, "Debit the Asset that Increases"

For example, if you want to practice accounting for cooking a simple breakfast, you might proceed as follows:

  • Dr the frying pan 2 egg yolks
  • Dr the frying pan 2 egg whites
  • Dr the trash basket 2 egg shells
    • Cr the carton of eggs 2 whole eggs

To record breaking the eggs and putting the eggs in the frying pan

In this transaction, an asset, (the egg) is split into parts and some of the asset goes in the pan and some in the trash. A Debit (Dr) is used to show that the assets in the pan and the trash both increase. A balancing Credit (Cr) is used to show that the amount of assets (whole eggs) in the egg carton has decreased.

This transaction is in balance because the total Credits equal the total Debits. Everything that is covered by the Debits (yolk, white and shell) is also covered by the Credits (one whole egg)

Of course if you:

  • Debit the asset that increases

Then logically you would:

  • Credit the asset that decreases
  • Credit the liability or owners equity that increases
  • Debit the liability or owners equity that decreases

A popular acronym to help accounting students to remember what to do when an account INCREASES is DEAD CURLS. It's silly, but it helps:

D - Debit INCREASES in E - Expenses A - Assets D - Dividends

C - Credit INCREASES in U - Unearned Revenue (Sometimes the 'U' will just be blank as a filler, because Unearned Revenue is technically a liability) R - Revenue L - Liabilities S - Stockholder/Owner's Equity


More about Debits

An elderly accountant had just retired. The boss was cleaning out his desk. Taped to the center of the top middle drawer was a piece of paper with the words:

  • Debits go on the Window side

i do not understand joke and debits and credits too)