Finance Essentials: Accounting System, Accounting Equation, Debits, and Credits

To succeed in finance, one must understand the basics of (i) the Accounting System and (ii) debits/credits. At the heart of all businesses or transactions, “it goes back to the ledger”. And with that, it also is able to understand the flows between different accounts within a complete set of financial statements, which can be done through the help of the accounting equation.

The following is the simple overview of the Accrual Accounting System and the process: 
1. Journal Entries and Adjusting Journal Entries: A journal is a document in which transactions are recorded in the order they occur. A general journal is a collection of all business transactions sorted by date. Journal entries show the accounts and amounts affected as per a business transaction. Adjusting journal entries are made at the end of an accounting period to record items that have not been reflected in the accounting system.

2. General Ledger (“GL”) and T-Accounts: The ledger shows all business transactions by account. It serves as the crux of every accounting system (showing the same entries as the general journal). T-accounts are representations of the ledger used to describe accounting transactions.

3. Trial Balance (“TB”) and Adjusted Trial Balance: A TB is a document that lists account balances at a particular point in time. It is typically prepared at the end of the accounting period (showing ending balances). After the initial TB was created, an adjusted TB should be prepared.

4. Financial Statements: Final product based on adjusted TB totals. A complete set of financial statements includes Balance Sheet, Income Statement, Cash Flow, and Other Comprehensive Income.

The Accounting Equation: The following is maybe the most important equation for all finance and executive professionals. The breakdown is also provided by account. 

1. Assets (“A”) = Liabilities (“L”) + Owner’s Equity (“OE”)
2. A = L + Contributed Capital (“CC”) + Ending Retained Earnings (“RE”)
3. A = L + CC + Beginning RE + Net Income – Dividends
4. A = L + CC + Beginning RE + Revenues – Expenses – Dividends

Understanding Debits and Credits
1. A debit is an increase in assets or a decrease in liabilities or owners’ equity. Typically, increases on the left hand side of the equation or decreases on the right hand side of the equation would result in debits.

2. A credit is a decrease in assets or an increase in liabilities or owners’ equity. Typically, increases on the right hand side of the equation or decreases on the left hand side of the equation would result in credits.

3. Do keep in mind, however, that expenses affect owners’ equity in the opposite direction. For instance, increases in expenses decreases owners’ equity (and vice versa). The same applies to dividends.