General Accounting Principle

Accounting is based on a simple formula:  Assets = Liabilities + Equity

Here is how it works:  Let’s say you wanted to open a new business selling t-shirts. What is one of the first things you would need?  Equity or starting capitol.  You decide to write up a business plan and investment $10,000 into your new company.  You would then write a $10,000 check made payable to your business.  Here is how the accounting formula, using your new business, now looks:

Assets	Liabilities	Equity
Bank - $10,000	$0	$10,000

  Your asset and equity accounts changed.  Your liability account did not.

Now you have capitol, what is the next step?  Before you start selling t-shirts you need to buy some t-shirts to stock in inventory.  You decide to spend $1,000 on new t-shirts.  Now, let’s see how your business looks:

Assets	Liabilities	Equity
Bank - $9,000	$0	$10,000
Inventory - $1,000

In this scenario, only the asset account changed.  The bank account had $1,000 deducted from it and the inventory account had $1,000 worth of t-shirts added to it.  The liability and equity accounts stayed the same.

Now you have inventory, what is the next step.  Are you planning on selling t-shirts out of your car?  Of course not.  You decide that a store would work best for your type of product.  You look around and find the perfect building.  Unfortunately it costs $15,000.  Since you only have $9,000 in the bank, you decide to purchase a loan.  (In this example we’ll assume that you are financing the entire $15,000 with zero percent down.)

Here is how your business now looks:

Assets	Liabilities	Equity
Bank - $9,000	Bank Loan - $15,000	Starting Capitol - $10,000
Inventory - $1,000
Buildings - $15,000

Now let’s total everything up.  Your assets total $25,000, your liabilities total $15,000, and your equity totals $10,000.  Are you in balance?  Yes!  $25,000 = $15,000 + $10,000.

This was just a basic example of how the accounting formula works.  We will explore additional accounts (such as expense and income accounts) and how debits and credits work into the equation in a future post.