The accounting equation provides a place for every transaction to settle. Most commonly, it is stated as Assets = Liabilities + Equity. Not every single transaction impacts all three elements, however. What matters is that, following the recording of a transaction, the equation continues to hold true. When you are first learning about these concepts, a good way to think about it is not just “What account goes up?” but rather, “What did the business receive, surrender, borrow, earn, or consume?”
Suppose a sole proprietor puts $2,000 into a business checking account. The asset Cash goes up $2,000, and so does the equity of the business by $2,000, because the money was added by the owner instead of being borrowed or collected from a client. The accounting equation still holds: the business has $2,000 more cash as an asset, and an equal amount of equity. Usually, this would be recorded as a debit to Cash and a credit to Owner’s Capital.
Let us say the business then buys a computer for $600 in cash. Both assets are affected. The Equipment asset increases by $600, and Cash decreases by $600. Total assets do not change, and neither do liabilities or equity. Again, notice that paying cash does not always result in an expense. The computer might provide value for more than one accounting period, and therefore we call it an asset rather than expensing the full cost immediately.
Consider the purchase of $300 worth of office supplies on credit. Supplies (an asset) go up by $300, and so does Accounts Payable (a liability). No payment has been made at this point, but we have still affected the accounting equation. Both assets and liabilities increase by $300. When the payment is eventually made, Cash goes down and Accounts Payable goes down, with the equation remaining in balance.
Revenue and expenses impact equity through operations. Suppose the business performs services and receives $450 in cash. Cash goes up and revenue goes up. The revenue account increases equity, although it is often kept in a separate temporary account during the reporting period. Next, the business pays $100 for a regular current period expense. Cash goes down, and the expense decreases equity. These transactions illustrate why cash flow and income are not the same thing. A loan increases cash, but is not revenue. A credit sale increases revenue before cash is received.
To practice, pick a sample invoice, receipt, or check and analyze it before deciding which accounts will be debited and credited. List the accounts affected, identify if they are assets, liabilities, equity, revenues, or expenses, and determine whether they increase or decrease. Next, write out the accounting equation with the updated values. Finally, create the journal entry. Doing it in this sequence will help you avoid posting it in the wrong direction and make it easier to explain your choice of debits and credits.
A helpful check is to trace the transaction through to the ledger. Make sure that both dollar amounts have been entered in the proper ledger accounts, that the reference number matches the supporting document, and that the new account balances still satisfy the accounting equation. Progress will be evident once you can explain why a transaction caused an increase or decrease before looking up a rule. The figures should balance, but so should the logic.