The equation behind every set of books
Everything a business owns came from somewhere: either from its owner's money or from other parties who lent to it or sold to it on credit. This simple idea is the accounting equation:
Assets = Liabilities + Equity
- Assets: what the business owns and expects to benefit from, such as cash, inventory, accounts receivable and equipment.
- Liabilities: what it owes to others, such as suppliers, loans and tax payable.
- Equity: the owner's share, including capital and retained earnings. It increases with revenue and decreases with expenses and drawings.
The equation never goes out of balance if transactions are recorded correctly, because every transaction affects at least two sides by the same amount.
Double entry: every debit has a credit
Double-entry bookkeeping means every transaction is recorded in two or more accounts, so that total debits equal total credits. The practical rule accountants memorize:
- Assets and expenses: increase with a debit and decrease with a credit.
- Liabilities, equity and revenue: increase with a credit and decrease with a debit.
If debits equal credits in every entry, the equation stays balanced automatically, and the trial balance will balance at the end of the period.
Worked example: an auto parts store in its first month
Someone opened a store selling auto spare parts, and the following transactions took place in the first month (figures before VAT to keep the idea simple):
- The owner deposited 200,000 SAR in cash as capital.
- Bought goods on credit from a supplier for 80,000 SAR.
- Sold goods costing 30,000 SAR for 45,000 SAR in cash.
- Paid the supplier 50,000 SAR.
- Paid the shop's rent for the month, 6,000 SAR.
| Transaction | Assets | Liabilities | Equity |
|---|---|---|---|
| 1. Capital | 200,000 | 0 | 200,000 |
| 2. Credit purchase | 280,000 | 80,000 | 200,000 |
| 3. Cash sale (profit 15,000) | 295,000 | 80,000 | 215,000 |
| 4. Payment to supplier | 245,000 | 30,000 | 215,000 |
| 5. Rent payment | 239,000 | 30,000 | 209,000 |
After every line: Assets = Liabilities + Equity. At the end of the month: 239,000 = 30,000 + 209,000.
Journal entries for the same transactions
Now we turn the transactions into double entries as they are recorded in the general journal:
| Transaction | Debit | Credit | Amount |
|---|---|---|---|
| 1 | Cash on hand | Capital | 200,000 |
| 2 | Inventory | Accounts payable | 80,000 |
| 3a | Cash on hand | Sales | 45,000 |
| 3b | Cost of sales | Inventory | 30,000 |
| 4 | Accounts payable | Cash on hand | 50,000 |
| 5 | Rent expense | Cash on hand | 6,000 |
Notice that the sale needed two entries under the perpetual inventory system: one for the revenue and one for the cost of the goods that left inventory. The difference between them (15,000 SAR) is the gross profit that increased equity.
Where does VAT come in?
In practice, a store registered for Value Added Tax (VAT) collects 15% on top of the selling price. This tax is not revenue for the store; it is a liability that the store pays over to ZATCA. If it sold a part for 10,000 SAR before VAT:
| Account | Debit | Credit |
|---|---|---|
| Cash on hand | 11,500 | |
| Sales | 10,000 | |
| VAT payable | 1,500 |
Assets increased by 11,500, liabilities increased by 1,500, and equity increased by 10,000 from the revenue. The equation is still balanced.
Beginner mistakes in applying double entry
Now that you understand the equation, these are the mistakes we see most often among accountants early in their careers. All of them relate to understanding the nature of the account, not to the arithmetic:
- Recording purchases directly as an expense: goods bought for resale are an asset (inventory) until they are sold, and only then do they become cost of sales. Recording them as an expense lowers profit in the month of purchase and inflates it in the month of sale.
- Treating a loan as revenue: the amount received from the bank increases cash and increases liabilities, and has nothing to do with revenue. Revenue comes from selling goods or providing a service.
- Mixing the owner's money with the business's money: when the owner pays his home electricity bill from the shop's cash box, that is drawings, which reduce equity, not an electricity expense of the business. The separate entity principle means the business is a separate entity from its owner.
- Recording a purchase of equipment entirely as an expense: a display refrigerator costing 18,000 SAR serves for years, so it is a fixed asset spread over its useful life through depreciation.
A quick check before posting any entry: ask yourself three questions. Which accounts are affected? Did each account increase or decrease? And which side reflects that increase or decrease, given the account's nature? If you can answer all three clearly, the entry is most likely correct. If you hesitate on any of them, go back to the source document before recording.