Ok, the basic accounting equation Assets = Liabilities + Equity. Got it. For every debit there will always be a credit and vice-versa. Got it. But there’s something I’m not understanding:
There are the Balance Sheet accounts that fall under the three main categories of Asset, Liability and Equity. There are also Income Statement accounts documenting Revenue and Expenses. Now to take a trivially simple transaction as an example, the company sells something and so Cash (an asset) is debited and the corresponding Revenue account is credited. Got that.
But here’s what I don’t get: Cash (an asset account) has changed in value, it’s bigger than before. So why isn’t the balance sheet now out of balance? An asset has increased but there has been no corresponding increase in either liability or equity. Sure eventually at the end of the fiscal year the Revenue (technically, the Earnings) account will be closed out to the appropriate equity account. And if you count ALL debits and credits, balance sheet and income statement accounts together, they’ll balance. But just the balance sheet by itself would seem to be out of balance. What am I misunderstanding?
You are seriously all over the place with this. It’s confusing for most people at first; there are much more experienced accountants on the bord than me(I’m just a student) so probably one of them will be able to answer it for you.
Yes, simplifying. This also doesn’t consider APIC, OCI, for profit vs. not for profit, Statutory accounting, government accounting, or other various nuance.
If you sell something, both transactions take place on the same side of the equation.
You add cash to your assets and you subtract whatever you sold from the assets as well. That, in and of itself, nets zero. There are some other things to go along with it to show profit, but if you just what to keep it simple, that’s how you do it.
While that could loosely be true if selling inventory or other fixed assets that’s not really a good response to the question posed.
Selling an item need not be a credit to assets. The basic tansaction is described just fine in the OP.
Again simplifying:
DR cash
CR revenue
(Record sale)
DR revenue
CR retained earnings
(close net income to equity assuming only 1 transaction)
The second transaction happens when you close a reporting period and roll your balances. Since the balance sheet is at a point in time closing net income to retained earnings is required to present the BS correctly. This is assuming a US GAAP company.
If you sell something (a car) for it’s book value of 100, only the assets change (Car -100, Cash +100)
If you sell for a gain/loss, the Liabilities & Equity side change through retained earnings by the gain/loss. (Car -100, Cash +120, Equity +20) (This last part as Bone said goes through your income statement and then to your balance sheet when retained earnings is calculated, so it’s not a direct balance sheet entry.
In order to get a better understanding of things, I think it will be best if you look at everything separately first. I will start with the basic equation and the balancing of it; and then go on to the financial statements.
Debit and Credit mean left and right - that’s it.
In the basic accounting equation debits *increase * the left side (assets) of the equation and **credits ** increase the right side (liability and equity) in your example.
A simple example would be performing a service for cash for $2. In this situation, you would debit cash and credit service revenue. Cash is an asset account on the left side of the equation, so debiting cash means add 2 to the left side. Revenue is an equity account on the right side of the equation so crediting revenue means adding 2 to the right side. Therefore you have added 2 to the left side of the equal sign and also added 2 to the right side. Where most people get confused, and I did also in the beginning is the fact that debit and credit will add to or subtract from an account depending upon the account, so that’s why it is important to keep in mind that debit and credit only mean left and right not plus or minus.
In your example, you are saying there is no increase in a liability or an equity; but there is - revenue is the equity account being increased. Crediting revenue means increasing revenue.
In the financial statement part, you are confusing what balance sheets and income statements do. A balance sheet and an income statement do not have the same accounts. Certain accounts are balance sheet accounts, certain accounts are income statement accounts. They are derived from the equation. The result of closing out entries is to update retained earnings which goes on the balance sheet, but you do not take the balance sheet and income statement and balance them together. In regards to balancing of financial statements, the balance sheet needs to balance in such a way that assets equal liabilities and equity. The income statement and income statement accounts are not directly involved in this but are only involved to the extent that they increase or decrease a single equity account - retained earnings.
I was just trying to over simplify it to remind the OP that both transactions can happen on the same side of the equation. That seemed to me to be the reason why he didn’t understand why his balance sheet was out of balance.
He said:
Which, IMO, is a typical thing someone that just started Accounting (like within the past few weeks) would say if they didn’t know that you could also subtract the thing you sold from assets as well. People would similarly get tripped up if they subtracted the thing they sold from Assets and then didn’t know what to do with the cash that the business put into their bank account.
I think he or she is missing the part where you add to the other side of the equation, not where you add and subtract from the same side. I am using a service revenue example above because that is a more simple transaction, only affecting 2 accounts.
In a product sale you then have 2 entries and four accounts affected Sales Revenue, Cost of Goods Sold, Inventory and Cash(or A/R if payment is on terms).
No, that is incorrect; kind of on the right track, but you have things backwards. You’re misapplying debits and credits and leaving out portions. Should be:
This isn’t actually that complicated. Lumpy has a basic grasp of transaction flow described in the OP. Here is the fact pattern:
Now to take a trivially simple transaction as an example, the company sells something and so Cash (an asset) is debited and the corresponding Revenue account is credited. Got that.
There are only two questions presented:
[ol]
[li]So why isn’t the balance sheet now out of balance? [/li][li]What am I misunderstanding?[/li][/ol]
The answer is straightforward, no need to get into AR, asset sales, or anything like that. The answer is that when you prepare your balance sheet, net income from the P&L is closed to retained earnings which is part of equity on the balance sheet.
Check out this illustration. Ignore the cash flow statement as it wasn’t part of your question. The only complication here is that retained earnings in this sample didn’t start at zero, it has a value from prior period.
So you’re saying you don’t worry about the balance sheet until you’re ready to prepare a balance statement, and then you do update the retained earnings so it balances?
Say I own a used car lot. One day I buy a used car for five hundred dollars. My assets have been reduced by five hundred dollars in cash and raised by the value of the car. To balance my books, do I assign a value of five hundred dollars to the car because that’s what I paid for it? And when I’m figuring up the total value of my inventory of cars do I use that value?
Now three months later, I sell that car for a thousand dollars. My assets are now reduced by one car and raised by a thousand dollars. Was the car still worth five hundred dollars when I sold it or did it rise in value to the price it sold for? Was it really worth five hundred dollars when I held it in my inventory or should I have valued it at a thousand dollars?
Yes. You can’t appropriately prepare a balance sheet without also preparing and determining the impact of net income to retained earnings. If you are preparing a balance sheet, it is assumed that you have also prepared your P&L. If you are using software to do this, anytime you run your B/S it will perform this for you for presentation purposes. If you are doing it manually with Excel, have the B/S on one tab and the P&L on another tab. Have the net income flow into the retained earnings section of equity and your statements will balance.
As long as you are doing double sided accounting (debits match credits) then your statements should balance.
Under GAAP you would use the cost basis for inventory - inventory would be valued at the price you paid.
For the second part of your question, you add another account, gain on sale, which is an equity account.
Debit cash 1000
Credit Gain on sale 500 and credit inventory 500
There is more that can be said about this; but for simplicity sake this should be sufficient to answer your question.
