Accounting Income Is Generally Equal To Operating Cash Flow Understanding Double Entry Accounting

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Understanding Double Entry Accounting

Sir Isaac Newton’s third law of motion, the law of reciprocation, states that for every action there is an equal and opposite reaction. The same can be said for accounting. Every financial transaction has two sides. There is a debit side and a credit side. For every transaction, these sides must be equal to balance your books.

To understand double entry accounting, you must first understand what a debit is and what a credit is. Simply put, debit is money you own or owe to you, and credit is money you owe someone else. Let’s look at different types of business accounts.

Assets – These are debit items because they are items owned by the company. An increase in an asset is a debit and a decrease in an asset is a credit.

Liabilities – These are credit items because they are items that the business owes to someone else. An increase in liabilities is a credit and a decrease in liabilities is a debit.

Owner’s Equity – This is a credit account because the balance in the owner’s equity account is money owed by the business to the owner of the business. An increase in owner’s equity is a credit and a decrease in owner’s equity is a debit.

Expenses – These are debit items because the purchase of expense items reduces the asset item (eg cash in bank) which is the credit site of the transaction.

Revenue – These are credit items because the receipt of revenue increases the asset item (eg cash at bank) which is the debit side of the transaction.

Let’s look at a simple example:

Suppose you want to go to the store to buy a bottle of milk, which costs $3. Your purchase of milk is a financial transaction. Before you go to the store, you own $3 so this is a debit item, balanced by owner’s equity.

When you go to the store and pick up a bottle of milk, you now have a bottle of milk, which costs $3, and you owe the store owner $3. So, the bottle of milk is a debit and the $3 you have is a credit.

When you pay the shop owner for a bottle of milk, you reduce the amount you own (a debit item will be credited) as well as the amount you owe (a credit item will be debited).

Note that at each stage of the transaction, the debit and credit sides of the transaction are equal, and the balances of all accounts are equal on the debit and credit sides.

So what happens after drinking a bottle of milk? You no longer have a $3 bottle of milk; You have an empty bottle worth nothing! This is why we have expense accounts. Assets, which are debit items, are things that are owned by the business for a long period of time. Expenses, which are also debit items, are things that the business owns for a short period of time before they are used.

That’s why we have two separate key reports for businesses. A balance sheet is used for items that are fixed in a business. A profit and loss statement (or income and expense statement) is used to account for items that come in and out of a business on a regular basis. The resulting balance of the profit and loss statement is kept in the capital section of the balance sheet to balance the items.

Another report you’ve probably heard of is the trial balance. It is used to ensure that you have not made a mistake before preparing the balance sheet and profit and loss statement. At the end of the accounting period, this report maintains the closing balance of all your accounts (assets, liabilities, owner’s equity, expenses, and revenues) to ensure that your debits equal your credits. If they don’t, then you know you made a mistake somewhere and you need to find your mistake before creating the main report. The total of the debit column should equal the total of the debit column.

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