Basic accounting theory

From time to time I will refer to basic accounting theory. Here is what I mean.

  • Debits and credits, and how they always equal each other.
  • The chart of accounts (COA). This is a list of categories that are assigned to financial transactions. The categories are called accounts in accounting parlance, and I will refer to them as accounts, not as categories.
  • Account types within the COA (I could have said category types, but I said I wasn’t going to do that). The types are asset, liability, equity, income, COGS, expense, other income, other expense.
  • Normal balance for the account types (again, I could have said category types…). Assets, COGS, expense, and other expense have balances that will be represented as debits under normal conditions. Liabilities, equity, income, and other income have balances that will be represented as credits under normal conditions.
  • Whether accounts in the COA belong on the Balance Sheet or Income Statement. Assets, liabilities, and equity belong to the Balance Sheet. The others belong to the Income Statement.
  • The accounting equation (assets = liabilities + equity).
  • The relationship of the Income Statement to the Balance Sheet.

It is basic because it is the foundation. Everything else in accounting is built on this. It is also irreformable. The FASB isn’t going to say that liability accounts now have normal debit balances, or that we’re no longer going to be using credits in accounting, or that Revenue now belongs in the asset section of the Balance Sheet, or that Net Income will now flow to Accounts Payable instead of to Retained Earnings. There is nothing ad hoc about this system, nothing added for a particular case or without thought for future ramifications.

yin yang debits credits
Here is the Balance Sheet in an aesthetic format.

If any one of the items above gets deleted or has its nature changed, the entire system collapses. Like one of those puzzle balls, it is a unified whole. The yin-yang image conveys the same idea. It is a aesthetic way to represent the Balance Sheet. The white equals the black. Assets equal liabilities plus equity. Assets have normal debit balances, and liabilities and equity have normal credit balances.

See the black dot on the white side, and the white dot on the black side? That shows how there will be some credit balances in the asset side, and some debit balances on the liability/equity side. We call those “contra-accounts.” The squigly line down the center is the COA.

I hope the yin-yang symbol doesn’t scare-off people with a Western view of the world. It is simply a representation of the duality of life, hot and cold, light and dark, male and female, life and death, order and chaos, etc. Debits and credits are financial aspects of this duality.

If you’re new to accounting theory, I recommend meditating on the image and what I’ve said here. Let me know if it helps things “click” for you.