The accounting equation and double-entry bookkeeping

All of accounting rests on a very simple equality. Once you understand it well, financial statements, journal entries and a good part of the exam become much more logical.

The accounting equation

\text{Assets} = \text{Liabilities} + \text{Stockholders' equity}

Assets: the resources the entity controls, resulting from past transactions, from which it expects future economic benefits. For example: cash, accounts receivable, inventory and machinery.
Liabilities: the entity's present obligations, expected to be settled by giving up resources. For example: accounts payable to suppliers, bank loans and taxes payable.
Stockholders' equity (capital contable in Mexico): what remains of the assets after subtracting the liabilities; it is the owners' share (their contributions plus retained earnings).

The formal definitions of these elements are in the Conceptual Framework of the NIF (Normas de Información Financiera, Mexico's Financial Reporting Standards), issued by the CINIF (the Mexican Financial Reporting Standards Board).

Double-entry bookkeeping

Double entry is the method that keeps the equation in balance: every transaction affects at least two accounts, so the equality never breaks.

Let's look at the first transactions of a fictional stationery store (amounts in Mexican pesos):

#	Transaction	Assets	Liabilities	Stockholders' equity
1	Partners contribute $100,000 in cash	+100,000 (cash in bank)		+100,000 (capital stock)
2	Merchandise bought on credit for $30,000	+30,000 (inventory)	+30,000 (suppliers)
3	$10,000 paid to suppliers	−10,000 (cash in bank)	−10,000 (suppliers)
4	Computer equipment bought in cash, $15,000	+15,000 (equipment) and −15,000 (cash)
	Ending balances	120,000	20,000	100,000

At the end: $120,000 = $20,000 + $100,000. Transaction 4 doesn't even change total assets: it only changes their mix (less cash, more equipment).

Debits and credits

In practice, double entry is recorded with debits (the left side of the account; cargo or debe in Spanish) and credits (the right side; abono or haber). In every entry, total debits equal total credits.

Account type	Increases with	Decreases with
Assets	Debit	Credit
Liabilities	Credit	Debit
Stockholders' equity	Credit	Debit

For example, transaction 2 (merchandise bought on credit) is recorded with a debit to inventory of $30,000 (an asset increases) and a credit to suppliers of $30,000 (a liability increases).

Summary

Assets = Liabilities + Stockholders' equity, always.
Every transaction affects at least two accounts (double entry).
Assets increase with debits; liabilities and equity increase with credits.

The accounting equation and double-entry bookkeeping