When I went from Philosophy to Accounting, I thought I would find certainty and truth. Alas, in accounting I found one absolute TRUTH (now keep in mind, my research isn’t exhaustive). Luca Pacioli, an Italian mathematician, first published this equation in 1494, and it’s been THE method of accountants and bookkeepers ever since.
Another way of saying this is: everything you own less everything you owe is what you’re worth. When you list your assets, liabilities and equity together on paper, it’s usually called a “balance sheet”. It’s a snapshot of your business just as if you had snapped a picture. It tells nothing of the past, nothing of the activities, and nothing of the future. A snapshot. Obviously, if you want to know how your business is doing (and the IRS has a big interest in this little tidbit), you’re going to need something else.
The second part of Luca’s clever little idea: Income and Expenses. These aren’t like snapshots — they’re more like a video. They record a period of time — a day, a month, a year. Income less expenses equals your profit or loss, and this is called an Income Statement. Profit or loss then fits into equity on the balance sheet. And in a good and perfect world, Debits = Credits.
Other than a brief accounting lesson, the point of this is that when people set up their accounting on a computer (and ALL computer accounting programs are based on this method whether they let you know or not) without an understanding of this, strange and scary things happen. I have clients bring in an income statement to me off of their Quickbooks program. I say, “where’s the balance sheet?” They say, “Oh, it’s so messed up that I can’t make heads or tails of it.” What they don’t understand is that is all fits together. You can’t trust the income statement if the balance sheet is screwed up.
Now this isn’t to say that you can’t by “hand” keep up with your income and expenses, and have a quite good summary of your business. It can easily be done. And I suggest that business owners begin that way. It never hurts to understand your business.