Every concept in financial accounting flows from one fundamental relationship:
Assets = Liabilities + Equity
Assets are everything the business owns or controls — cash, inventory, equipment, property. Liabilities are everything the business owes — loans, accounts payable, accrued expenses. Equity is the residual interest of the owners: what would be left for shareholders if all assets were sold and all liabilities were paid off. This equation must always balance. Every single financial transaction keeps it in balance, which is why accounting is called double-entry: every entry affects at least two accounts.
The terms “debit” and “credit” do not mean good or bad, increase or decrease in isolation. Whether a debit increases or decreases an account depends entirely on what type of account it is. The DEAD CLIC mnemonic captures the rule:
This means assets and expenses have debit normal balances — a debit entry makes them go up. Liabilities, equity, and revenue have credit normal balances — a credit entry makes them go up. To reduce an account, you record the opposite: credit an asset to reduce it, debit a liability to reduce it.
Memory trick — DEAD CLIC: Debits increase Expenses, Assets, Dividends. Credits increase Liabilities, Income, Capital. Once this is memorised, every journal entry becomes logical rather than arbitrary.
Double-entry bookkeeping is the system that keeps the accounting equation permanently balanced. The rule is simple: every transaction is recorded as at least one debit and one equal credit. The total dollar amount of all debits in a transaction must equal the total dollar amount of all credits. If they do not balance, an error has been made.
This self-checking property makes double-entry bookkeeping far more reliable than single-entry systems. A trial balance — a list of all accounts and their balances — will immediately reveal whether total debits equal total credits. If they do not, at least one error exists somewhere in the ledger.
A journal entry shows which accounts are debited (Dr) and which are credited (Cr), and by how much. Here are three common examples:
| Transaction | Debit | Credit | Amount |
|---|---|---|---|
| Purchase equipment for cash | Equipment (Asset) | Cash (Asset) | $10,000 |
| Sale on credit | Accounts Receivable (Asset) | Revenue (Income) | $5,000 |
| Pay salaries | Salaries Expense (Expense) | Cash (Asset) | $3,000 |
Notice in the equipment purchase: both accounts are assets. Debit Equipment increases it; Credit Cash decreases it. Total assets stay the same — the business just converted one type of asset (cash) into another (equipment). In the credit sale, an asset (Accounts Receivable) increases while Revenue also increases — this correctly reflects that the business earned revenue but has not yet received cash.
The four core financial statements each answer a different question about the business. Together they give a complete picture of financial health.
The balance sheet is a snapshot of the business at a single point in time — typically the last day of an accounting period. It shows exactly what the business owns (assets), what it owes (liabilities), and the residual equity of the owners. The balance sheet must balance: Assets = Liabilities + Equity.
Assets are divided into current (expected to be converted to cash within one year: cash, accounts receivable, inventory, prepaid expenses) and non-current (long-lived: property, plant and equipment, intangible assets, long-term investments). Liabilities are similarly divided: current liabilities (due within one year: accounts payable, accrued liabilities, short-term debt) and non-current liabilities (long-term debt, deferred tax). Equity consists of paid-in capital (amounts invested by shareholders) plus retained earnings (accumulated net income not yet distributed as dividends).
The income statement — also called the Profit and Loss (P&L) — shows performance over a period of time (a month, a quarter, a year). It starts with revenue at the top, deducts cost of goods sold to arrive at gross profit, then deducts operating expenses to arrive at operating income. After adding or deducting interest income/expense and income tax, the final figure is net income — the “bottom line.”
Gross Profit = Revenue − Cost of Goods Sold. Operating Income = Gross Profit − Operating Expenses. Net Income = Operating Income − Interest Expense − Income Tax.
The cash flow statement explains how cash changed during the period. It has three sections:
A company can show high net income on the income statement while simultaneously having negative operating cash flow. This happens when revenue is recognised on an accrual basis before customers pay — the profit is recorded but the cash has not arrived yet. Fast-growing businesses commonly experience this pattern.
This statement explains how the equity section of the balance sheet changed during the period. The core calculation for retained earnings is:
Beginning Retained Earnings + Net Income − Dividends Paid = Ending Retained Earnings
The statement also captures other changes in equity such as new shares issued during the period or any other comprehensive income items. It bridges the income statement (net income flows into retained earnings) and the balance sheet (ending retained earnings appears in the equity section).
| Ratio | Formula | What it measures |
|---|---|---|
| Current Ratio | Current Assets / Current Liabilities | Short-term liquidity; >1 generally healthy |
| Quick Ratio | (Current Assets − Inventory) / Current Liabilities | Liquidity excluding inventory |
| Return on Equity (ROE) | Net Income / Shareholders’ Equity | Profit generated per dollar of equity |
| Debt-to-Equity | Total Debt / Total Equity | Financial leverage |
| Gross Profit Margin | Gross Profit / Revenue × 100% | Profitability after cost of goods sold |
| Inventory Turnover | COGS / Average Inventory | How quickly inventory is sold |
The current ratio and quick ratio measure a company’s ability to meet short-term obligations. The quick ratio is more conservative because inventory (the least liquid current asset) is excluded — some inventory cannot be quickly converted to cash at full value. Inventory turnover varies widely by industry: a supermarket might turn over inventory 20 times per year, while a jeweller might turn over inventory 2 or 3 times.
When a business purchases a long-term asset such as equipment or a vehicle, the cost is not recorded as an expense immediately. Instead, it is spread over the asset’s useful life through depreciation. Three common methods:
Key point: Depreciation is a non-cash expense. It reduces net income on the income statement but does not reduce cash. This is why it is added back to net income when calculating operating cash flow on the cash flow statement.
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Take the Free Accounting Practice TestDebits and credits are not inherently good or bad — they are directions of entry in double-entry bookkeeping. Whether a debit increases or decreases an account depends entirely on the account type. Debits increase asset and expense accounts. Credits increase liability, equity, and revenue accounts. The opposite entry decreases each account.
Cash accounting records transactions when cash physically changes hands — revenue when received, expenses when paid. Accrual accounting records revenue when it is earned and expenses when they are incurred, regardless of when the cash actually moves. Most businesses above a certain size are required to use accrual accounting under GAAP or IFRS, because it gives a more accurate picture of financial performance.
Because profit is calculated on an accrual basis. Revenue is recorded when earned, not when cash is collected. If a company has made many sales on credit but customers have not yet paid, the income statement shows high profit while the cash flow statement shows little or no cash coming in. This is particularly common in fast-growing businesses where sales are outpacing cash collections.
The bottom line refers to net income — the final figure on the income statement after all revenues have been counted and all expenses, interest, and taxes have been deducted. It is called the bottom line because it literally appears at the bottom of the income statement. A positive bottom line means the company was profitable during the period; a negative bottom line means it ran at a net loss.