Understanding the Relationship between Assets, Liabilities, Income and Expenses
Perhaps one of the most difficult concepts to understand in beginning accounting is the relationship between assets, liabilities, income and expenses. I discovered the most lucid explanation of this relationship in Robert T. Kiyosaki's book Cash Flow Quadrant. Let's define these terms in a way that is easier to grasp. Kiyosaki defines an asset as something that puts money into your pocket. That is, assets generate income. Conversely, liabilities take money out of your pocket. Expenses not paid with cash generate liabilities. For example, the mortgage on your home is a liability; so is the outstanding balance on your credit cards.
In the double-entry accounting system customarily used by business and taught in accounting classes, the assets and income must counter-balance each other. In a solvent business, assets acquired are recorded as a debit amount; income is entered as a credit amount. To counterbalance the asset and liability entries, we enter income as a credit amount and expenses as debit amounts. What do we mean by debit and credit. The terms go back to the old manual accounting forms used by business in the days before personal computers. Your personal checkbook register is an example of such a form. Debits are always recorded in the left column; credits are recorded in the right column. Some forms, such as the checkbook register have a running balance column to the right of the debit and credit columns. Some accounting textbooks try to teach debits and credits as positive and negative which, in my opinion, causes more confusion than clarification for the accounting student.
Kiyosaki's definition also allows the accounting student to better see the relationship's in the Basic Accounting Equation:
Assets = Liability + Equity
Other names you may see for equity are net worth and retained earnings. Assets as we said earlier, have debit balances; liabilities and equity have credit balances. Thus, we could rewrite the above equation as
Debits = Credits
In a double-entry accounting system the total amount of all debit postings must be equal to the total amount credit postings or there is an error in the books. This what we refer to as the books being out of balance.
* assets put money in your pocket and are recorded as debit amounts,
* the corresponding income is recorded as credit amounts,
* liabilities take money out of your pocket and are recorded as credit amounts, and
* the corresponding expenses are recorded as debit amounts.
* Finally, equity or net worth is recorded as a credit amount.