The accounting equation is essentially a formulaic representation of a company's balance sheet. This equation is that assets must equal liabilities, plus equity. As its name suggests the balance sheet must always balance to ensure that it does each and every transaction of a company must have at least two effects on the balance sheet so that it remains in balance. For example, if a company takes out a bank loan, its asset of cash will increase since it now owns that asset. But its liabilities will increase by the amount it owes back to the bank. Keeping the balance sheet in balance. And if the company buys a machine with that cash, one asset cash will go down, but another asset equipment will go up. Again, keeping the balance sheet in balance, accountants use a double entry bookkeeping system using debits and credits. For every debit, there has to be a corresponding credit to ensure that the left hand side of the ledger, the debits balances with the right hand side. The credits, all accounts will either be a debit or credit balance by nature, looking at the balance sheet assets or debit balances, while liabilities and equity are credit balances. So a transaction that results in a debit to an asset balance means it increases that balance. Whereas a credit decreases an asset balance for liabilities and equity, a debit will decrease the account balance while a credit will increase the balance.

This might sound a little confusing if you have not studied accounting, but the good news is that you don't need to understand the intricacies of debits and credits to analyze financial accounts. What is important to understand is how transactions actually impact assets, liabilities, and equity. What will increase and what will decrease in order to keep the accounting equation in balance. Now, you might be wondering about income statement items. Are they recorded in terms of debits and credits too? And how does the income statement impact the balance sheet? Absolutely. Income items are credits and expenses are debits, but what is More important is how income statement transactions impact our balance sheets. The bottom line of the income statement, net profit, gets added on to the retained earnings balance, which is part of equity. At the end of the period, these profits belong to shareholders, and so they are added on to the equity balance in the balance sheet. So anything that makes profit in the income statement go down is ultimately a reduction to retained earnings and therefore equity. The opposite is true for income items.

To illustrate this, let's say a company pays salaries of a million dollars in cash. The first part of this transaction is to reduce the cash balance on the balance sheet by 1 million, but we now need a balancing entry. Salaries are an expense in the income statement. They reduce the net profit of the company. As just mentioned, net profit feeds through to equity in the balance sheet. Anything that reduces net profit ultimately reduces equity. So the corresponding entry in our example is to reduce equity, specifically retained earnings. Cash is down 1 million. The asset side of the accounting equation and equity is down 1 million. The liabilities plus equity side of the accounting equation. And so we have honored this golden rule of accounting.