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Accounting tracks the value of a business's or an individual's finances using a method called double-entry. At its most basic, double-entry accounting is an algebraic equation consisting of x = y + z. This system was first published in the 15th century by Luca Pacioli to describe the accounting method Venetian merchants used.
The fundamental algebraic equation in accounting is "assets = liability + capital." Capital is commonly called equity. If the only thing you own is a car, and you are making car payments, you can use this formula to depict this particular financial situation as the car's market value = the amount you owe + equity, or $15,000 = $10,000 + $5,000. Accountants refer to the equal amount on both sides of the equation as "balance."
Say you open a savings account with $1,000. You now can add this amount to your equation on both sides, as (x + 1,000) = (y + z + 1,000), or $16,000 = $10,000 + $6,000. You still only have $5,000 equity in your car, but you have another $1,000 in capital.
Debits and Credits
Accountants refer to entries as "debits" and "credits." They always enter at least one debit and at least one credit to balance the equation. If you buy a new computer and spend $700 on it, you need to debit your assets to reflect the new total of $16,700. To make the equation balance, you need to add a third column to indicate expenses paid. The algebraic equation becomes [(x + 1,000) + 700] = (y + z + 1,000) + 700.
As you make monthly car payments, you change amounts on the right side to reflect this. Over time, your equation might read, $16,700 (car's market value + your savings account + computer) = $7,000 (amount you owe on the car) + $8,000 (your equity in the car) + $1,000 (your original capital) + $700 (the expenses you paid for the computer).
The algebraic equation becomes more complicated as more factors are added. For instance, the car depreciates. After a couple of years, the car is only worth $12,000. An individual keeping track of personal finances may not feel the need to be so precise, but business accountants definitely must be. They'll add a factor of depreciation on both sides of the equation.
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