What is accounting? (Claudio’s beach business)
Imagine we’re in Italy, a nice beach city, where a man called Claudio is selling souvenirs to tourists.
He only sells one item, a beautiful plate made from colorful glass.
In the morning, he leaves his home with 100 euros, and goes to the manufacturer of the souvenir.
Each plate costs one euro, so Claudio buys 100 pieces with his 100 euros.
He walks to the beach and sells the plates to tourists for five euros a piece, and by noon, he sold out.
He goes home happily and repeats the same process the next day.
After a month, he wants to know how much the business made.
- What if he sold more than one item? Which one was more profitable?
- Would it make sense to expand his business, like rent a fixed stand at the beach?
Without a way of recording the daily activities of his business, he’s not going to be able to answer these questions.
What is the income statement? (Revenue minus expenses)
Not only will each financial transaction be recorded, but Claudio will also get detailed reports, summarizing his financial performance.
We call these reports financial statements.
Let’s start with Claudio’s profitability.
If you want to find out about a business’s profitability, you go to their income statement.
This is one of the main financial statements.
There you can find out how much sales a business had in a certain period, which costs, and what was the resulting profit or loss.
There is another name you may hear for the income statement. “P&L”, for profit and loss.
It’s a fairly simple business model, and the P&L for Claudio’s business would look like this.
He sold 100 plates for five euros each.
That’s what we call sales or revenue, which were 500 euros.
The plates he sold, he didn’t get for free, right? He incurred costs to buy them.
Each plate cost him one euro.
Therefore, in total, his costs were 100 euros.
We call this the cost of goods, which we need to deduct from revenue.
To keep it simple, we don’t consider any other costs for now, like fees and taxes.
If we add this up, we can see that Claudio made a profit, or a net income of 400 euros.
That’s how a simple income statement would look like.
What is a balance sheet? (Assets, liabilities, equity)
Next, we’re going to take a quick look at the second main financial statement, the balance sheet.
The balance sheet shows which ASSETS the company owns, the LIABILITIES it owes to others, and the EQUITY that belongs to the owners.
Assets
Assets are usually things of value, or resources the company owns and uses.
For instance, land and buildings, office equipment, inventory, or cash, just to name a few.
Liabilities
Liabilities are what you owe to others.
For example, a bank loan, or what you owe to your suppliers for goods, or to the IRS in taxes.
Equity
The third component is equity.
This is a bit more abstract.
It’s the residual amount that would be left if the company sold all its assets and paid off all its liabilities.
In other words, it’s the difference between total assets and total liabilities.
This leftover money belongs to the owners of the company.
In the balance sheet, the assets are on one side, and equity and liabilities are on the other side.
If you draw a line between the two, and one on top, it looks like a T.
This is what accountants use to visualize accounting transactions.
It’s a very helpful tool, and we’re going to come back to these T accounts all the time.
You can see that the left side of the T is just as big as the right side.
That’s because everything the company owns, its assets, was purchased either from debt, so somebody else’s money, or its own money, meaning equity.
For money to go to one account, it must come out of another.
We call this a flow of economic benefit from a source to a destination.
We already said that assets minus liabilities equals equity.
If we rearrange this, like this, we get assets equal liabilities plus equity.
Both sides are always in balance, hence the name balance sheet.
And that is the foundation for any accounting system; the accounting equation.
The total amount of assets equals total liabilities plus equity.
Both sides are in balance.
What is the accounting equation? (Assets = Liabilities + Equity)
The accounting equation is Assets = Liabilities + Equity. It is the foundation of every accounting system in the world.
Everything a business owns (its assets) was funded in one of two ways:
- Through debt (liabilities): money the business owes to someone else
- Through equity: the owners’ own money plus any profit the business has kept
Both sides of the equation always stay in balance, which is why the balance sheet is called a balance sheet. If assets go up, something on the right side must also go up. If Claudio buys 100 euros of plates with 100 euros of cash, his inventory asset increases by 100 and his cash asset decreases by 100. Assets stay the same. Both sides balance.
If Claudio borrows 500 euros from a friend to expand the business, his cash asset increases by 500 and his liability (a loan payable) also increases by 500. Both sides go up equally. Still in balance.
This is the logic that double-entry accounting is built on. Every transaction has two sides, and the equation is the referee that keeps everything honest.
How does a balance sheet work? (Example)
With that in mind, let’s see how the balance sheet looks like for Claudio.
A balance sheet is always created at a certain point in time, like at the end of the business year, or at the end of a quarter.
In our example, it’s the end of Claudio’s business day.
Claudio started out with 100 euros in cash, which is also the money, or equity, he put into the business.
The cash on the left side equals equity on the right side.
The balance sheet, at this point, is in balance.
Then, he spent the cash in the morning, to buy the colorful plates.
The plates are what we call his inventory.
In the process, his cash got reduced to zero, but in exchange, he received another asset, inventory.
He didn’t get richer or poorer by that, right? The total amount of assets is still 100, but of course, his equities too.
After he sold the plates five euros each, he ended up with 500 euros in his pocket at the end of the day.
His inventory is gone because he sold all the plates to the tourists.
At the end of the day, his inventory value, therefore, is zero.
He doesn’t have any more plates.
If we look at Claudio’s balance sheet at the end of the day, we can see that the total value of assets, the left side, is 500 euros.
That’s the cash he came home with.
On the credit side, we only have 100 euros.
The balance sheet is out of balance.
As we know, this can’t be.
Both sides always need to be in balance.
So, what’s wrong here?
How is profit calculated in accounting?
The missing component is the profit he made during the day.
If you go back to the income statement, we see that Claudio’s net income was 400 euros.
This will be added to equity, why? Because due to his successful business, he made the business more valuable.
When he started out the day, it was worth only 100 euros, which was the money he put into the business when he walked out the door.
When he came home, he had sold all his plates with a profit of 400 euros.
So, his business is now worth more, which is reflected in a higher equity.
Net income is the link between the income statement and the balance sheet.
So, when we add the profit of 400 euros he achieved to equity, also the right side gets to a total of 500 euros, and the balance sheet balances like it should.
So, that’s how it would look like for Claudio at the end of his successful day at the beach.
What are debits and credits in accounting?
Debits and credits are the two sides of every accounting transaction. A debit is the destination where money flows in. A credit is the source where money flows out.
Think of it like a bank transfer. If you send 100 euros from your savings account to your checking account, the savings account is the source (credit) and the checking account is the destination (debit). Every transaction has both sides, and the total debits must always equal the total credits.
The ADEx LER memory trick
Different account types behave differently when debited or credited. The easiest way to remember which is which is the ADEx LER shortcut:
| Shortcut | Stands for | Increases with |
|---|---|---|
| ADE | Assets, Dividends, Expenses | Debits |
| LER | Liabilities, Equity, Revenue | Credits |
So if Claudio’s cash account (an Asset) goes up, it needs a debit. If his paid-in capital (Equity) goes up, it needs a credit. The totals balance automatically.
For a deep dive on the ADEx LER method, see our guide on debits and credits made easy with ADEx LER. Once the concepts click, practice with real transactions in our walkthrough on how to properly record debits and credits with examples.
Ready to try it yourself? The practice file below gives you 7 transactions for a fitness business called XelFit. Enter each journal entry with debits and credits, then check your work against the solution tab.
Practice Recording Debits and Credits
Grab the free XelFit practice file and record 7 real transactions with guided dropdowns.
Download the Free Practice FileHow do transactions flow into financial reports?
Every business activity eventually shows up on one of two reports: the income statement or the balance sheet. Here is the full flow, end to end:
- A transaction happens. Claudio buys 100 plates. XelFit pays its contractor 1,200 euros.
- The transaction is recorded as a journal entry. Each entry has a debit side and a credit side. The totals must match.
- Journal entries are posted to T-accounts. Every account has its own T. Debits go on the left, credits on the right.
- T-account balances roll up into a trial balance. The trial balance lists every account and its current balance.
- The trial balance feeds the financial statements. Revenue and expense accounts build the income statement. Asset, liability, and equity accounts build the balance sheet.
- Profit from the income statement flows to equity on the balance sheet. This is what ties the two reports together.
This is the full bookkeeping cycle. Every accounting course in the world is built on these six steps, and every business uses them daily, whether the books are on paper, in Excel, or in enterprise software like SAP.
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Accounting Basics FAQ
What is accounting in simple terms?
Accounting is the systematic recording, analysis, and reporting of financial information. It tracks money flowing in and out of a business, what the business owns (assets), and what it owes (liabilities). The goal is to show the financial health of a company so owners, investors, and regulators can make informed decisions.
What is the accounting equation?
The accounting equation is Assets = Liabilities + Equity. Everything a business owns (assets) was funded either through debt (liabilities) or the owners’ own money (equity). Both sides of the balance sheet must always equal, which is why it is called a balance sheet.
What is the difference between an income statement and a balance sheet?
The income statement shows performance over a period (a month, quarter, or year) and calculates profit as revenue minus expenses. The balance sheet shows a snapshot at one specific point in time and lists assets, liabilities, and equity. Think of the income statement as a video and the balance sheet as a photograph.
What are debits and credits in accounting?
Debits and credits are the two sides of every accounting transaction. A debit is the destination where money flows in. A credit is the source where money flows out. In double-entry accounting, every transaction has both, and the total debits must always equal the total credits.
Why are debits and credits so confusing?
The confusion comes from thinking debit means minus and credit means plus, which is wrong. Debit simply means the left side of an account, credit means the right. Whether a debit increases or decreases an account depends on the account type. Assets, Dividends, and Expenses (ADE) increase with debits. Liabilities, Equity, and Revenue (LER) increase with credits.
What is bookkeeping versus accounting?
Bookkeeping is the act of recording transactions in journals and ledgers. Accounting is the broader process that includes bookkeeping plus analysis, reporting, financial statement preparation, and interpretation of the data. Every accountant does bookkeeping, but not every bookkeeper does full accounting work.
Leila Gharani
Founder of XelPlus and ten-time Microsoft MVP. Leila helps over 500,000 professionals master Excel, Power BI, and data automation through practical, real-world training.
