What is the fundamental accounting equation?

Project managers and project management methods are becoming more widely known, and project management successes are becoming more frequent. For this reason project managers are being given more responsibility in the businesses they work in. It has become more important that project managers treat their projects like small businesses and that they be responsible for more of the functions that were traditionally managed by others. This is because project managers are seen as being successful in what they do. Why not give them more responsibility? One of the areas where project managers need to take more responsibility is in the accounting for cost of their projects.

The fundamental accounting equation is the basis for any accounting system used in business today. These accounting systems are called double-entry accounting. This is somewhat different from the accounting system we use at home, which is single-entry accounting or cash accounting.

In a cash accounting system we make one entry for each transaction and worry about maintaining our cash balance in positive numbers. We subtract money that we spend, and we add money that we receive. As long as we maintain a positive balance, we have money in the bank and can continue to spend it. When our balance approaches zero, we have to stop spending.

In business we need to have a more accurate way of accounting for all the money and other assets and liabilities we have in our business. This brings us to the fundamental accounting equation:

Assets = Liabilities + Equity

Assets are the things of value that the company owns. These are things such as cash, equipment, property, land, accounts receivable, loans due from others, stock that is owned in other companies, and so forth. Liabilities are the things of value that the company owes to others. These are things like accounts payable, long-term loans, short-term loans, and so forth. Equity is the amount of value the company has after all of its liabilities are subtracted from its assets. The equity account is divided into stockholder equity and retained earnings. Retained earnings are monies that are held by the company to be used for anticipated expenditures. What is left after all of that is the stockholder's equity.

Each of these major areas is divided up into accounts. The various accounts are referred to as asset accounts or liability or owner's equity accounts. On the asset side we might have accounts such as cash, accounts receivable, inventory, buildings, and equipment. On the liability side we might have accounts such as accounts payable and long-term loans payable.

This equation is fundamental to all business accounting because the things called assets of the business must always be equal to the sum of the liabilities plus the owners' equity. Whenever any change is made in the business, it is called a transaction. Each transaction causes two entries to be made in the accounting system.

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The fundamental accounting equation is the basis for all accounting in business today. Any transaction that is made in the business must have two entries in the system to keep the books balanced. If, for example, one of our customers pays us $1,000 against its account, we would have one entry to reduce the accounts receivable by $1,000 and another to increase the cash account by $1,000. These are both asset accounts so to keep the accounts balanced, we have an increase of the cash account and a decrease of the accounts receivable, and the equation remains balanced.

Let us say that we have a customer who writes us a purchase order for a new project that has a purchase price of $1,000,000. Let us further say that the project's actual cost was $700,000 and that the money was divided as $400,000 material cost, $200,000 internal payroll cost, and $100,000 subcontract cost.

Let us start with the most pleasant part, the billing of the customer. When we send the invoice for the project to the customer, we make an entry in our own accounts receivable, an asset. The second entry cannot be a liability so it must increase equity by $1,000,000. Equity goes up, and assets go up. This is a good thing, but we are not done yet. We have to pay money to do the project.

We accumulate cost in the payroll due account as work is done. We do not pay all our employees at the end of each day, so this money accumulates until we write paychecks. We first make entries in payroll due that will eventually total $200,000. Each time we pay our employees for the work they do, we pay them from our cash account by writing them a check. When the employee works, the payroll due account must be increased. The second entry to balance the equation reduces the equity account. These are both on the right side of the accounting equation.

When the money is actually paid to the employees, a check is given to each employee for his or her pay. This money comes from the cash account, so it is reduced by the amount of the payroll check. The second entry is made to the payroll due account on the liability side of the equation, and it is reduced by the amount of the payroll check written. Once we have paid everyone, the payroll due account goes to zero.

When we buy material, the invoice is sent to us when the material is delivered. This causes an entry for the amount of the invoice to be made in the accounts payable account. This increases this account, and the second entry reduces the equity account. When the invoice is paid, it is paid from the cash account as were our payroll checks. The cash account is reduced by the amount of the check that is paid for the invoice due, and the accounts payable is reduced to show that the invoice was paid.

Subcontractor fees are paid like material cost. The hours that a subcontractor works are generally accumulated over a period of time, and the supplier submits an invoice for the amount due, which causes an entry in the accounts payable.

When this project is completed, all the accounts payable will be paid out of cash and the accounts payable will be reduced to zero for the project's suppliers. The invoice that went to our customer will eventually be paid, the accounts receivable relevant to the project will be reduced to zero, and the cash account will be increased by the amount of the invoice to the customer. Since we have $1,000,000 coming into our cash account, and we have only $700,000 being paid out to our suppliers and staff, we have to increase our equity account. This means that our company is making a profit.

Notice that whenever a transaction is made, there are two entries that keep the equation in balance. It is not necessary to have one entry on each side of the equal sign since both positive and negative entries can be made. If a positive entry is made on the asset side, another entry, a negative entry, must be made on the asset side or a positive entry must be made on the liability-equity side of the equation. If a negative entry is made on the asset side of the equation, a positive entry must be made on the asset side, or a negative entry must be made on the liability-equity side of the equation.

 
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