I don’t have a CPA so my qualifications in tax accounting are suspect. Most of what I know about tax accounting I picked up in my free time in the office.
Okay, okay, okay. That’s not entirely true. I have an undergraduate degree in accounting so it’s not like I’m completely toothless; but I’m still a lawyer that plays at accounting. Truth be told though, I actually found tax accounting more satisfying than tax lawyering. Tax law was always gray areas and “I don’t knows” where accounting always seemed like fun puzzles.
Now, this isn’t going to be a very orthodox way of approaching tax accounting. If anything, all of my tax accounting posts will just be enough to get someone by. I approach accounting with one main premise: what is the most accurate way of conveying information to someone reviewing a financial statement. More often than not this premise will lead you to the right answer (and should lead you to the right answer). At the very least, it gives you a framework to ask why the actual answer is different than the one that the premise seems to suggest to you. Ultimately, to get the correct answer you would have to consult the accountants, but it’s good to have the basic tools to have that discussion.
On to the very, very basics. I’m pretty sure that many of you have heard of debits and credits. If you haven’t heard of those concepts, you’ve probably heard of their synonyms: left and right. So, like port and starboard, accountants just gave new names for the terms left and right, yin and yang, Tom and Jerry. At the end of the day, one of the most important rules of accountingness is to make sure that your debits and credits are in balance. That is, every account that is a debit must also have an offset that is a credit.
The second basic layer of accountingly is that Assets = Liabilities + Equity. This must also always be in a balance.
Now, before trying to simplify this, I’m going to confuse you by layering the debits and credits into this equation. As a general rule, debits increase Assets and decrease Liabilities and Equity. On the flip side, credits generally decrease Assets and increase Liabilities and Equities.
These paragraphs are probably a meaningless jumble to you. However, there is a handy-dandy tool that you can use to help you sort out these things.
How? What? How? Three excellent questions. This chart layers the debits and credits on the left and right hand side of the fundamental accounting equation. Here are a couple of things to remember about the chart:
- Greens increase the part of the equation it lines up with; Reddish/Pinkish decreases it.
- When doing an entry, the sum of the left side must be equal the sum of the right side.
Let’s take an example. You borrow $100. Easy enough, by borrowing $100 you now have $100 of cash. Cash is an asset; therefore, you debit cash for 100. Since you borrowed money, your liabilities went up and therefore, you credit liabilities for 100. This is illustrated as follows:
You now have your first balance sheet! Debits equal credits and Assets of 100 is equal to liabilities of 100.
Understanding the basic debit/credit stuff is fairly important to understanding more advanced tax accounting entries so I’ll stop here. However, I have illustrated a few of the important accounts that are important in the tax world just so you can have a preview of where they fall in this debit/credit world and what we’ll be talking about in the future.