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Establishing a causal relation behind the dreaded Accounting Equation.

Assets = Liabilities + Owners Equity

This is where we were wedged today, when a student in my executive management class called out, that he has so far not been able to establish any causal relationship between “Debits & Credits”, “Income & Expenses" or “Assets & liabilities" as some accountants may say there is. And that, most concepts seem so forced in management accounting unlike in science where every hypothesis is put to test, and that for every effect that science explains, there is always a cause that is scientifically known to be proven based on empirical study.

I took no offence to his observation because I knew most people who have shallow knowledge of accounting grow up to the same belief, and often, study of accounting, to them, becomes one of those boring and complex subjects which an average student would like to be done with ASAP, expecting never to look back to those tormenting years ever again. Quite on the contrary, I have always found passion in studying this branch of finance, and therefore took this challenge in the class to explain the causal relationship to my science student, that translates at the end to the Accounting Equation which most text books qualify as just Assets = Liabilities + Owners Equity. However, the foundations of this equation comes from a transactional cause and effect relationship which most books ignore to explain, leading to these concepts of accounting seem like they are being thrust on, rather than following a logic - quite like my student’s take on science.

So I asked my dear student, if he relates to Newton’s 3rd law - that for every action, there is an equal and opposite reaction? To which he said yes, and therefore the analogy that followed was, if Newtons third law was to apply to business, then “whatever could potential go out from business must necessarily be equal to what comes into business”. It took a little while for him to digest what I said, but I assume he quickly played the cause and effect math in his mind before affirming. Hence what went to the white board is this cause and effect relationship which we decided to bisect further till we reached the accounting equation.

The class was then asked to think loud of all possible sources from where resources could come into business. By this time they had found a newfound interest on the subject and answers started flowing in more easily than before, like bank loan, personal funds, shares, corporate debt, sales etc . Of course, no answer was wrong, but I particular picked my science student and asked him if all answers could be clubbed into two broader heads - “What is Earned by Business” plus what is “Borrowed by Business”?And of what is borrowed by business can it be further classified as either “borrowed from owners” or “borrowed from outsiders”? The answer was obviously yes. Similarly, substantiating for the right hand side of the equation the class concluded that whatever is consumed by business could be either “Stored”, or “Spent” or “Lost”. The above equations could thus be also expressed as:

Now for the first time during this discussion we used some of the terms accountants use. Re-writing left hand side of the equation we used the term “Revenue" for what is earned, “Equity” for what is contributed by owners and “Debt” for what is borrowed from outsiders. Likewise, for the right-hand side of the equation an accountant would term what is stored as “Asset”, what is spent as “Expenses” and what is lost as “Losses”. Rewriting the same stuff what the equations translated to was:

By this time the class was thinking, their scientific minds were already converging on the otherwise dreaded and boring subject being discussed here. So when they were asked to apply some basic math and play around with this equation, they did with more eagerness. They were asked, if they see PnL and Balance Sheet embedded in the same equation and surprisingly it wasn’t hard for them to figure it out and the above equation emerged into:

This was the accounting equation we had started to derive using Newton’s third law and we were successful in doing so. For a change, accounting had turned a little more interesting for these working executives who were mostly software engineers. The class had been able to put some life on a subject that otherwise, had started becoming dreadfully boring.

However, the fun was not yet over as my curious science student seemed still not very convinced, as he asked another question – If we credit ‘who gives to business’ and debit ‘what is given’, then why do we write “Debit” before “Credit when we journalize? Because after all if Credit is the Cause and Debit is the Effect, then science would decide to express Credit (cause) before Debit (effect), and not the reverse, since without a cause there can't be an effect.

As insane as the questions seemed to me, I still acknowledged his reasoning, and told him that even though 'cause' should logically precede 'effect', however as humans we never ponder on a cause till we see the effect that it has resulted into. Even Newton saw the apple falling (which was the effect) before he pondered on what could be the cause. And therefore, as accountants we have embraced the behavioral view of science too in defining our rules.

Sincerely hoping, that when the class meets next in 2020, we all shall experience more inclusive sessions filled with even more thought provoking questions, turning accounting as a body of knowledge, more interesting than what it seems.

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