Lesson 1 in the Basic Accounting series:
Understanding basic accounting concepts is a must for every small business owner.
Even if you have an accountant that takes care of that “accounting stuff”, you need to know business accounting basics such as debits and credits and some accounting terminology.
Foundation of Basic Accounting Concepts:
The basic accounting equation is the foundation of all basic accounting concepts.
The financial position of all companies both large and small, while similar, are calculated slightly differently depending on the business entity:
For sole proprietorships: Assets = Liabilities + Owner’s Equity
For corporations: Assets = Liabilities + Stockholders’ Equity
- Assets are what a company owns
- Liability accounts are what a company owes
- Owner’s Equity or Stockholder’s Equity is the difference between total assets and liabilities.
Learn more about accounting basic terms.
An example of this accounting equation for a small business owner:
You buy a computer (an asset) for $5,000. If you borrowed $3,000 (a liability) and paid the balance with your savings, here is what the accounting equation would look like: $5,000 computer (asset) = $3,000 loan (liability) + $2,000 (owner’s equity) in the computer.
Recording Basic Accounting Transactions: There are two basic ways to record your financial transactions: single-entry bookkeeping and double-entry bookkeeping. See what the difference is between the two on this page: Double-Entry Bookkeeping vs. Single-Entry Bookkeeping. Most businesses use the double-entry accounting system. In this system, every business transaction is recorded in at least two business accounts. Write a big T on a piece of paper. Above the left arm of that T write Debit and above the right arm write Credit. We are going to use this T account as a visual aid to see how debit and credit work with your accounts. Now imagine you were paid $100 for your one-of-a-kind thingamajig. To record this business transaction in the general ledger of a double-entry system, you would debit your Cash account by recording it under the left arm of that big T you drew and credit your Sales (Revenue) account by writing it under the right arm of that T–under the Credit heading.
Getting these transactions right, will make a huge impact on your financial statements; such as the income statement, cash flow statement or statement of cash flows, and balance sheet. The financial statements are powerful tools to calculate the financial ratios that are used to evaluate the financial performance of a business.
Accounting Basics Tips:
Debit just means left
Credit just means right
Debits and Credits must always equal!
To determine how you would record the transaction you have to determine what kind of account is being affected and if it was increased or decreased.
In the above example, Cash is an asset account and we increased our cash with the sale, so looking at the chart below, you see that to increase our asset account, we would need to record it on the Debit side (left side).
We also increased our Sales Revenue, but since it is an income account we would need to record it on the Credit side (right side).
See how even though we increased both accounts–the debits and credits equal? That is the basic accounting concept of debits and credits.
When first learning about accounting, debits, and credits are very difficult to understand. Since more accounting is built off of the double-entry bookkeeping system, each entry will have a debit or credit and many people initially assume the word debit is the same as subtracting or an expense. In actuality, debit or credit will work differently depending on the financial statement. For example, debits increase assets and reduce liabilities on the balance and on the income statement, credits decrease expenses or increase revenue.
Debits And Credits Vs. Account Types:
Anytime an accounting transaction is created, there will be at least two accounts impacted. There will always be a debit entry and credit entry recorded and the totals of all of the debits and credits must be equal. Without a balance between debit and credits, financial statements would not be accurate.
As shown in the table below, the debit can either increase an asset or expenses and decrease a liability or equity entry, while a credit increases a liability or equity entry and decreases assets or expenses. Just remember the debit entry goes on the left and the credit goes on the right!
Debits are sometimes noted as DR and credits as CR. Why is a debit called a DR and credit CR? There isn’t a solid answer, but it is widely believed that debit used to stand for debit record and credit as credit record and the DR and CR were shorthand notations.
Remember: Debits go on the left and Credits on the right!
Note: Need more help remembering which account to debit and which account to credit?
See this page on basic accounting concepts for recording accounting journal entries for some sure-fire tips on debits and credits.
A Couple Of Pointers:
Although it is called a double-entry system, a transaction may involve more than two accounts.
For example to record a loan payment you would debit two accounts Notes Payable and Interest Expense. Then credit the total loan payment because we decreased our asset account Cash.
Although I used the T account to illustrate how debits and credits work, most professional accountants use the format shown on this page: Accounting Journal Examples.
Notice you first show the account and amount to be debited. Then indent the next line and show the account and amount to be credited.
Several basic accounting principles have been developed that are the basic building blocks that form the basis for modern accounting or today what we know of as “Generally Accepted Accounting Principles” or GAAP.
Without these core principles and common practices, the reporting of accounting would be inconsistent and unreliable. Additionally, these core principles provide a standardized way to compare financial reports between companies.
Below are some of the core accounting principles
Accounting Period Principle – A business should report the results of its operations over a standard period of time, typically monthly, quarterly, or annually to make useful comparisons.
Accrual Principle – Under the accrual accounting method, all accounting transactions are recorded in the period when it is earned, rather than when cash was received from the customer. This also holds for expenses as they are recorded when they were incurred, rather than when they were paid.
Consistency Principle – Once a business adopts an accounting method or policy, that method or policy should continue to be used in similar situations, unless there are reasonable reasons. Not following this principle means useful comparisons of financial statements over multiple accounting periods cannot be made due to inconsistent data being used
Cost Principle – A business should record its fixed short and long-term assets at the original cost and not fair value at the time of acquisition minus accumulated depreciation.
Economic Entity Principle – A business is considered a separate entity from its owners and should be kept separate from the business.
Full Disclosure Principle – All non-standard financial information or notes are disclosed in the financial statements to allow a reference point.
Going Concern Principle – Stipulates that a business is expected to continue indefinitely and assets are not intended to be sold immediately or liquidated.
Matching Principle – When revenue is recorded all related expenses are recorded in the same period to provide an accurate picture of the profitability of the business.
Materiality Principle – Errors or omissions of financial accounting procedures that involve immaterial or small amounts may not need attention or correction as they would not alter business decisions.
Monetary Unit Principle – Business transactions that are recognized as monetary currency are only recorded in a business’s accounting records.
Reliability Principle – Only those transactions that have supporting documentation like a receipt and are accurate and unbiased should be recorded.
Revenue Recognition Principle – Revenue is only recognized only when it is earned.
Some common basic accounting terms that you will likely come across when learning accounting concepts include:
Accounting Cycle – The accounting cycle refers to the process steps that are taken to close the books and generate financial statements.
Accounts Payable – Also referred to as A/P, accounts payable is a record of bills that have been entered into a ledger or accounting software, but have not yet been paid.
Accounts Receivable – Also referred to as A/R, accounts receivable are the revenue a company has made to customers but has not yet collected payment on.
Accrual Method – The accrual method of accounting recognizes revenue and expenses on the day the transaction takes place, not when payment is received as in the cash method.
Book Value – Book value refers to the value or net worth of a company if it liquidated all of its assets and paid back all liabilities.
Burn rate – The burn rate is a measure of how quickly a business is spending its cash reserves.
Cash Method of Accounting – Cash basis accounting or sometimes called cash accounting refers to income being recorded when customers pay (and not as sales are made as in accrual accounting) and expenses being recorded in the period in which they are actually paid. Learn more about the difference between cash accounting and accrual accounting.
Chart of accounts – The chart of accounts lists all of the accounts found in the general ledger, which is where all of your accounting entries reside.
Cost of Goods – Cost of Goods Sold (or COGS) are the expenses that directly relate to the cost of producing a product or delivering a service.
Current Assets – Current assets are assets that will be converted to cash within one year.
General Ledger – The general ledger is the record-keeping system for a company’s financial data.
Fixed Cost – A fixed cost is a cost that does not change regardless of how many sales are made, Common examples are things like labor or rent.
Gross Margin – Gross margin, better known as profit, is sales minus any costs associated with creating the product or service, divided by revenue.
Gross Income – Gross income, also known as gross profit is calculated by taking total revenue and subtracting the cost of creating the product.
Journal Entry – Journal entries are a summary of a transaction and are how updates and changes are made to a company’s books.
Net Income – Net income, or net profit, is the revenue earned in a specific time period. Net income is calculated by taking revenue and subtracting all expenses such as COGS, operating expenses, depreciation, and taxes.
Present Value – Present value is the current value of a future sum of money based on a specific rate of return.
Stockholders’ Equity – Stockholder’s equity, sometimes referred to as owner’s equity is the money invested by the owners into the company.
Trial Balance – The trial balance is recorded at the end of an accounting period in the general ledger.
Variable Expense – A variable expense is one where the amount changes (or varies) in proportion to the change in volume. Common examples include labor, commissions, or raw materials.
Working capital – Working capital is calculating current assets and subtracting current liabilities.
Next Section: Lesson 2 – Double Entry Bookkeeping