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 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 is measured by the following equation:
For corporations: Assets = Liabilities + Stockholders’ Equity
- Assets are what a company owns
- Liabilities are what a company owes
- Owner’s Equity or Stockholder’s Equity is the difference between assets and liabilities.
An example of this accounting equation for a small business owner:
You buy a computer (an asset) for $5,000 dollars. 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 a debit and credit works 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 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 basis 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, a 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 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 short hand notations.
Note: Need more help remembering which account to debit and which account to credit?
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 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.
A number of 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 in order to make useful comparisons.
Accrual Principle – Accounting transactions are recorded in the period when it is earned, rather than when cash was received from the customer. This also holds true 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 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 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 in order to provide an accurate picture of the profitability of the business.
Materiality Principle – Errors or omissions of accounting procedures that which involves 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.
Next Section: Lesson 2 – Double Entry Bookkeeping