Accounting Basics

If you understand the definition and goals of an accounting system, you are ready to learn the following accounting concepts and definitions.

Assets: Things of value held by the business. Assets are balance sheet accounts. Examples of assets are cash, accounts receivable, and furniture and fixtures.

Liabilities: What your business owes creditors. Liabilities are balance sheet accounts. Examples are accounts payable, payroll taxes payable, and loans payable.

Equity: The net worth of your company. Also called owner's equity or capital. Equity comes from investment in the business by the owners, plus accumulated net profits of the business that have not been paid out to the owners. It essentially represents amounts owed to the owners. Equity accounts are balance sheet accounts.

The accounting equation: Assets = liabilities + owner's equity. The financial statement called the balance sheet is based on the "accounting equation." Note that assets are on the left-hand side of the equation, and liabilities and equities are on the right-hand side of the equation. Similarly, some balance sheets are presented so that assets are on the left, liabilities and owner's equity are on the right.

Balance sheet: Also called a statement of financial position, a balance sheet is a financial "snapshot" of your business at a given date in time. It lists your assets, your liabilities, and the difference between the two, which is your equity, or net worth. The balance sheet is a real-life example of the accounting equation because it shows that assets = liabilities + owner's equity.

Once you master the above accounting terms and concepts, you are ready to learn about the following day-to-day accounting terms.

Debits: At least one component of every accounting transaction (journal entry) is a debit amount. Debits increase assets and decrease liabilities and equity. For this reason, you will sometimes see debits entered on the left-hand side (the asset side of the accounting equation) of a two-column journal or ledger.

Credits: At least one component of every accounting transaction (journal entry) is a credit amount. Credits increase liabilities and equity and decrease assets. For this reason, you will sometimes see credits entered on the right-hand side (the liability and equity side of the accounting equation) of a two-column journal or ledger.

In bookkeeping texts, examples, and ledgers, you may see the words "Debit" and "Credit" abbreviated. Dr. stands for Debit; Cr. Stands for Credit.

Double-entry accounting: In double-entry accounting, every transaction has two journal entries: a debit and a credit. Debits must always equal credits. Because debits equal credits, double-entry accounting prevents some common bookkeeping errors. Errors that do occur are easier to find. Double-entry accounting is the basis of a true accounting system.

In double-entry accounting, every transaction in your business affects at least two accounts, since there is at least one debit and one credit for each transaction. Usually, at least one of the accounts is a balance sheet account. Entries that are not made to a balance sheet account are made to an income or expense account. Income and expenses affect the net profit of the business, which ultimately affects owner's equity. Each transaction (journal entry) is a real-life example of the accounting equation (assets = liabilities + owner's equity).

Some simple accounting systems do not use the double-entry system. You will have to choose between double-entry and single-entry accounting. Because of the benefits described above, we recommend double-entry accounting. Many accounting programs for the computer are based on a double-entry system, but are designed so that you enter each transaction once, and the computer makes the corresponding second entry for you. The double-entry part goes on "behind the scenes," so to speak.

You also need to decide whether you will be using the cash or accrual accounting method. We recommend the accrual method because it provides a more accurate picture of your financial situation.