Basic Terms and
Concepts
There are a few (and only a few) things you need to understand
in order to make setting up your accounting system easier.
They're basic (trust me), and they will probably clear up any
confusion you may have had in the past when talking with your
CPA or other technical accounting types.
Debits and Credits
These are the backbone of any accounting system. Understand how
debits and credits work and you'll understand the whole system.
Every accounting entry in the general ledger contains both a
debit and a credit. Further, all debits must equal all credits.
If they don't, the entry is out of balance. That's not good.
Out-of-balance entries throw your balance sheet out of balance.
Therefore, the accounting system must have a mechanism to
ensure that all entries balance. Indeed, most automated
accounting systems won't let you enter an out-of-balance
entry-they'll just beep at you until you fix your error.
Depending on what type of account you are dealing with, a
debit or credit will either increase or decrease the account
balance. (Here comes the hardest part of accounting for most
beginners, so pay attention.) Figure 1 illustrates the entries
that increase or decrease each type of account.
Figure 1
Debits and Credits vs. Account Types
Account Type
Debit Credit
Assets
Increases
Decreases
Liabilities Decreases
Increases
Income
Decreases
Increases
Expenses Increases
Decreases
Notice that for every increase in one account, there is an
opposite (and equal) decrease in another. That's what keeps the
entry in balance. Also notice that debits always go on the left
and credits on the right.
Let's take a look at two sample entries and try out these
debits and credits:
In the first stage of the example we'll record a credit sale:
- Accounts Receivable
$1,000
Sales Income
$1,000
If you looked at the general ledger right now, you would see
that receivables had a balance of $1,000 and income also had a
balance of $1,000.
Now we'll record the collection of the receivable:
- Cash
$1,000
Accounts Receivable
$1,000
Notice how both parts of each entry balance? See how in the
end, the receivables balance is back to zero? That's as it
should be once the balance is paid. The net result is the same
as if we conducted the whole transaction in cash:
- Cash
$1,000
Sales Income
$1,000
Of course, there would probably be a period of time between
the recording of the receivable and its collection.
That's it. Accounting doesn't really get much harder.
Everything else is just a variation on the same theme. Make sure
you understand debits and credits and how they increase and
decrease each type of account.
Assets and Liabilities
Balance sheet accounts are the assets and liabilities. When we
set up your chart of accounts, there will be separate sections
and numbering schemes for the assets and liabilities that make
up the balance sheet.
A quick reminder: Increase assets with a debit and decrease
them with a credit. Increase liabilities with a credit and
decrease them with a debit.
Identifying assets
Simply stated, assets are those things of value that your
company owns. The cash in your bank account is an asset. So is
the company car you drive. Assets are the objects, rights and
claims owned by and having value for the firm.
Since your company has a right to the future collection of
money, accounts receivable are an asset-probably a major asset,
at that. The machinery on your production floor is also an
asset. If your firm owns real estate or other tangible property,
those are considered assets as well. If you were a bank, the
loans you make would be considered assets since they represent a
right of future collection.
There may also be intangible assets owned by your company.
Patents, the exclusive right to use a trademark, and goodwill
from the acquisition of another company are such intangible
assets. Their value can be somewhat hazy.
Generally, the value of intangible assets is whatever both
parties agree to when the assets are created. In the case of a
patent, the value is often linked to its development costs.
Goodwill is often the difference between the purchase price of a
company and the value of the assets acquired (net of accumulated
depreciation).
Identifying liabilities
Think of liabilities as the opposite of assets. These are the
obligations of one company to another. Accounts payable are
liabilities, since they represent your company's future duty to
pay a vendor. So is the loan you took from your bank. If you
were a bank, your customer's deposits would be a liability,
since they represent future claims against the bank.
We segregate liabilities into short-term and long-term
categories on the balance sheet. This division is nothing more
than separating those liabilities scheduled for payment within
the next accounting period (usually the next twelve months) from
those not to be paid until later. We often separate debt like
this. It gives readers a clearer picture of how much the company
owes and when.
Owners' equity
After the liability section in both the chart of accounts and
the balance sheet comes owners' equity. This is the difference
between assets and liabilities. Hopefully, it's positive-assets
exceed liabilities and we have a positive owners' equity. In
this section we'll put in things like
-
- Partners' capital accounts
- Stock
- Retained earnings
Another quick reminder: Owners' equity is increased and
decreased just like a liability:
-
- Debits decrease
- Credits increase
Most automated accounting systems require identification of
the retained earnings account. Many of them will beep at you if
you don't do so.
By the way, retained earnings are the accumulated profits
from prior years. At the end of one accounting year, all the
income and expense accounts are netted against one another, and
a single number (profit or loss for the year) is moved into the
retained earnings account. This is what belongs to the company's
owners-that's why it's in the owners' equity section. The income
and expense accounts go to zero. That's how we're able to begin
the new year with a clean slate against which to track income
and expense.
The balance sheet, on the other hand, does not get zeroed out
at year-end. The balance in each asset, liability, and owners'
equity account rolls into the next year. So the ending balance
of one year becomes the beginning balance of the next.
Think of the balance sheet as today's snapshot of the assets
and liabilities the company has acquired since the first day of
business. The income statement, in contrast, is a summation of
the income and expenses from the first day of this accounting
period (probably from the beginning of this fiscal year).
Income and Expenses
Further down in the chart of accounts (usually after the owners'
equity section) come the income and expense accounts. Most
companies want to keep track of just where they get income and
where it goes, and these accounts tell you.
A final reminder: For income accounts, use credits to
increase them and debits to decrease them. For expense accounts,
use debits to increase them and credits to decrease them.
Income accounts
If you have several lines of business, you'll probably want to
establish an income account for each. In that way, you can
identify exactly where your income is coming from. Adding them
together yields total revenue.
Typical income accounts would be
-
- Sales revenue from product A
- Sales revenue from product B (and so on for each
product you want to track)
- Interest income
- Income from sale of assets
- Consulting income
Most companies have only a few income accounts. That's really
the way you want it. Too many accounts are a burden for the
accounting department and probably don't tell management what it
wants to know. Nevertheless, if there's a source of income you
want to track, create an account for it in the chart of accounts
and use it.
Expense accounts
Most companies have a separate account for each type of expense
they incur. Your company probably incurs pretty much the same
expenses month after month, so once they are established, the
expense accounts won't vary much from month to month. Typical
expense accounts include
-
- Salaries and wages
- Telephone
- Electric utilities
- Repairs
- Maintenance
- Depreciation
- Amortization
- Interest
- Rent
