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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.