Reviewing Accounting Basics

Overview

Even though bookkeepers and accountants use complex terminology like debits, credits, receivables, payables, depreciation, ledgers, and journals, the basic principles of accounting are very easily understood. If you have a personal bank account and household expenses, you are probably already familiar with them. This terminology was borne in the days before computers when numbers were hand-written in journals by different people and then combined, checked, and re-checked before the books were considered balanced. With computer-based accounting, much of this old terminology is unnecessary.

This article is intended to de-mystify these concepts and to provide you with a high-level understanding of accounting basics.

General Ledger and the Chart of Accounts

At the heart of all accounting systems is the general ledger (often called the GL for short). The general ledger is the place where all account entries are recorded. To help you organize the account entries, the ledger is divided into several Accounts. Each account holds similar types of entries (e.g., bank account, rent expenses, salary income, etc.). The list of all the accounts that make up the general ledger is called the Chart of Accounts.

Practically (but not technically) speaking, you may hear others refer to the general ledger and chart of accounts interchangeably. 

To summarize, the General Ledger holds all the account entries. The Chart of Accounts lists all the accounts in the ledger.

Primary Sections of the Chart of Accounts

The chart of accounts is organized into five primary sections:

1. Assets
2. Liabilities
3. Equity
4. Income
5. Expenses

Technically speaking, you could manage your accounting system using only these five accounts. However, with this approach, it would be difficult to find specific transactions and run meaningful reports. So in practice, you will probably create several accounts under each primary section to organize the entries. In basic terms, these five primary sections can be described as follows:

• Assets: Things of commercial value (cash, property, furniture, equipment, etc.)
• Liabilities: Money you owe (mortgages, unpaid bills, etc.)
• Equity: How much you (or the business) is currently worth (i.e. assets less liabilities)
• Income: Money coming in (proceeds from sales, interest income, etc.)
• Expenses: Money going out (bill payments, staff salaries, etc.)

Furthermore:

• Equity = Assets - Liabilities
• Profile/Loss = Income - Expenses

Debits and Credits

Debits and credits are at the heart of double-entry accounting principles. They also cause much of the confusion and anguish to people who are new to accounting:

• Debits and credits mean different things depending on whether you're looking at them from a business's perspective or from a bank's perspective.
• A debit to one account will increase the balance, where in another account, it will decrease the balance.
• A debt may sound like a kind of debit, but it's not really.
• An account can be said to be in credit, but that is a different thing to a credit entry in the Account.
• Banks issue debit cards and credit cards, but these have little to do with debits and credits posted to the accounts.

To keep it simple, let's ignore all other uses of the words debit and credit and focus only on entries in an account in the general ledger.

Each entry of an amount into an account in the GL must be identified as either a debit or credit. This governs what effect the entry will have on the balance of the account.

Using the above rule, you can usually figure out what effect the other side of the transaction will have.

So for example, if you are going to pay a bill then the bank account is going to decrease (credit). Hence, the other side of the transaction will be a debit. Since the bill is an expense, the transaction will look like this:

You can even use this rule if no asset account is involved in the transaction. Let's say you used a loan to purchase something. You would record this as an entry to Liabilities and as an entry to Expenses.

So how do you figure out which is the debit and which is the credit? Knowing you want to increase the balance of the liabilities account (because you will end up owing more), think about what bank transaction would cause a liability account to increase. If you took out a loan and added the money to a bank account, then you would be increasing liabilities (which is your aim), and increasing the bank balance (by depositing the loan funds into the bank). If you increase the bank balance, then it must be a debit (according to the above rule), so the liabilities entry must be a credit.

Going back to the example, you now know that you need to credit liabilities, and therefore you must debit expenses.

Double Entry Accounting

Another fundamental concept of accounting is that each accounting transaction is composed of an equal and opposite set of debit and credit entries.

Transactions vs. Entries

A balanced set of debit and credit entries are linked together as a single transaction. The transaction is saved (posted) to the General Ledger as a whole. If any entry fails to be saved, then the whole transaction is aborted.

A DEBIT to accounts in the five primary sections has the following effect on the account balances:

• Assets (Increase) 
• Liabilities (Decrease) 
• Equity (Decrease) 
• Income (Decrease) 
• Expenses (Increase) 

A CREDIT to accounts in the five primary sections has the following effect on the account balances:

• Assets (Decrease) 
• Liabilities (Increase) 
• Equity (Increase)
• Income (Increase) 
• Expenses (Decrease) 

This is probably best illustrated by examples.

EXAMPLE 1: Receive Money 
Let's say you want to record the receipt of your monthly salary in your personal accounting system. This will affect your bank balance and your income account. 

Your bank account is an asset account so remember the rule: a debit to an asset account increases the balance. This means that you will debit the bank account and then to balance out the transaction, you will need to credit the income account.

• Debit Bank $5,000 (increase balance)
• Credit Income $5,000 (increase balance).

EXAMPLE 2: 
When you make a mortgage payment, part of the payment goes to interest and the other part to reducing the principal. Money will be leaving your bank account so using the rule, a debit to an asset account increases the balance, you must be crediting the bank account because you are decreasing the balance. This transaction consists of one credit and two debit entries: 

• Credit Bank $2,000 (decrease balance)
• Debit Interest Expense $1,700 (increase balance)
• Debit Mortgage Liability $300 (decrease balance)

The credits and the debits match, so the transaction is balanced.

General Journals

Most transactions are posted to the general ledger from the appropriate areas of the accounting software (e.g., Sales, Purchases, Banking, etc.). These areas are sometimes referred to as source journals.

Occasionally, however, you (or more commonly your accountant) will need to correct entries that are not directly related to a source journal. These transactions are known as general journal transactions (or simply GJs).

An example of a GJ is the recording of a depreciation expense of an asset.

Financial Statements

Of the wide variety of reports and statements you generate for an accounting system, there are two key reports that underpin the accounting framework: the Balance Sheet and the Income Statement.

Balance Sheet (Statement of Financial Position)

The balance sheet provides a summary of your financial position at a single point in time. It does this using the balances in the first three primary sections: Assets, Liabilities, and Equity.

The balance part of balance sheet comes from comparing the difference between assets and liabilities. These two amounts should always be in balance:

• Equity = Assets - Liabilities

Example:

The last two figures match, so the balance sheet is balanced.

Income Statement (Statement of Financial Performance)

The income statement compares income (revenue) with expenses over a certain period of time. The difference between income and expenses is the net profit or loss for the period:

• Profit/Loss = Income - Expenses

Example:

The Balance Sheet and Income Statement are Linked

Once you understand these concepts, you will understand one of the central points of accounting.

Looking at the example balance sheet above, let's say that you now pay a bill for $1,000. This will decrease your bank balance and consequently your total assets and your balance sheet will look something like the following:

This balance sheet is out of balance because Equity does not equal Assets minus Liabilities. So what's the problem? It is that the other side of the bill payment went to Expenses (which is on the Income Statement) and reduced the net profit by $1,000. To fix this, move the net profit (or loss) from the Income Statement and add it under Equity in an account called Current Year Earnings. Once you do this, the equity will change to $6,000 and the balance sheet will balance again.

EXAMPLE: 
Let's walk through a simple household example: 

First, list all the things you own under an Assets column and any loans under a Liabilities column. If you subtract the two, you then have a snapshot of your net worth (or equity in business-speak) at this specific point in time. This is essentially your personal balance sheet.

Now, list all sources of income and expenditures in a typical month. In this example, assume the household has two salary earners. 

Essentially, this is your personal income statement for the month. You earned more than you spent during the month, so this can be retained as savings ('profit' in business-speak).

Now take a look at how the individual debits and credits are entered to make up the Balance Sheet and Income Statement. 

To make things easier, start with a blank slate and assume that you have just received an inheritance. You have decided to start recording your personal finances from this point forward. According to the double-entry principle, you need to enter a debit and a credit to record the receipt of the inheritance. So in this case, you can debit the bank account (debits increase the asset accounts) and credit the inheritance account under equity (credits increase equity accounts).

Equity = Assets - Liabilities (there are no liabilities) so everything is balanced.

Now that the money is in the bank, you might want to decide how to spend your new wealth. For example, you might put down a $100,000 deposit on a new house. Normally, you would record all the entries in a single transaction, but for clarity, let's do this is two stages: 

First, record the purchase of the house with the full mortgage as a liability. You haven't paid the deposit yet so all you are doing is creating a new asset (debit house $400,000) and an equal offsetting liability (credit mortgage $400,000):

Equity = Assets - Liabilities, so things are all balanced. 

Second, pay the deposit, which credits the bank $100,000 (credit to an Asset account, which decreases the balance), and debits the mortgage $100,000 (recorded as a debit to Liability account, which decreases the balance). 

Equity = Assets - Liabilities, so things are all balanced.

Now you should record your salaries for the first month and make your first mortgage payment. For simplicity, assume that this is an interest-only payment.

Debit the bank $8,000 for the salaries
Credit the bank $2,000 for the mortgage payment

Unfortunately, the balance sheet is no longer balanced. This is because the other side of the previous two entries were recorded under Income and Expenses, which are not Balance Sheet accounts.

This is where you connect the Income Statement and the Balance Sheet. In order to get everything to balance, you must move the net result of the monthly change in Income and Expenses to the Balance Sheet.

In this case you have mode a "profit" of $6,000 for the month, so our net worth (or Equity) has increased by $6,000 from where we started. Therefore move this to the Balance Sheet under the Equity section. This is normally entered under an account called Current Year Earnings.

Equity = Assets - Liabilities, so we're still all balanced again.

Note: In reality, mortgage payments are normally a combination of interest and capital and so you would record it as follows:
• Bank (asset): $2,000 recorded as a credit, which decreases the balance
• Interest paid (expense): $1,800, recorded as a debit, which increases the balance
• Mortgage (liability): $200, recorded as a debit, which decreases the balance

Receivables and Payables

In most businesses, the process of buying and selling is accomplished through the exchange of invoices. An invoice lists the items, price, tax component, and payment due date. Payment is not normally required immediately and credit terms are extended to the purchaser, giving them a certain amount of time to pay (2 weeks, 1 month, etc.).

When the invoice is created, the sale (or purchase) is recorded in the accounting system However, since no money is actually received or paid, at that point you cannot record the entry in the bank account. To deal with this, special Asset and Liability accounts are created to record these anticipated payments. These are called Accounts Receivable (asset account) and Accounts Payable (liability account).

To record a sales invoice, the entries would be as follows:

When you receive a payment, the income remains unchanged since the sale has already been recorded, and you simply record the payment for the bank account, and remove the amount from Accounts Receivable.

To record a sales invoice payment, the entries would be as follows:

The same process would occur for purchases, except that you would use the Accounts Payable account instead (and the debits and credits would be swapped).

"Aged" Receivables/Payables

At any point in time, the current balance of the Accounts Receivable or Accounts Payable show you the net amount of money owing to you by customers (or how much you owe to suppliers).Because each invoice has a due date, it is important to know which of these amounts are overdue and require attention.

The Aged Receivables and Payables reports will list all unpaid invoices, with columns grouping overdue payments by how much they are overdue (30-days, 60-days, 90-days, etc.)

Debtors and Creditors

Traditionally customers who owe you money are called debtors and suppliers to whom you owe money are called creditors.

Cash vs. Accrual Methods

Cash versus accrual accounting methods are simply a means of dealing with sales and purchases for tax purposes. The issue arises from the difference in time between recording the invoice in the accounting system and receiving the payment.

Using the cash method, tax is only assessed when payment is made/received. With the accrual method, tax is assessed on the invoice date.

Choosing between cash or accrual methods is most often left for the company to decide. For large corporations, accrual is sometimes the only option. The reason for choosing one method over the other can be quite complex, but generally has to do with optimizing cashflow, or making sure that profits are recorded in the correct periods.

Some companies may elect to use one method for tax purposes, but may still run financial reports in both methods to compare their cash position with their financial position.

Sales Tax (GST, VAT)

In some jurisdictions, businesses are required to collect sales tax on the goods and services they sell and then pay this to the government. The amount of sales tax the business owes is reduced by the amount of sales tax it pays to its suppliers.

In cases where businesses buy more goods than they sell in a certain period, the government will pay the business a cash refund. The timing of the sales tax payments to/from the government will depend on whether the business has elected to report on a cash or accrual basis.

Sales tax is sometimes called Goods and Services Tax (GST) or Value-Added Tax (VAT).

When you record a sale with a sales tax component, only the tax-exclusive portion is recorded under income, and the sales tax component is recorded as a liability (since you owe this to the government).

The transaction would look something like (assuming 10% sales tax):

Capital vs. Revenue Expenses

Normally, when you buy something for the business, you exchange cash for something of equal value, so there should be no change to the balance sheet after the purchase. Essentially, all you would be doing was moving the amount between asset accounts.

For example, if you buy a new computer:

The total assets remain the same and so the balance sheet is unchanged.

This works for large items of tangible value; however, if you are buying smaller items (e.g., paperclips and pens) you would not want to go through all of the trouble of recording these as assets. They have a limited lifespan and would be difficult to re-sell to recover the cash. For these items, it is more convenient to treat them as an expense. The transaction would look like this:

Note, the slight decrease in profit for that month as a result of this expense would be included in Current Year Earnings to balance the balance sheet).

Based on this, a limit needs to be decided whether an item should be recorded as a capital expense (and recorded as an asset), or as a revenue expense (and recorded as an expense). The local tax jurisdiction will define these limits and you need to be aware of them in order to code your entries correctly.

Depreciation

In the example above, the computer that was purchased for $2,500 will not hold that value forever. After a year or two, you would only be able to sell it for a part of the purchase cost. However, since it is still listed under assets for $2,500, your balance sheet would not show you a true snapshot of your business value at that time.

In this case, you need to periodically depreciate your assets. This means that you need to remove part of the value under assets, and push this through to expenses. 

Let's say that at the end of the first year, you decide that the computer is only now worth $1,800. You could then enter the following transaction to correct the balance sheet:

In practice, the tax authorities set the amounts you can depreciate your assets by over time. Some of the more common methods you might hear about are straight-line method, declining-value method, etc.

Terminology