Sound bookkeeping practices are essential for every business.
They allow you to easily:
- Understand the financial health of your business.
- Identify financial trends within your business, which you can use to make more strategic decisions.
- Prepare financial statements and maximize tax deductions.
- Appeal to investors.
- Apply for bank financing.
There’s a lot of confusing vocabulary in bookkeeping. Here are some quick definitions of terms you’ll need to understand.
Account: An account is the place where financial transactions are recorded. Accounts are sub-categories of the broader account types. Generally, they fall below one of the following: Assets, Expenses, Liabilities, Equity, or Revenue.
Accounting Equation: The accounting equation is the heart of double-entry bookkeeping. The equation is:
Assets + Expenses = Liabilities + Owner’s Equity + Revenue.
Generally each financial transaction is recorded in one account on each side of this equation. Doing so keeps the books “balanced”.
Balance Sheet: The balance sheet is a financial report about the equity in a business at a given time. It is a summary of a business’ Assets, Liabilities, and Equity.
Chart of Accounts: The chart of accounts is like a table of contents for the general ledger. It makes it easy to find the name of an account and its number.
Income Statement: An income statement is a financial report made up of the accounts in the general ledger which contain information on a company’s revenue and expenditures. An income statement is also called a profit and loss statement.
Double-entry bookkeeping is the standard bookkeeping method for modern business accounting. It’s called double-entry because every financial transaction that takes place is recorded twice in the general ledger.
That is, for every credit recorded in one account, an equal debit is recorded in another account and vice versa. If done correctly, the total credits always equal the total debits so the books balance.
Example: A business makes a $750 sale out of inventory.
- Two equal entries are made for this one transaction, a debit and a credit.
- Debits increase an asset, and credits increases a revenue account.
Note these entries keep the accounting equation balanced:
Assets + Expenses = Liabilities + Owner’s Equity + Revenue
Credits and debits often confuse beginners who assume debit simply means, “subtract” and credit means, “add.” But in accounting, credits and debits have a different meaning.
Debits are recorded on the left side of the account column in the General Ledger and Credits are recorded on the right.
Whether those entries increase or decrease the amount in the account depends on the account type the entry is made in.
- A debit is a transaction that creates an increase when entered in an asset or expense account type, and a decrease when entered as a liability, equity, or revenue account type.
- A credit is a transaction that creates a decrease when entered in an asset or expense account type, and an increase when entered as a liability, equity, or revenue account type.
Confusing? It takes a while to fully grasp. Using a quality accounting software helps a lot.
Both the chart of accounts and the general ledger are made up of the balance sheet and income statement, which are in turn made up of the five account types: assets, liabilities, equity, expenses, and revenue.
The Balance Sheet: Assets, Liabilities, Equity
The Income Statement: Expenses, Revenue
These broad account types are in turn composed of various accounts, in which financial transactions are recorded. Every financial transaction that takes place in a company will be recorded in at least two of these accounts. In one, it will be recorded as a credit, and in another it will be recorded as a debit.
Assets: Assets are anything your business has of value.
- Cash, accounts receivable, inventory, equipment, real estate, vehicles
Liabilities: Liabilities are any debts your company owes.
- Accounts payable, wages payable, taxes payable, loans payable
Stockholder’s Equity: The total amount owners have invested in the company.
- Common stock, retained earnings
Revenue/Income: Revenue is money earned by your company.
Expenses: Expenses include items that must be purchased to stay in business.
- Payroll, rent, travel, utilities, client dinners
Proper bookkeeping requires the recording of all financial transactions. This includes purchases, sales, receipts and payments, and accruals for payables or receivables.
Remember, for every transaction that occurs you will record a credit in one account and an equal debit in another. The reason for this is so that you can keep your books balanced at all times using the basic accounting equation.
This process is best explained by the following examples.
A corporation is in need of cash, so they seek $50,000 in exchange for common stock. The new cash would increase the company’s assets on the left side of the equation with a debit. It would also increase the company’s stockholder equity on the right side of the equation with a credit.
Recorded first in a journal, the transaction will look like this:
Debit: Cash (an asset account) $50,000
Credit: Common stock (an equity account) $50,000
A debit to assets of $50,000 increases assets by that amount, and a debit to Stockholder Equity increases equity by that amount. The equation remains balanced.
UnA company makes a sale and bills a customer $100. This would be recorded in the accounts receivable (an asset) and also in service revenues (an equity account).
In the journal it would look like this:
Debit: Accounts receivable (asset) $400(dr)
Credit: Service Revenues (equity) $400(cr)
Let’s take a look at how an expense effects the equation. Say a company spends $2,000 on advertising. An expense will reduce assets on the left side of the equation and reduce stockholder equity on the right side of the equation.
The journal entry would look like this
Debit: Advertising expense $150
Credit: Cash $150