Accounting is one of those concepts and fields that can easily throw you off, especially when it comes to all that terminology used. While that might come out as the case, it doesn’t mean that things like bookkeeping, income statements, or ‘debits’ and ‘credits’ are alien terms.
You can grasp these and many other basic accounting principles with ease. This tutorial is tailored to provide you with all you need to know about the basics of accounting and finance.
Concepts in this tutorial:
- General Ledger and the Chart of Accounts
- Understanding Debit and Credit Entries
- How Double Entry Accounting Works
- The General Journal
- Financial Statements
- Income Statement
- Account Receivables and Account Payables
- Accounting Methods: Cash or Accrual?
- Recording Sales Tax
- Deciding between Capital & Revenue Expenses
General Ledger and the Chart of Accounts
General Ledger and the Chart of Accounts are central to accounting and understanding what it is and how it works is very crucial to proper accounting.
A General Ledger contains account entries that summarize financial information, with various entries made into specific sections called ‘Accounts’. For example, you record all property under assets; salaries under expenses, and sales under income.
An ‘Account’ holds entries of a similar type to make up a sub-ledger that we call ‘Chart of Accounts’. Entries in the chart of accounts are then summarized into a financial report that can be validated by a document called a trial balance.
The Chart of Accounts generally has 5 main sections:
It is possible to organize and create an accounting system based on the above five primary Accounts. However, to make the accounting process more organized and easier to locate specific transactions, it is advisable to create various smaller Accounts under each major entry.
Under “Assets” list sub-accounts like Cash, Inventory, Equipment, and Accounts Receivable. Assets refer to things the company or business owns and that have commercial value. (Assets= Liabilities-Equity).
Under “Liabilities” list accounts such as Mortgages, Notes Payable, and Accounts Payable. Liabilities are debts the business owes.
For Equity, add accounts like Common Stock and Retained Earnings. Equity is the company’s worth when you subtract liabilities from assets (Equity = Assets – Liabilities).
Income section can have accounts listing revenues from sales, interest, and other monies that come into the business.
Expenses include money spent in the course of business transactions. Accounts could include labor, advertising costs, salaries, and other bills.
To calculate Profit/Loss, take income and subtract expenses (P/L= Income-Expenses).
Debits and Credits
An understanding of the accounting process largely relies on these two terms: Debits and Credits.
Although the terminology can be a little confusing, mastering their application in accounting is essential in double-entry accounting.
Every entry in a General Ledger is recorded as either ‘debit’ or ‘credit,’ though how it impacts the account’s balance depends on the transaction and chart of accounts.
For example, assume your business secures a bank loan thus increasing the bank balances. That makes the transaction a debit entry because it increases cash at the bank, but because the loan increases liabilities, it is also recorded on the credit side.
If you withdraw the cash to pay for equipment then the bank account decreases (credit) while cash on hand increases (debit).
What’s Double Entry Accounting?
Debit and Credit entries are at the center of the double-entry accounting concept. What this means is that every transaction has to balance i.e. the same entry appears as debit and credit.
Differentiating transactions from entries
Every record as a debit or credit in the general ledger is an entry. The set of entries form a single ‘transaction’ that must occur in General Ledger.
You must post or record the entries correctly on either side of the ledger. Failing to post any entry affects transaction records, which in effect will result in errors. Note that every transaction has to be of equal value and appear as debit and credit.
Here is how debit and credit entries impact the Accounts in General Ledger.
A DEBIT entry in any of the five primary Accounts will have these effects on account balances:
- Assets (balances will increase)
- liabilities (balances decrease)
- equity (balances decrease)
- income (balances decrease)
- expenses ( balances increase)
Any CREDIT entry made to any of the primary Accounts will change balances as follows:
- Assets (balance value decreases)
- Liabilities ( entry increases balances)
- Equity (triggers an increase in the balances)
- Income (account balances increase)
- Expenses (credit entries decrease expense account balances)
Look at this example that illustrates the above scenarios.
Assuming you receive $10,000 as a salary into your bank account. Record the transactions in a double-entry system to reflect on both bank account and income account balances.
Using the above rules, debit the bank account (it’s an asset) to increase its balance. You will then need to match the transaction by recording it on the credit side in the income account (still under Assets). That will increase the income account balance.
Bank account – debit $10,000 (increase balance)
Income account – credit $10,000 (increase balance)
Apply the above rules for debit or credit entries to any transaction and ensure they balance out.
Each entry has a date, the account names to be debited and credited and the amount(s) involved. To make the recording more organized, indent the account name of the entry to be recorded to the credit side.
Using the double-entry method, make the transaction appear as below:
|April 20, 2020||Bank account
|April 22, 2020||Equipment||80,000|
What’s a General Journal?
General Ledger has transactions posted to it from the Chart of Accounts like Cash, Sales, Purchases, Bank loans, and so forth. Transaction/entries from these accounts consist of ‘source journals’.
In other cases, however, accountants find it necessary to post correcting entries that do not directly come from the source journals. It’s these transactions that go into the ‘General Journal,’ also called ‘GJ’.
An entry in a general journal would be something like miscellaneous expenses.
Financial statements refer to the various reports and documents accountants generate from the information recorded in the general ledger. Of financial statements in accounting, the balance sheet and the income statement are the most common.
The Balance Sheet is an accounting document that summarizes a businesses’ financial position. The report is prepared at a given period and uses information sourced from three Accounts in the ledger: Assets, Liabilities, and Equity.
The report offers a ‘balance’ in accounts that compares amounts in the Assets and Liabilities sections to total equity.
Take total assets and subtract total amounts in liabilities. The resultant figure should “balance” with the amount under Equity.
A sample balance sheet
|Assets – Liabilities||$6,000|
Equity and the amount from the difference between Assets and Liabilities are matching, thus making the Balance Sheet “balanced.”
The Income Statement reports a company’s financial performance. Accountants prepare the Income Statement (Profit and Loss Statement) by comparing the company’s income (or revenue) with its total expenses, usually over a set period (monthly, quarterly or yearly).
To calculate net profit or net loss, take total income, and subtract total expenses incurred over the period in question.
Understanding the relationship between the Balance Sheet and the Income Statement
One principle you need to understand is the fact that there is a direct link between the balance sheet and then the income statement. Grasping how these two documents work is a big step towards understanding accounting.
Let’s base our calculations on the above Balance Sheet, and assume that you pay $1000 for rent. That automatically reduces the amount under Assets to $9,000. In that case, the Balance Sheet will not “balance” as Equity does not match (Assets-Liabilities).
Here is how it would look like:
|Assets – Liabilities||$6,000|
The above scenario appears because the bill amount is an entry under Expenses which is used in the Income Statement. When profit decreases it affects the Balance Sheet.
Fix the imbalance by recording the net profit/loss entered in the Income Statement under Equity in the Balance Sheet. This amount is put under a new account labeled “Current Year Earnings“. Doing this in the example above changes the Equity figure to $6,000 thus balancing the Balance Sheet.
In this example, we show you how to make specific debit and credit entries and use that to generate a Balance Sheet and Income Statement.
Let’s take that you have decided to record all your financial transactions. All you have is $1,000,000 in the bank.
We begin with two entries to reflect the ‘double-entry’ principle. The money is in your bank account- debit that as an Asset. The same amount is your net worth so that goes to Equity and is recorded on the credit side.
Remember debits increase Assets while credits increase Equity. At this point, you have no liabilities. In short;
Equity = Assets – Liabilities.
The records, therefore, are balanced.
Add another transaction
If you have another financial transaction, say a mortgage payment and a monthly salary, make the entries on the appropriate sides of the accounting model.
Assume the mortgage is $300,000, with a deposit of $100,000 and your monthly income (salary) is $6,000.
Record the transactions thus;
Asset (house) – debit $300,000 and Liability (mortgage) – credit $300,000. Record the deposit under Assets (bank account) – credit side. Do the same to offset and balance the accounts by putting down under Liability (mortgage bill) a debit entry of $100,000.
These new entries decrease the balances in both the bank account and on the mortgage.
At this point, notice that Equity = Assets – Liabilities. It means your books are still balanced.
Add another entry
This time you have income in the form of a $6,000 salary. You also have to pay your mortgage at $2,000. Under “bank account,” debit $6,000 and credit $2,000 for the mortgage.
Try to balance the accounts. What you should see is that the Balance Sheet does not “balance.”
Note that you recorded salary under Income and the bill under Expenses. These two accounts are not used when generating a Balance Sheet.
Correct this by moving the $4,000 net profit ($6,000-$2,000) to Equity and record it under ‘Current Year Earnings.’ This should see the Equity = Assets – Liabilities to have the accounts balanced.
In most cases, we record mortgage payments in two parts: interest and capital. Your entries for the above transaction will, therefore, be something like this:
|Asset (Bank deposit)||$2,000|
|Interest Paid (Expense)||$1,600|
|Liability (Mortgage paid)||$400|
As you can see, the transaction balances. For a long list of journal and ledger entries, use the figures to formulate a trial balance to ascertain there are no entry errors.
Account Receivables and Payables
These are special accounts put in place to record invoice amounts related to a sale or purchase.
Most sales/purchases do not have immediate payments and thus the invoice provides for a ‘credit term’ with no actual money received or paid into the bank account.
For Assets, we use “Accounts Receivable” while under Liability we use “Accounts Payable.”
Record the entries in the appropriate account as either debit or credit. However, when payment is made, move the record to the bank account (values will increase or decrease as per the type of transaction.)
List the unpaid invoices under Aged Receivables/Payables in groups depending on the time e.g. 30 days, 60 days, or 90-days.
Accounting Methods: Cash or Accrual?
The accounting method you choose will depend on how you handle sales and purchases concerning tax reporting.
‘Cash’ versus ‘Accrual’ methods reflect two approaches that indicate how you handle invoicing and receiving payment.
- The cash method is when tax assessment only occurs on payment and not the date of the invoice.
- The accrual method has tax assessment done on the invoice date.
Choosing either method depends on the size of the company or if the wish is to optimize cash-flow. Sometimes it’s down to need to ensure you have profits recorded at the correct reporting period.
It is possible to use both methods, with reports on cash position complementing the need to report on tax correctly.
Recording Sales Tax
Some jurisdictions demand that businesses collect sales tax and remit the same to tax authorities. You may find terms like ‘Value-Added Tax’ (VAT and ‘Goods and Services Tax’ (GST) which essentially refer to the same thing.
What business pays as sales tax reduces in tandem with what the business pays to suppliers as sales tax. Businesses can also benefit from cash refunds from the government in case the company has more purchases than sales within a certain period.
As noted above, reporting on sales tax will be timed depending on what method of accounting method chosen (cash vs. accrual)
Record the sale under income, while the tax part under liability accounts. If the sales tax is 10% on a $110 sale, record the transaction thus:
|Account Receivable (Asset)||$110|
|Product Sales (Income)||$100|
|Sales Tax Payable (Liability)||$10|
Is the Entry a Capital or Revenue Expense?
Buying assets most often does not affect the Balance Sheet if the asset’s value is equal to the cash value. When dealing with these entries, the amounts involved will be the same within the Asset Accounts. That, however, works if the assets have tangible value and command a re-sale value. For current assets that are likely to lose value over a short period, it is better to record them under Expenses.
|Office supplies (Expenses)||$28.55|
To make the Balance Sheet ‘balance’, record the expenses (as a decrease in profit) under “Current Year Earnings.”
Decide whether the items you buy qualify as long-term or fixed assets (Capital Expense) or short term and thus Revenue Expense. Check with your local tax authorities on this to properly code entries on your Balance Sheet and Income Statement.
This tutorial helps you to learn accounting step by step and consistently. It represents the core things to know in accounting for beginners.