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Understanding the basic principles of accounting will put you ahead of the curve in business, finance, and investing.
Small business owners and entrepreneurs will need to be involved in both bookkeeping and accounting.
A serious investor should be able to understand financial statements and know how to evaluate a business.
The principals and concepts of accounting may seem complicated, but getting the basics down isn’t hard.
If you are a business owner, using accounting software will make it easier, but you should still have a strong understanding of the basic terms and concepts.
Key Basic Accounting Principles Summarized
- Basic Accounting Equation Formula: Assets = (Liabilities + Owner’s Equity) This equation is the basis of a balance sheet.
- Double-entry accounting keeps accounts in balance and relies on the basic accounting equation.
- Debits and credits are the entries used in double-entry accounting to either increase or decrease account balances.
- Bookkeeping is the process of recording financial transactions, while accounting is responsible for analyzing, translating, and summarizing the financial data. It’s common for small business owners to do both.
- Financial statements summarize critical financial data for decision-makers like business owners and investors.
Accounting Terms and Principles to Know
GAAP stands for Generally Accepted Accounting Principles, and it is the commonly known and accepted guidelines for financial reporting and accounting.
The Financial Accounting Standards Board (FASB) issued the standards known as GAAP.
Being GAAP compliant is crucial for publicly-traded companies as they are monitored by the Securities Exchange Commission (SEC).
Businesses that follow GAAP make it easier for investors and lenders to trust and understand their financials.
Accounts Payable (AP)
Accounts payable is money owed by the business to its vendors and or suppliers. AP is shown as a liability on the balance sheet.
When a company receives an invoice (bill), it is payable by the company and is recorded as short-term debt.
Accounts payable is found in the current liabilities section on a balance sheet. AP is increased by a credit and decreased by a debit.
Once an invoice is paid, a debit is made to decrease the accounts payable, and a credit is made to decrease the cash account.
Accounts Receivable (AR)
Accounts receivable is money that is owed to the business by its debtors. AR is shown as an asset on the balance sheet.
Accounts receivable are accounts that the business has a right to receive because the business has delivered its product and or service and is awaiting payment.
Accounts receivable is increased by a debit and decreased by a credit.
Accrual Basis Accounting Method
Accrual accounting recognizes and records revenue and expenses when they occur and not when they are paid.
Businesses that sell products and have employees commonly use the accrual accounting method. Accrual accounting uses accounts payable and accounts receivable accounts, cash accounting does not.
Cash Basis Accounting Method
Cash basis accounting is a simple accounting method that only recognizes and records revenue and expenses when the cash is received or paid.
It is easier to track the cash flow of a business using the cash basis accounting method.
One problem with cash basis accounting is with no accounts payable, a cash-heavy business may look healthy, but in reality, owes a lot of money.
Accounts receivable and accounts payable accounts will have aging. Aging is a way to handle money coming in and money that is going out.
AR aging keeps track of outstanding invoices and money owed so you can reach out and request payment.
AP aging keeps track of all the bills owed by the business so you can pay them when it is due or find out when they become late.
Chart of Accounts
A chart of accounts is simply the listing of names of the accounts that a business has identified and will use for recording transactions in its general ledger.
Companies use a chart of accounts to keep their finances organized and tailored to the needs of the business.
The list of accounts is commonly put in order as the accounts appear in its financial statements.
Financial transactions are recorded in a journal and are known as journal entries. Journal entries consist of the transaction date, which accounts will be debited, which accounts will be credited, and a short description of the transaction.
Double-entry accounting has been used for thousands of years; it is a proven method of keeping accounts accurate and in balance. For each debit, there must be a credit, and vice versa.
Credits to one account must be equal to debits to another account to keep the accounts in balance.
Debits and Credits
Debits and credits are used to record all of the business’s financial transactions. A debit or credit is neither bad nor good; think of them as neutral.
Debits are always on the left side, and credits will always be on the right side. How a debit or credit affects the account is strictly dependent on the account type.
Remember these rules about debits and credits:
- Assets increase by debits and decrease by credits.
- Expenses increase by debits and decrease by credits.
- Liabilities and equity increase by credits and decrease by debits.
- Revenues increase by credits and decrease by debits.
A very useful trick to remember these rules is by memorizing DC ADE LER.
Debits increase assets, draws (distributions, dividends, withdrawals), and expenses.
Credits increase liabilities, equity, revenue.
Expense and revenue = the income statement and assets, liabilities, and equity = the balance sheet.
Liabilities are another term for debt; it’s anything that the business owes like a loan from the bank. Accounts payable is a liability because it is money owed to suppliers for delivered goods or services.
Assets are anything that is considered to have financial value that the business owns—cash, equipment, property, supplies, electronics, etc. Accounts payable is shown as an asset because it is money that is owed to the business.
Any legitimate financial business cost is an expense. Utilities, cost of goods, wages for employees, repairs, rents, etc. Using an expense report is a common and effective way of tracking businesses’ expenses.
Revenue is money received by the business from selling a product or service.
Net profit is the amount of income left over after subtracting expenses and cost of goods sold. The lower the net profit of a company, the lower its tax liability.
Equity is the amount of financial interest or the amount you are invested in the business. It’s typically calculated by the sum of the business’s total assets minus its liabilities, just like calculating your net worth.
It is also referred to as shareholders equity because, in a publicly-traded company, it is the remaining amount of assets available to the shareholders.
You don’t have to be a Certified Public Accountant (CPA) to understand the basic principles of accounting. Learning these terms helps business owners keep more accurate books and helps investors evaluate companies.
Accounting makes it possible for companies to be financially transparent and provides the bigger picture of how well the company is or isn’t doing.
Whether you’re a business owner, entrepreneur, investor, or just someone studying accounting, mastering these accounting basics is the right step in becoming more financially literate.