While you may find the bookkeeping and financial admin side of your business the most daunting, understanding a few basic concepts will help you understand what your accountant is trying to tell you. It's important to have some basic knowledge so that it's harder for someone to pull the wool over your eyes.
Debits and credits
These are the backbone of any accounting system. Every accounting entry in the general ledger contains both a debit and a credit. To balance, all debits must equal all credits. Out-of-balance entries, which happen if your clients don't pay, for example, throw your balance sheet out of balance.
The table below illustrates the entries that increase or decrease each type of account.
Debits and credits vs. account types
For every increase in one account, there is an opposite (and equal) decrease in another. That's what keeps the entry in balance. Also, debits always go on the left and credits on the right. Make sure you understand debits and credits and how they increase and decrease each type of account.
Assets and Liabilities
Balance sheet accounts are the assets and liabilities. When we set up your chart of accounts, there will be separate sections and numbering schemes for the assets and liabilities that make up the balance sheet.
A quick reminder: Increase assets with a debit and decrease them with a credit. Increase liabilities with a credit and decrease them with a debit.
Simply stated, assets are those things of value that your company owns. The cash in your bank account is an asset. So is the company car you drive. Assets are the objects, rights and claims owned by and having value for the firm.
Since your company has a right to the future collection of money, accounts receivable are an asset-probably a major asset, at that. The machinery on your production floor is also an asset. If your firm owns property or other property, those are considered assets as well.
There may also be intangible assets owned by your company. Patents, the exclusive right to use a trademark, and goodwill from the acquisition of another company are such intangible assets. Their value can be somewhat hazy.
Generally, the value of intangible assets is whatever both parties agree to when the assets are created. In the case of a patent, the value is often linked to its development costs. Goodwill is often the difference between the purchase price of a company and the value of the assets acquired (net of accumulated depreciation).
Think of liabilities as the opposite of assets. These are the obligations of one company to another. Accounts payable are liabilities, since they represent your company's future duty to pay a vendor. So is the loan you took from your bank. If you were a bank, your customer's deposits would be a liability, since they represent future claims against the bank.
We separate liabilities into short-term and long-term categories on the balance sheet. This division is nothing more than separating those liabilities scheduled for payment within the next accounting period (usually the next twelve months) from those not to be paid until later. We often separate debt like this. It gives readers a clearer picture of how much the company owes and when.
After the liability section in both the chart of accounts and the balance sheet comes owners' equity. This is the difference between assets and liabilities. Hopefully, it's positive-assets exceed liabilities and we have a positive owners' equity. In this section we'll put in things like
- Partners' capital accounts
- Retained earnings
Remember, owners' equity is increased and decreased just like a liability.
At the end of one accounting year, all the income and expense accounts are netted against one another, and a single number (profit or loss for the year) is moved into the retained earnings account. This is what belongs to the company's owners, so that's why it's in the owners' equity section.
The income and expense accounts go to zero. That's how we're able to begin the new year with a clean slate against which to track income and expense.
The balance sheet, on the other hand, does not get zeroed out at year-end. The balance in each asset, liability and owners' equity account rolls into the next year. So the ending balance of one year becomes the beginning balance of the next.
Think of the balance sheet as today's picture of the assets and liabilities the company has acquired since the first day of business. The income statement, in contrast, is a summary of the income and expenses from the first day of this accounting period (probably from the beginning of this fiscal year).
Income and expenses
Further down in the chart of accounts (usually after the owners' equity section) come the income and expense accounts. Most companies want to keep track of just where they get income and where it goes (cash flow), and these accounts tell you.
If you have several lines of business, you'll probably want to establish an income account for each. In that way, you can identify exactly where your income is coming from. Adding them together yields total revenue.
Typical income accounts would be:
- Sales revenue from product A
- Sales revenue from product B (and so on for each product you want to track)
- Interest income
- Income from sale of assets
- Consulting income
Most companies have only a few income accounts. That's really the way you want it. Too many accounts are a burden for the accounting department and probably don't tell management what it wants to know. Nevertheless, if there's a source of income you want to track, create an account for it in the chart of accounts and use it.
Most companies have a separate account for each type of expense. Your company probably incurs pretty much the same expenses month after month, so once they are established, the expense accounts won't vary much from month to month. Typical expense accounts include salaries and wages, telephone bills, water and electricity, rent and so on.
The content in this article is sourced from Adam
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