Understanding basic accounting concepts is a must for every small business owner.
Even if you have an accountant that takes care of that “accounting stuff”, you need to know accounting basics such as debits and credits and some accounting terminology.
The basic accounting equation is the foundation of all basic accounting concepts.
The financial position of all companies both large and small is measured by the following equation:
For sole proprietorships:
Assets are what a company owns
Liabilities are what a company owes
Owner’s (Stockholders’) Equity is the difference between assets and liabilities.
An example of this accounting equation for a small business owner:
You buy a computer (an asset) for $5,000 dollars. If you borrowed $3,000 (a liability) and paid the balance with your savings, here is what the accounting equation would look like: $5,000 computer (asset) = $3,000 loan (liability) + $2,000 (owner’s equity) in the computer.
There are two basic ways to record your financial transactions: single entry bookkeeping and double entry bookkeeping. See what the difference is between the two on this page: Double Entry Bookkeeping vs. Single Entry Bookkeeping
Most businesses use the double entry accounting system. In this system every business transaction is recorded in at least two business accounts.
Write a big T on a piece of paper. Above the left arm of that T write Debit and above the right arm write Credit.
We are going to use this T account as a visual aid to see how debits and credits work with your accounts.
Now imagine you were paid $100 for your one-of-a-kind thingamajig. To record this business transaction in a double entry system, you would debit your Cash account by recording it under the left arm of that big T you drew and credit your Sales (Revenue) account by writing it under the right arm of that T--under the Credit heading.
Accounting Basics Tips:
Debit just means left
Credit just means right
Debits and Credits must always equal!
To determine how you would record the transaction you have to determine what kind of account is being affected and if it was increased or decreased.
In the above example Cash is an asset account and we increased our cash with the sale, so looking at the chart below, you see that to increase our asset account we would need to record it on the Debit side (left side).
We also increased our Sales Revenue, but since it is an income account we would need to record it on the Credit side (right side).
See how even though we increased both accounts--the debits and credits equal? That is the basis accounting concept of debits and credits.
Debits and Credits vs. Account Types:
Note: Need more help remembering which account to debit and which account to credit?
Couple of pointers:
Although it is called a double entry system, a transaction may involve more than two accounts.
For example to record a loan payment you would debit two accounts Notes Payable and Interest Expense. Then credit the total loan payment because we decreased our asset account Cash.
although I used the T account to illustrate how debits and credits work, most accountants use the format shown on this page: Accounting Journal Examples.
Notice you first show the account and amount to be debited. Then indent the next line and show the account and amount to be credited.
Next Section: Lesson 2