Some of the basic accounting terms that you will learn include revenues, expenses, assets, liabilities, income statement, balance sheet, and statement of cash flows. You will become familiar with accounting debits and credits as we show you how to record transactions. You will also see why two basic accounting principles, the revenue recognition principle and the matching principle, assure that a company's income statement reports a company's profitability.
A Story for Relating to Accounting Basics
In this explanation of accounting basics, and throughout the entire website, AccountingCoach.com will often omit some accounting details and complexities in order to present clear and concise explanations. This means that you should always seek professional advice for your specific circumstances.
We will present the basics of accounting through a story of a person starting a new business. The person is John lee—a savvy man who sees the need for a parcel delivery service in his community. John has researched his idea and has prepared a business plan that documents the viability of his new business.
John has also met with an attorney to discuss the form of business he should use. Given his specific situation, they concluded that a corporation will be best. John decides that the name for his corporation will be Direct Delivery, Inc. The attorney also advises John on the various permits and government identification numbers that will be needed for the new corporation.
John is a hard worker and a smart man, but admits he is not comfortable with matters of accounting. He assumes he will use some accounting software, but wants to meet with a professional accountant before making his selection. He asks his banker to recommend a professional accountant who is also skilled in explaining accounting to someone without an accounting background. John wants to understand the financial statements and wants to keep on top of his new business. His banker recommends Marilyn, an accountant who has helped many of the bank's small business customers.
At his first meeting with Marilyn, John asks her for an overview of accounting, financial statements, and the need for accounting software. Based on John's business plan, Marilyn sees that there will likely be thousands of transactions each year. She states that accounting software will allow for the electronic recording, storing, and retrieval of those many transactions. Accounting software will permit John to generate the financial statements and other reports that he will need for running his business.
John seems puzzled by the term transaction, so Marilyn gives him five examples of transactions that Direct Delivery, Inc. will need to record:
John will no doubt start his business by putting some of his own personal money into it. In effect, he is buying shares of Direct Delivery's common stock.
Direct Delivery will need to buy a sturdy, dependable delivery vehicle.
The business will begin earning fees and billing clients for delivering their parcels.
The business will be collecting the fees that were earned.
The business will incur expenses in operating the business, such as a salary for John, expenses associated with the delivery vehicle, advertising, etc.
With thousands of such transactions in a given year, John is smart to start using accounting software right from the beginning. Accounting software will generate sales invoices and accounting entries simultaneously, prepare statements for customers with no additional work, write checks, automatically update accounting records, etc.
By getting into the habit of entering all of the day's business transactions into his computer, John will be rewarded with fast and easy access to the specific information he will need to make sound business decisions. Marilyn tells John that accounting's "transaction approach" is useful, reliable, and informative. She has worked with other small business owners who think it is enough to simply "know" their company made $30,000 during the year (based only on the fact that it owns $30,000 more than it did on January 1). Those are the people who start off on the wrong foot and end up in Marilyn's office looking for financial advice.
If John enters all of Direct Delivery's transactions into his computer, good accounting software will allow John to print out his financial statements with a click of a button. In Parts 2 through 7 Marilyn will explain the content and purpose of the three main financial statements:
Income Statement
Balance Sheet
Statement of Cash Flows
Income Statement
Marilyn points out that an income statement will show how profitable Direct Delivery has been during the time interval shown in the statement's heading. This period of time might be a week, a month, three months, five weeks, or a year—John can choose whatever time period he deems most useful.
The reporting of profitability involves two things: the amount that was earned (revenues) and the expenses necessary to earn the revenues. As you will see next, the term revenues is not the same as receipts, and the term expenses involves more than just writing a check to pay a bill.
A. Revenues
The main revenues for Direct Delivery are the fees it earns for delivering parcels. Under the accrual basis of accounting (as opposed to the less-preferred cash method of accounting), revenues are recorded when they are earned, not when the company receives the money. Recording revenues when they are earned is the result of one of the basic accounting principles known as the revenue recognition principle.
For example, if John delivers 1,000 parcels in December for $4 per delivery, he has technically earned fees totaling $4,000 for that month. He sends invoices to his clients for these fees and his terms require that his clients must pay by January 10. Even though his clients won't be paying Direct Delivery until January 10, the accrual basis of accounting requires that the $4,000 be recorded as December revenues, since that is when the delivery work actually took place. After expenses are matched with these revenues, the income statement for December will show just how profitable the company was in delivering parcels in December.
When John receives the $4,000 worth of payment checks from his customers on January 10, he will make an accounting entry to show the money was received. This $4,000 of receipts will not be considered to be January revenues, since the revenues were already reported as revenues in December when they were earned. This $4,000 of receipts will be recorded in January as a reduction in accounts receivable. (In December John had made an entry to Accounts Receivable and to sale.)
B. Expenses
Now Marilyn turns to the second part of the income statement—expenses. The December income statement should show expenses incurred during December regardless of when the company actually paid for the expenses. For example, if John hires someone to help him with December deliveries and John agrees to pay him $500 on January 3, that $500 expense needs to be shown on the December income statement. The actual date that the $500 is paid out doesn't matter—what matters is when the work was done—when the expense was incurred—and in this case, the work was done in December. The $500 expense is counted as a December expense even though the money will not be paid out until January 3. The recording of expenses with the related revenues is associated with another basic accounting principle known as the matching principle.
Marilyn explains to John that showing the $500 of wages expense on the December income statement will result in a matching of the cost of the labor used to deliver the December parcels with the revenues from delivering the December parcels. This matching principle is very important in measuring just how profitable a company was during a given time period.
Marilyn is delighted to see that John already has an intuitive grasp of this basic accounting principle. In order to earn revenues in December, the company had to incur some business expenses in December, even if the expenses won't be paid until January. Other expenses to be matched with December's revenues would be such things as gas for the delivery van and advertising spots on the radio.
John asks Marilyn to provide another example of a cost that wouldn't be paid in December, but would have to be shown/matched as an expense on December's income statement. Marilyn uses the interest expense on borrowed money as an example. She asks John to assume that on December 1 Direct Delivery borrows $20,000 from John's aunt and the company agrees to pay his aunt 6% per year in interest, or $1,200 per year. This interest is to be paid in a lump sum each on December 1 of each year.
Now even though the interest is being paid out to his aunt only once per year as a lump sum, John can see that in reality, a little bit of that interest expense is incurred each and every day he's in business. If John is preparing monthly income statements, John should report one month of Interest Expense on each month's income statement. The amount that Direct Delivery will incur as Interest Expense will be $100 per month all year long ($20,000 x 6% ÷ 12). In other words, John needs to match $100 of interest expense with each month's revenues. The interest expense is considered a cost that is necessary to earn the revenues shown on the income statements.
Marilyn explains to John that the income statement is a bit more complicated than what she just explained, but for now she just wants John to learn some basic accounting concepts and some of the accounting terminology. Marilyn does make sure, however, that John understands one simple yet important point: an income statement, does not report the cash coming in—rather, its purpose is to (1) report the revenues earned by the company's efforts during the period, and (2) report the expenses incurred by the company during the same period. The purpose of the income statement is to show a company's profitability during a specific period of time. The difference (or "net") between the revenues and expenses for Direct Delivery is often referred to as the bottom line and it is labeled as either net income or net loss.
Balance Sheet – Assets
Marilyn moves on to explain the balance sheet, a financial statement that reports the amount of a company's (A) assets, (B) liabilities, and (C) stockholders' (or owner's) equity at a specific point in time. Because the balance sheet reflects a specific point in time rather than a period of time, Marilyn likes to refer to the balance sheet as a "snapshot" of a company's financial position at a given moment. For example, if a balance sheet is dated December 31, the amounts shown on the balance sheet are the balances in the accounts after all transactions pertaining to December 31 have been recorded.
(A) Assets
Assets are things that a company owns and are sometimes referred to as the resources of the company. John readily understands this—off the top of his head he names things such as the company's vehicle, its cash in the bank, all of the supplies he has on hand, and the dolly he uses to help move the heavier parcels. Marilyn nods and shows John how these are reported in accounts called vehicles, cash supplies, and equipment. She mentions one asset John hadn't considered—accounts receivable. If John delivers parcels, but isn't paid immediately for the delivery, the amount owed to Direct Delivery is an asset known as Accounts Receivable.
Prepaids
Marilyn brings up another less obvious asset—the unexpired portion of prepaid expense. Suppose Direct Delivery pays $1,200 on December 1 for a six-month insurance premium on its delivery vehicle. That divides out to be $200 per month ($1,200 ÷ 6 months). Between December 1 and December 31, $200 worth of insurance premium is "used up" or "expires". The expired amount will be reported as insurance expense on December's income statement. John asks Marilyn where the remaining $1,000 of unexpired insurance premium would be reported. On the December 31 balance sheet, Marilyn tells him, in an asset account called prepaid insurance.
Other examples of things that might be paid for before they are used include supplies and annual dues to a trade association. The portion that expires in the current accounting period is listed as an expense on the income statement; the part that has not yet expired is listed as an asset on the balance sheet.
Marilyn assures John that he will soon see a significant link between the income statement and balance sheet, but for now she continues with her explanation of assets.
Cost Principle and Conservatism
John learns that each of his company's assets was recorded at its original cost, and even if the fair market value of an item increases, an accountant will not increase the recorded amount of that asset on the balance sheet. This is the result of another basic accounting principle known as the cost principle.
Although accountants generally do not increase the value of an asset, they might decrease its value as a result of a concept known as conservatism. For example, after a few months in business, John may decide that he can help out some customers—as well as earn additional revenues—by carrying an inventory of packing boxes to sell. Let's say that Direct Delivery purchased 100 boxes wholesale for $1.00 each. Since the time when John bought them, however, the wholesale price of boxes has been cut by 40% and at today's price he could purchase them for $0.60 each. Because the replacement cost of his inventory ($60) is less than the original recorded cost ($100), the principle of conservatism directs the accountant to report the lower amount ($60) as the asset's value on the balance sheet.
In short, the cost principle generally prevents assets from being reported at more than cost, while conservatism might require assets to be reported at less then their cost.
Depreciation
John also needs to know that the reported amounts on his balance sheet for assets such as equipment, vehicles, and buildings are routinely reduced by depreciation. Depreciation is required by the basic accounting principle known as the matching principle. Depreciation is used for assets whose life is not indefinite—equipment wears out, vehicles become too old and costly to maintain, buildings age, and some assets (like computers) become obsolete. Depreciation is the allocation of the cost of the asset to depreciation expense on the income statement over its useful life.
As an example, assume that Direct Delivery's van has a useful life of five years and was purchased at a cost of $20,000. The accountant might match $4,000 ($20,000 ÷ 5 years) of Depreciation Expense with each year's revenues for five years. Each year the carrying amount of the van will be reduced by $4,000. (The carrying amount—or "book value"—is reported on the balance sheet and it is the cost of the van minus the total depreciation since the van was acquired.) This means that after one year the balance sheet will report the carrying amount of the delivery van as $16,000, after two years the carrying amount will be $12,000, etc. After five years—the end of the van's expected useful life—its carrying amount is zero.
John wants to be certain that he understands what Marilyn is telling him regarding the assets on the balance sheet, so he asks Marilyn if the balance sheet is, in effect, showing what the company's assets are worth. He is surprised to hear Marilyn say that the assets are not reported on the balance sheet at their worth (fair market value). Long-term assets (such as buildings, equipment, and furnishings) are reported at their cost minus the amounts already sent to the income statement as Depreciation Expense. The result is that a building's market value may actually have increased since it was acquired, but the amount on the balance sheet has been consistently reduced as the accountant moved some of its cost to Depreciation Expense on the income statement in order to achieve the matching principle.
Another asset, office equipment , may have a fair market value that is much smaller than the carrying amount reported on the balance sheet. (Accountants view depreciation as an allocation process—allocating the cost to expense in order to match the costs with the revenues generated by the asset. Accountants do not consider depreciation to be a valuation process.) The asset land is not depreciated, so it will appear at its original cost even if the land is now worth one hundred times more than its cost.
Short-term (current) asset amounts are likely to be close to their market values, since they tend to "turn over" in relatively short periods of time.
Marilyn cautions John that the balance sheet reports only the assets acquired and only at the cost reported in the transaction. This means that a company's reputation—as excellent as it might be—will not be listed as an asset. It also means that Jeff Bezos will not appear as an asset on Amazon.com's balance sheet; Nike's logo will not appear as an asset on its balance sheet; etc. John is surprised to hear this, since in his opinion these items are perhaps the most valuable things those companies have. Marilyn tells John that he has just learned an important lesson that he should remember when reading a balance sheet.
Balance Sheet – Liabilities and Stockholders' Equity
(B) Liabilities
The balance sheet reports Direct Delivery's liabilities as of the date noted in the heading of the balance sheet. Liabilities are obligations of the company; they are amounts owed to others as of the balance sheet date. Marilyn gives John some examples of liabilities: the loan he received from his aunt (Notes Payable or Loan Payable), the interest on the loan he owes to his aunt (Interest Payable), the amount he owes to the supply store for items purchased on credit (Accounts Payable), the wages he owes an employee but hasn't yet paid to him (Wages Payable).
Another liability is money received in advance of actually earning the money. For example, suppose that Direct Delivery enters into an agreement with one of its customers stipulating that the customer prepays $600 in return for the delivery of 30 parcels every month for 6 months. Assume Direct Delivery receives that $600 payment on December 1 for deliveries to be made between December 1 and May 31. Direct Delivery has a cash receipt of $600 on December 1, but it does not have revenues of $600 at this point. It will have revenues only when it earns them by delivering the parcels. On December 1, Direct Delivery will show that its asset Cash increased by $600, but it will also have to show that it has a liability of $600. (It has the liability to deliver $600 of parcels within 6 months, or return the money.)
The liability account involved in the $600 received on December 1 is Unearned Revenue. Each month, as the 30 parcels are delivered, Direct Delivery will be earning $100, and as a result, each month $100 moves from the account Unearned Revenue to Service Revenues. Each month Direct Delivery's liability decreases by $100 as it fulfills the agreement by delivering parcels and each month its revenues on the income statement increase by $100.
(C) Stockholders' Equity
If the company is a corporation, the third section of a corporation's balance sheet is Stockholders' Equity. (If the company is a sole proprietorship, it is referred to as Owner's Equity.) The amount of Stockholders' Equity is exactly the difference between the asset amounts and the liability amounts. As a result accountants often refer to Stockholders' Equity as the difference (or residual) of assets minus liabilities. Stockholders' Equity is also the "book value" of the corporation.
Since the corporation's assets are shown at cost or lower (and not at their market values) it is important that you do not associate the reported amount of Stockholders' Equity with the market value of the corporation. (Hence, it is a poor choice of words to refer to Stockholders' Equity as the corporation's "net worth".) To find the market value of a corporation, you should obtain the services of a professional familiar with valuing businesses.
Within the Stockholders' Equity section you may see accounts such as Common Stock, Paid-in Capital in Excess f Par Value-Comon Stock, Preferred Stock Retained Earnings, and Current Year’s Net Income. The account Common Stock will be increased when the corporation issues shares of stock in exchange for cash (or some other asset). Another account Retained Earnings will increase when the corporation earns a profit. There will be a decrease when the corporation has a net loss. This means that revenues will automatically cause an increase in Stockholders' Equity and expenses will automatically cause a decrease in Stockholders' Equity. This illustrates a link between a company's balance sheet and income statement.
Statement of Cash Flows
The third financial statement that John needs to understand is the Statement of Cash Flows. This statement shows how Direct Delivery's cash amount has changed during the time interval shown in the heading of the statement. John will be able to see at a glance the cash generated and used by his company's operating activities, its investing activities, and its financing activities. Much of the information on this financial statement will come from Direct Delivery's balance sheets and income statements
Double Entry System
The field of accounting—both the older manual systems and today's basic accounting software—is based on the 500-year-old accounting procedure known as double entry. Double entry is a simple yet powerful concept: each and every one of a company's transactions will result in an amount recorded into at least two of the accounts in the accounting system.
The Chart of Accounts
To begin the process of setting up John's accounting system, he will need to make a detailed listing of all the names of the accounts that Direct Delivery, Inc. might find useful for reporting transactions. This detailed listing is referred to as a Chart of Accounts. (Accounting software often provides sample charts of accounts for various types of businesses.)
As he enters his transactions, John will find that the chart of accounts will help him select the two (or more) accounts that are involved. Once John's business begins, he may find that he needs to add more account names to the chart of accounts, or delete account names that are never used. John can tailor his chart of accounts so that it best sorts and reports the transactions of his business.
Because of the double entry system all of Direct Delivery's transactions will involve a combination of two or more accounts from the balance sheet and/or the income statement. Marilyn lists out some sample accounts that John will probably need to include on his chart of accounts:
Balance Sheet accounts:
Asset accounts (Examples: Cash, Accounts Receivable, Supplies, Equipment)
Liability accounts (Examples: Notes Payable, Accounts Payable, Wages Payable)
Stockholders' Equity accounts (Examples: Common Stock, Retained Earnings)
Income Statement accounts:
Revenue accounts (Examples: Service Revenues, Investment Revenues)
Expense accounts (Examples: Wages Expense, Rent Expense, Depreciation Expense)
Sample Transactions #1
On December 1, 2010 John starts his business Direct Delivery, Inc. The first transaction that John will record for his company is his personal investment of $20,000 in exchange for 5,000 shares of Direct Delivery's common stock. Direct Delivery's accounting system will show an increase in its account Cash from zero to $20,000, and an increase in its stockholders' equity account Common Stock by $20,000. Both of these accounts are balance sheet accounts. There are no revenues because no delivery fees were earned by the company, and there were no expenses.
After John enters this transaction, Direct Delivery's balance sheet will look like this:
Direct Delivery, Inc. Balance Sheet December 1, 2010 | |||
Assets | Liabilities & Stockholders' Equity | ||
Cash | $ 20,000 | Liabilities Stockholders’ Equity Common Stock | $20,000 |
Total Assets | $20,000 | Total Liabilities. & Stockholders’ Equity | $20,000 |
Marilyn asks John if he can see that the balance sheet is just that—in balance. John looks at the total of $20,000 on the asset side, and looks at the $20,000 on the right side, and says yes, of course, he can see that it is indeed in balance.
Marilyn shows John something called the basic accounting equation, which, she explains, is really the same concept as the balance sheet, it's just presented in an equation format:
Assets | = | Liabilities | + | Stockholders’ (owner’s) Equity |
$20,000 | = | $0 | + | $20,000 |
The accounting equation (and the balance sheet) should always be in balance.
Debits and Credits
Did the first sample transaction follow the double entry system and affect two or more accounts? John looks at the balance sheet again and answers yes, both Cash and Common Stock were affected by the transaction.
Marilyn introduces the next basic accounting concept: the double entry system requires that the same dollar amount of the transaction must be entered on both the left side of one account, and on the right side of another account. Instead of the word left, accountants use the word debit; and instead of the word right, accountants use the word credit. (The terms debit and credit are derived from Latin terms used 500 years ago.)
Here’s a TiP
Debit means left.
Credit means right.
John asks Marilyn how he will know which accounts he should debit—meaning he should enter the numbers on the left side of one account—and which accounts he should credit—meaning he should enter the numbers on the right side of another account. Marilyn points back to the basic accounting equation and tells John that if he memorizes this simple equation, it will be easier to understand the debits and credits.
Here’s a TiP
Memorizing the simple accounting equation will
help you learn the debit and credit rules for
entering amounts into the accounting records.
Let's take a look at the accounting equation again:
Assets | = | Liabilities | + | Stockholders’ (or Owner’s) Equity |
Just as assets are on the left side (or debit side) of the accounting equation, the asset accounts in the general ledger have their balances on the left side. To increase an asset account's balance, you put more on the left side of the asset account. In accounting jargon, you debit the asset account. To decrease an asset account balance you credit the account, that is, you enter the amount on the right side.
Just as liabilities and stockholders' equity are on the right side (or credit side) of the accounting equation, the liability and equity accounts in the general ledger have their balances on the right side. To increase the balance in a liability or stockholders' equity account, you put more on the right side of the account. In accounting jargon, you credit the liability or the equity account. To decrease a liability or equity, you debit the account, that is, you enter the amount on the left side of the account.
As with all rules, there are exceptions, but Marilyn's reference to the accounting equation may help you to learn whether an account should be debited or credited.
Since many transactions involve cash, Marilyn suggests that John memorize how the Cash account is affected when a transaction involves cash: if Direct Delivery receives cash, the Cash account is debited; when Direct Delivery pays cash, the Cash account is credited.
When a company receives cash, the Cash account is debited.
When the company pays cash, the Cash account is credited.
Marilyn refers to the example of December 1. Since Direct Delivery received $20,000 in cash from John in exchange for 5,000 shares of common stock, one of the accounts for this transaction is Cash. Since cash was received, the Cash account will be debited.
In keeping with double entry, two (or more) accounts need to be involved. Because the first account (Cash) was debited, the second account needs to be credited. All John needs to do is find the right account to credit. In this case, the second account is Common Stock. Common stock is part of stockholders' equity, which is on the right side of the accounting equation. As a result, it should have a credit balance, and to increase its balance the account needs to be credited.
Accountants indicate accounts and amounts using the following format:
Account Name | Debit | Credit |
Cash | 20,000 | |
Common Stock | 20,000 |
Accountants usually first show the account and amount to be debited. On the next line, the account to be credited is indented and the amount appears further to the right than the debit amount shown in the line above. This entry format is referred to as a general journal entry.
(With the decrease in the price of computers and accounting software, it is rare to find a small business still using a manual system and making entries by hand. Accounting software has made the process of recording transactions so much easier that the general journal is rarely needed. In fact, entries are often generated automatically when a check or sales invoice is prepared.).....coming soon next
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