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Perhaps you are an owner or manager or a small business and have been thinking that it would be a good idea to know more about how accounting works? If so, you are not alone. There are probably thousands of other small business owners/managers in the same boat. Chances are, you already know quite a bit about accounting since you have to compile financial statements, at least annually, to prepare your income tax returns. I would venture to say that you may only be missing certain key elements of accounting knowledge that prevent you from seeing what accountants call “the big picture”.
The first step to take when learning accounting concepts is to set aside your pre-conceptions of what that experience will be like. You need to know that each accounting concept is simple and uncomplicated like 2+2=4. Combining these concepts into various systems is what constitutes “accounting”. Therefore, it is important to fully understand each concept before moving on to the next. This is called “step-by-step” learning.
Let’s start with the basics. When we are talking about financial statements, we are referring to a Balance Sheet and a Profit & Loss Statement. As you may already know, these two reports are made up of only five sections. The Balance Sheet has three sections: Assets, Liabilities, and Equity. The Profit & Loss Statement has two sections: Income and Expense. Each of these sections includes particular accounts, whereby all the transactions that occur within the business are accumulated. These accounts are called general ledger accounts.
A ledger is nothing more than a page with a line drawn down the middle. Therefore, the page is said to have a left side and a right side. Entries made to a particular ledger page are recorded on either side depending on their nature. The rule governing this process is called, “The Accounting Equation”, and it is stated as:
ASSETS = LIABILITIES + EQUITY
This is not mysterious at all if you have ever purchased a home. Let’s say you bought your home for $150,000. You took $50,000 out of your personal savings and made the down payment. You borrowed the remaining $100,000 from the bank. Sounds familiar doesn’t it? Apply this information to the “Accounting Equation”:
Asset ($150,000) = Liabilities ($100,000) + Equity ($50,000)
Now you could switch things around and say:
Assets ($150,000) – Liabilities ($100,000) = Equity ($50,000)
But, it is all the same. For instance, 2+2=4 or 4-2=2.
This is a key concept in accounting because this is why a Balance Sheet has to balance. This is known as “Double-Entry” accounting. Here is the reason:
Remember our ledger page? The rule is that the left side of the ledger page has to equal the right side in order to balance. Therefore, every entry made on one side of the ledger must have an equal entry on the opposite side when the transaction is complete. Here is a sample ledger page with our house transaction recorded on it:
LEDGER PAGE
LEFT SIDE:
Assets = $150,000
RIGHT SIDE:
Liabilities = $100,000 Equity = $ 50,000
You can see that they are equal. You can also see that there was nothing very complicated about that process, yet, you just learned the fundamental concept that forms the basis for double-entry accounting. Using this system, you can account for every single penny that comes into and goes out of your business.
Learning accounting is no different than learning a new card game. A card game has certain rules that make the game what it is. Without these rules, there is no game. Accounting rules make accounting work. Knowing the rules allows you to think in accounting logic. You get in trouble when you try to apply regular logic in place of accounting logic.
Keywords: accounting, double-entry, balance sheet, basic accounting, accounting equation, accounting language
About the Author
John Day, Sonora, CA USA
jday@reallifeaccounting.com
http://www.reallifeaccounting.com
John W. Day, MBA is the author of Real Life Accounting for Non-Accountants, an online course in accounting basics. He has written 3 e-Books pertaining to small business accounting and writes a monthly newsletter on accounting issues.
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