Think of your business as a car.
To start and run efficiently, it needs two things: energy and upkeep.
According to WalletHub’s 2019 survey, small business owners’ “biggest frustrations” are (1) acquiring customers and (2) accounting basics like cash flow, expenses, and taxes. New and existing alike, customers fuel your business.
But more gas doesn’t make the car last longer. It’s the knuckle-scraping ongoing maintenance that keeps the car running for years beyond it’s expected life.
In a similar way, a well-managed accounting system keeps your business running each day. It’s a process that gathers information, puts it in the right place, and reports useful information to you.
(You’ll see a more detailed definition of accounting below.)
To keep your car on the road, scheduled maintenance is a must. The same is true of your accounting system.
Let’s explore everything you need to know for basic accounting.
But first, three tips for the road ahead …
Number one: Throughout this article I’ll use a fictional business, Reliable Auto Repair, to illustrate the terms, principles, and processes.
Julie, Reliable’s owner, has operated the business successfully for the past five years. Steve is Julie’s bookkeeper, and he’s just graduated with an accounting degree.
Steve has worked part-time for Reliable for four years, and Julie promotes Steve into a full-time accounting role.
Julie discussed the hiring decisions with her CPA firm, and they agree that now is a perfect time to review the entire accounting system. The analysis will help Steve and Julie identify any weaknesses that should be addressed.
Number two: To make this as helpful and actionable as possible, I’ve also included three templates with the accounting equations preloaded:
- Income statement
- Balance sheet
- Cash flow statement
Number three: We’ve also created a cheat sheet with over 20 accounting terms and concepts that you can save as PDF:
Now, onto the basics …
What is accounting? Definition in plain language
Accounting is a system or software used to record more than just financial transactions. Done right, financial accounting (1) tracks and analyzes business transactions in total, (2) measures and improves the health of a business, as well as (3) reports financial results to investors, creditors, and regulators.
Your accounting system produces financial statements that address these issues:
- Financial position as of a specific date: Balance sheet
- Profit or loss for a stated time period: Income statement
- Cash inflows and outflows for a month or year: Statement of cash flows
The system requires you to perform work in a specific order, which is where the accounting cycle comes in.
Understanding the accounting cycle
Assume that, on August 1st, Reliable spends $2,000 on tires. Cash isn’t paid immediately, and the vendor gives Reliable an invoice.
How that event is tracked through a business is known as the accounting cycle. Here’s an overview, which we’ll breakdown:
1. Source document
A source document is generated when an event happens in your business.
In this case, Reliable receives a $2,000 invoice from the tire vendor and a shipping receipt. When tires are received at the warehouse, a Reliable employee reviews the shipment, to confirm that the entire order was sent. The data on the shipping receipt matches the invoice.
2. Financial impact
Next, Steve (the accountant) must decide how the event impacts the accounting records. He decides to record an increase in Inventory- Tires account, and an increase in the Accounts Payable account.
3. Journal entry
A journal is a record of each transaction that occurs, listed in chronological order. Journal entries are individual activities (transactions) within the journal, typically posted accountants.
Steve records the transaction using this journal: The Inventory- Tires and Accounts Payable balances are both increased by $2,000, and the journal entry is dated August 1st. The entry includes a brief explanation: “To purchase tires on credit.”
4. General ledger
A company’s general ledger is a record of every transaction posted to the accounting records throughout its lifetime. Steve frequently reviews general ledger to verify that he’s posted transactions correctly.
5. Trial balance
Reliable’s trial balance is a listing of each account used to post transactions and the current account balance.
This document provides a quick snapshot of Reliable’s current financial condition.
Steve can scan the list of accounts and balances to decide if the accounting data looks reasonable. If he wants more detail, the general ledger is the place to go.
6. Financial statements
The trial balance is used to generate the financial statements, including the balance sheet and income statement (or profit and loss statement).
Steve produces financial statements at the end of the month, and the cycle starts over next month. Reliable Auto Repair also needs a clearly defined system to record transactions.
Exactly how do you manage your accounting cycle?
That’s where we’ll turn next …
Basic accounting concepts
Julie and Steve manage the accounting process based on some key concepts.
The concepts help Reliable produce financial statements that are comparable with other companies. That’s important when Julie wants to assess the firm’s performance.
In addition, Julie’s stakeholders, such as creditors and investors, expect Reliable to use its industry’s accounting guidelines. These “apples-to-apples” comparisons are important. And they begin with the chart of accounts.
To keep track of all the accounting concepts and terms, grab the full cheat sheet as PDF
Chart of accounts
The chart of accounts is a list of each account needed to manage the business and a corresponding account number.
As your company grows, you may add, subtract, or change the accounts needed to post transactions.
A typical chart of accounts assigns account numbers to balance sheet accounts first, followed by income statement accounts. Cash accounts, for example, might be numbered from 1000 to 1005, while revenue accounts in the income statement are assigned 7000 to 7030.
The Inventory- Tires is account number 3100, and Accounts Payable is assigned #5000.
A pro tip: It’s important to eliminate accounts that you don’t need. If you stop selling a line of products, remove the related inventory accounts from the chart.
When you eliminate the clutter of extra accounts, posting accounting transactions is easier. Make it a point to review the chart of accounts each month.
A useful chart of accounts makes it easier to use double-entry accounting to post journal entries
Double-entry accounting starts with the balance sheet equation:
Assets – liabilities = equity
Think about the equation this way: Imagine that you sell all of your firm’s assets for cash, and you use the cash to pay off all of your accounts payable balances and your long-term debt. Any cash remaining is your equity, which is the true value of your business.
Double-entry bookkeeping keeps this equation balanced so that the total dollar amount of (assets – liabilities) equals total equity.
Debits and credits are accounting tools you need for double-entry bookkeeping.
Debit and credit rules
These rules help you post journal entries that keep the balance sheet equation in balance:
- Debit entries: Debit entries are posted on the left side of each journal entry. Asset and expense accounts are increased with a debit entry, with some exceptions.
- Credit entries: Credit entries are posted on the right side of each journal entry. Liability and revenue accounts are increased with a credit entry, with some exceptions.
- Totals: The total dollar amount of debits must always equal credits. Fortunately, accounting software requires each journal entry to post an equal dollar amount of debits and credits. The number of debit and credit entries, however, may be different.
- One of each: Every journal entry has at least one debit and one credit entry.
Here’s the journal entry to record the purchase of tires on credit:
Debit #3100 Inventory- Tires: $2,000
Credit #5000 Accounts Payable: $2,000
(To record purchase of tires on credit)
The journal entry includes the date, accounts, dollar amounts, and the debit and credit entries. The description makes it easier for Steve to understand why the transaction occurred if he needs to review the entry months down the road.
You’ll also note that the credit entry is moved slightly to the right, representing the right side of the journal entry.
What’s the impact on the balance sheet formula?
$2,000 increase assets – $2,000 increase liabilities = $0 change equity
The inventory purchase increases an asset account. Accounts payable increases a liability account. The two amounts net to zero, and the formula stays in balance.
Reliable may have hundreds (or thousands) of journal entries each month, and they’re all posted to the general ledger.
Using general ledger
The general ledger detail for a particular account may include dozens or even hundreds of transactions in a given month.
Here is Reliable’s Inventory- Tires general ledger account for August:
Account: #3100 Inventory- Tires
Inventory purchases are debited to increase the account. When goods are sold, the inventory account is decreased with a credit entry.
The general ledger ending balance is posted to the trial balance.
Reviewing the trial balance
The trial balance is a listing of each account and the current account balance.
Your chart of accounts determines how the trial balance is produced. Balance sheet accounts are listed first, based on the order that they appear in the balance sheet. Here’s a portion of Reliable’s 8/31 trial balance:
Reliable Trial Balance: August 31st, 20X9
The $19,000 Inventory- Tires account balance equals the 8/31 ending balance in general ledger.
The trial balance lists asset, liability, and equity accounts first. Then the report lists the revenue and expense accounts found in the income statement.
Before you can create the financial statements, you need to post adjustments to the trial balance using the accrual method of accounting.
Accrual method of accounting
The accrual method of accounting requires a business to post revenue when it is earned, and expenses when they are incurred. This method applies the matching principle, which matches revenue with the expenses that relate to producing the revenue.
The accrual basis presents a more accurate picture of net income, and this method ignores the timing of cash inflows and outflows.
So, before you can use a trial balance to produce the financial statements, you need to pump the brakes.
All of your transactions should apply the accrual method and not the cash method of accounting.
What’s the difference?
Accrual method vs. cash method
The differences between the accrual method and the cash method relate to the timing of revenue and expenses. Net income using the accrual method will be different than net income generated using the cash method.
To explain, let’s go back to the tire purchase.
Assume that Reliable pays the invoice for the tires on September 15th. Here’s the journal entry:
Debit #5000 Accounts Payable: $2,000
Credit #1000 Cash: $2,000
(To pay invoice for tires purchased on 8/1)
The entry reduces Accounts Payable (a liability account) and the Cash account.
The tires purchased on August 1st are sold on October 5th for $2,600 in cash. Here’s how the accounting works, using both methods:
The accrual method required two journal entries on October 5th. One increases expenses, and the other increases revenue:
Debit #6000 Cost of Sales: $2,000
Credit #3100 Inventory- Tires: $2,000
(To record a reduction in inventory and to post cost of sales expense)
Debit #1000 Cash: $2,600
Credit #7000 Sales: $2,600
(To record cash received for tires sold)
The cost of the tires is moved out of inventory and into an expense account, Cost of Sales.
At the same time, Reliable collected $2,600 in the Cash account and recognized a sale (a revenue account).
Here’s the key point: The revenue and expenses are both posted in October. The difference between revenue and expenses is a $600 profit in October.
The cash method does not match revenue with expenses.
What if you used your checkbook activity to post revenue and expenses?
When a client pays you cash, you increase revenue. Expenses are posted when you pay cash.
Sure, it’s simple, but it doesn’t match the revenue you earned with the related expenses. You really don’t know what your profit is on a particular transaction.
Confused? Here’s the cash method of accounting, using the tire purchase and sale.
When Reliable pays cash for the tires, the company recognizes an expense (Cost of Sales):
Debit #6000 Cost of Sales: $2,000
Credit #1000 Cash: $2,000
(To pay cash and record an expense for tires purchased)
The client pays in cash on October 5th, and Reliable posts this entry:
Debit #1000 Cash: $2,600
Credit #7000 Sales: $2,600
(To record cash received for tires sold)
The October 5th entry using the cash method is the same as the accrual method. That’s not always the case, however.
If the customer bought the tires on October 5th on credit, the accrual method would still post revenue on October 5th. The sale is completed when the customer receives the tires, so revenue should be posted.
Reliable would increase Accounts Receivable and Sales on October 5th. Assuming that the customer paid on November 3rd, Reliable would reduce Accounts Receivable and increase Cash on November 3rd.
Ok, let’s think about the cash method.
The problem with the cash method is that expenses are posted in September and revenue is posted in October. Revenue and expenses are not matched, and the financial statement reader doesn’t know how much money Reliable earned on the tire sale.
September doesn’t include the revenue entry. In a similar way, October is missing the expense entry.
The cash method of accounting is misleading, and should not be used.
To nail down the accrual method … let’s go over another common example.
We all have to deal with payroll.
You get that first job, and you realize you’re not always paid immediately for the days you work.
The lag time between the days worked and the payment date requires business owners to use the accrual method of accounting. So, here goes.
Reliable owes $3,000 in gross wages to mechanics on September 30th, and next payroll date is October 7th.
The accrual method requires the company to record the $3,000 wage expense in September- when the hours are worked. Here’s the journal entry on September 30th:
Debit #6100 Wage Expense: $3,000
Credit #5100 Wages Payable: $3,000
(To record wages owed to workers on 9/30)
This entry records an expense and a liability for wages owed on 9/30. When payroll is processed on October 7th, Reliable posts this entry:
Debit #5100 Wages Payable: $3,000
Credit #1000 Cash: $3,000
(To record wages paid in cash and to remove the payroll liability on 10/7)
The liability is removed and cash is paid in October.
This example reinforces the accrual method concept. Revenue and expenses are not posted based on cash inflows and outflows.
Feel like you’ve been on the road for a while? Well, you’ve approached your destination.
Lastly, let’s address how to create statements.
Financial statements for basic accounting
Reliable creates financial statements using an adjusted trial balance.
Steve reviews the general ledger, to determine if any adjusting entries need to be posted. Adjusting entries are posted to conform with the accrual method of accounting.
Think of adjusting entries as required maintenance for your accounting records.
If Steve reviews the September 30th entries and sees that the $3,000 wage expense is not posted, he should post the entry. Fortunately, your accounting software can provide reminders so that you don’t miss an adjusting entry.
Once the adjusting entries are posted, the adjusted trial balance is used to produce the Income Statement, Balance Sheet, and Statement of Cash Flows.
Did I make any money last month? Check the income statement.
The income statement reports on revenue, expenses, and net income (profit) or loss for a specified period. The statement is based on the income statement formula:
Revenue – expenses = net income (loss)
Here is Reliable’s income statement for the month ending October 31st:
If you want a better look under the hood, use a multi-step income statement.
Multi-step income statement
A multi-step income statement separates income into operating and non-operating categories, and this information helps you understand what activities are driving profitability.
Start at the top of the income statement.
As you can see, most of the business activity flows through gross profit:
$520,000 sales – $420,000 cost of sales = $100,000 gross profit
The materials, parts, and labor costs Julie incurs to make repairs are posted to Cost of Sales.
These costs are directly related to production. The more repairs Reliable performs, the more is spent on material, parts, and labor.
Reliable incurs other expenses to operate the business, including home office salaries, insurance premiums, and a building lease. Operating expenses are subtracted from gross profit to calculate net income:
$100,000 gross profit – $90,000 operating expenses = $10,000 net income
Reliable must be able to produce the vast majority of net income from vehicle repairs because the repair business is sustainable. Accountants refer to consistent, sustainable net income as operating income.
Non-operating income is not consistent or predictable.
No company can survive over the long-term by relying on non-operating income to produce profits. If Reliable sells a piece of equipment for a gain, the gain is considered non-operating income. Reliable is in the business of fixings cars- not selling equipment.
This income statement example doesn’t include any non-operating income.
Net income is connected to the balance sheet, as you’ll see below.
The balance sheet is a snapshot of a company’s financial position at a specific date. It reflects the company’s assets, liabilities, and equity balances.
Here are the components that make up a balance sheet:
- Assets: What your business owns. Assets are resources used to produce revenue.
- Liabilities: Amounts your business must pay other parties. Liabilities include accounts payable and long-term debt.
- Equity: Equity is the difference between assets and liabilities, and you can think of equity as the true value of your business.
The components are connected by a formula.
Assets = liabilities + owner’s equity
Here is Reliable’s balance sheet as of October 31, 20X9:
Not all assets are created equal.
Each asset account is defined as current or non-current.
Current assets include cash and assets that will be converted into cash within 12 months. Non-current assets will not be converted into cash within 12 months. The same categories apply to liabilities, as explained below.
- Cash: The total amount of money on hand.
- Accounts receivable: The amount that your customers owe you after buying your goods or services on credit.
- Inventory: Items purchased for resale to customers.
- Prepaid expenses: Expenses you’ve paid in advance, such as six months of insurance premiums.
- Investments: Money-market account balances, stocks, and bonds. Some investments may be categorized as long term, but most are short-term assets.
- Notes Receivable: Amounts you are owed that will be paid within 12 months.
These are the most frequently used current asset accounts.
If you’re wondering if a particular asset is a current asset, consider how quickly the asset can be converted into cash. If the conversion will happen within a year, it’s a current asset.
Your business has other resources are used over the long term.
- Fixed assets: Fixed assets include vehicles, equipment, and buildings used to produce revenue. These assets decrease in value over time. For that reason, depreciation expense is posted to record the decline in value of fixed assets.
- Intangible assets: Assets that have no physical manifestation, such as goodwill, patents, copyrights, and trademarks fall into this category.
If you’re able to use an asset over multiple years, odds are that it’s a long-term asset.
Creditors have a claim on some of your company assets. If you don’t pay a creditor, the firm can sue you and ask a court to award the firm some of your assets.
These claims are called liabilities.
- Current liabilities: These are amounts due to be paid within a year, such as accounts payable (amounts you owe suppliers), payroll liabilities, and amounts due on short-term business loans, such as a line of credit.
- Long-term liabilities: Amounts that are due to be paid in a year or more, including long-term loans, mortgage payments, and future employee benefits. These liabilities are non-current, but the category is often defined as “long-term” in the balance sheet.
If you sold all of your company assets and used the proceeds to pay off all liabilities, any remaining cash would be considered your equity balance.
Reliable has two components of equity—owner’s equity and retained earnings. More on that below.
Equity may include …
- Opening balance equity: The owner’s initial investment in the company. If an owner contributes $50,000 in cash and $10,000 in equipment, the opening equity balance is $60,000.
- Capital stock: The dollar amount of common and preferred stock a company issues to shareholders. Issuing stock increases the equity balance. Julie is the sole owner of Reliable, and the equity section does not have any stock-related categories.
- Net income: Total revenue less expenses, for a month or year. Net income is calculated in the income statement, and the balance increases equity.
Retained earnings are the last component of equity.
This balance is defined as total company earnings (net income) since inception, less all dividends paid to owners since inception. Firms can choose to retain earnings for use in the business or pay a portion (or all) of the earnings as a dividend.
Dividends reduce the equity balance.
The opening balance in equity, net income, and issuing stock all increase the equity balance. If your firm pays a dividend to owners or generates a net loss, equity is decreased.
Connection to income statement
Reliable’s balance sheet includes a $25,000 in owner’s equity. The balance represents cash or other assets contributed by Julie, the sole owner of the business.
The retained earnings balance is $10,000, and that amount equals the $10,000 in net income for 20X9. Let’s assume no beginning balance in retained earnings, and that Julie decides to leave the entire $10,000 in net income in the retained earnings balance.
Cash is the biggest issue facing many companies, so let’s not forget about cash inflows and outflows.
Statement of cash flows
The statement of cash flows reports cash inflows and outflows for operating, financing, and investing activities.
Cash flows are reported for specific time frames, such as a month or year. Here is Reliable’s statement of cash flows for the accounting period ending 10/31/X9:
Cash flows are assigned to one of three categories:
- Cash flows from operations: Operations refer to the day-to-day activities of managing a business. Reliable has cash inflows for customer payments, and cash outflows to purchase parts, and to fund payroll.
- Cash flows from investing: If a business purchases or sells an asset for cash, the impact is posted here. In 20X9, Reliable purchased $10,000 in equipment for cash.
- Cash flows from financing: When a company raises money from investors, borrows funds, or pays on a loan, the cash transactions are classified as financing activities. Julie’s firm paid $15,000 for loans in 20X9.
The $40,000 ending balance in cash equals the 10/31/X9 cash balance in the balance sheet.
The end of the accounting road (actually, just the beginning)
Whew! You’ve finally reached your destination.
You’ve seen the accounting cycle, learned about accounting principles, and reviewed the financial statements.
If you have an accounting system that produces accurate financial statements, you can make more informed decisions.
Better business decisions increase your profits.
Julie monitors her income statement, to make sure that she controls her spending on parts. She keeps an eye on long-term debt in the balance sheet, and see checks out the statement of cash flows to find out where her cash is going.
If you pay attention to the indicators on your dashboard, you’ll keep your car moving down the road this year, next year … and on into the future.