Accounting 101: A beginner's guide to essential concepts and practices

As a small business owner, understanding and implementing the best accounting 101 practices can improve your confidence and financial health. 

Just how important is accounting? Nine out of 10 business owners surveyed by QuickBooks recognize that their accounting professional(s) contributed to the success of their business. Plus, 98% of small business owners say their accountant or bookkeeper gives them greater confidence.

To help equip you with the knowledge to tackle your financial management confidently, we’ve put together this accounting 101 guide. We’ll walk through the core concepts of accounting, show you the process of how to do accounting, and offer you tips on how to use accounting to gain a better understanding of your business and its future.

• Understanding the accounting process
• Core accounting concepts
• Accounting principles (GAAP)
• Accounting methods: Cash vs. accrual
• The accounting cycle
• Key financial statements
• Basic financial ratio analysis
• Practical accounting tips
• Streamlining your accounting and save time

Understanding the accounting process 

Accounting is the systematic process of recording, categorizing, summarizing, interpreting, and analyzing a business’s financial information. This process is crucial to your business's financial well-being, from tracking revenue and expenses to tackling an audit.

Compared to basic bookkeeping or number crunching, accounting focuses on the overall picture. It can help business owners keep track of their assets, liabilities, and inventory, as well as provide insights into their company’s financial health, allowing them to proactively plan for the future.

Core accounting concepts

When trying to figure out how to do accounting, it is best to start with the core concepts. Understanding how the accounting process works and what the underlying figures mean can get you started on the path towards accurate accounting. 

The accounting equation

Your company’s assets are equal to the sum of your liabilities plus shareholder equity. This is the core concept behind double-entry accounting. Essentially, each debit should have a corresponding credit. The accounting process follows the following formula:

Liabilities + Equity = Assets 

Equity refers to company ownership, liabilities are amounts your business owes, and assets consist of the equipment, materials, and cash your business owns. 

Here’s a quick example. Suppose your business buys a computer for $1000 using $400 cash and $600 charged to your business credit card. In this example, the computer adds to your assets, while using cash decreases your assets, and the credit purchase increases liability. 

Using the account equation, $1000 = $600 + $400, the transaction balances out. 

Assets

Assets are resources your business owns (or controls) that are expected to have a future economic value. These can be tangible assets like equipment or real estate, or intangible assets like patents. 

Here are some examples of common business assets: 

• Buildings (warehouse, plant, office, etc.)
• Land
• Inventory
• Supplies
• Equipment (machinery, computers, etc.)
• Vehicles/fleet
• Accounts receivable
• Cash
• Prepaid expenses
• Patents
• Trademarks
• Investments

All assets fall into one or more of six different categories: tangible, intangible, operating, nonoperating, fixed, and current assets. Correctly classifying your assets is crucial when building your balance sheet.

Liabilities

Liabilities consist of any obligations your business owes to an outside party. This can include money owed to employees, suppliers, banks, and government entities. 

Some common business liabilities include: 

• Salaries to employees
• Money owed to suppliers (accounts payable)
• Mortgage payments
• Loan payments (buildings, vehicles, equipment, etc.)
• Lease obligations
• Unearned revenues (goods and services not yet delivered)
• Payroll taxes
• Sales tax owed
• Warranties for customers
• Bond payments
• Post-employment benefits (i.e., pension)

Business liabilities are classified as current or noncurrent (long-term). Essentially, any obligations due in the current year are current liabilities, while obligations that apply to future years are considered noncurrent liabilities. 

Equity

Equity is the ownership or claim to your business, calculated by subtracting your liability total from your asset total. The value that remains is your equity. 

If your business is publicly owned, this is considered shareholder equity. If your business is privately held, this is considered private equity. 

The components of equity listed on your balance sheet can include: 

Generally speaking, equity is what would be paid out to owners and shareholders if you liquidated your business.

Debits and credits

Debits and credits are necessary to balance the account equation. For each financial transaction, your business must record a debit and a credit on two different accounts. 

Let’s look at some common rules associated with debits and credits: 

When viewing your accounts' transactions, debits will always appear on the left side, and credits will appear on the right. 

The double-entry system

In the double-entry accounting system, each transaction is recorded twice to ensure that your credits and debits are balanced. For every transaction, the total amount debited must equal the total amount credited.

For instance, let’s say you purchase $1,000 worth of supplies from a vendor on credit. The $1,000 would appear as a debit on your inventory account and a credit on your accounts payable account. Your ledger would show: 

Pairing up your debits and credits like this ensures the accounting equation remains balanced. 

Accounting principles (GAAP)

To standardize accounting and ensure transparent financial statements, the Financial Accounting Standards Board (FASB) established a set of accounting rules called the Generally Accepted Accounting Principles (GAAP). These basic accounting principles provide a framework for how businesses should record and report their financial activities to ensure transparency, consistency, and comparability. 

For businesses operating in the US, adhering to GAAP rules is required. If your company does business globally, you may also need to adhere to the International Financial Reporting Standards (IFRS), which have separate guidelines and rules. 

Key accounting principles

To better understand GAAP, let's review some of the core rules and principles necessary for staying compliant. 

• Economic entity assumption: You must keep business finances separate from the owner's personal finances, even with sole proprietorships. 
• Monetary unit assumption: Record all financial activities in a single, stable currency (e.g., US dollars). 
• Time(accounting) period assumption: You should divide business activities into specific time periods (month, quarter, year) for reporting. 
• Going concern assumption: Assumes your business will continue operating indefinitely. 
• Cost principle (or historical cost): Initially record assets at their original purchase cost, regardless of their actual value.
• Full disclosure principle: You must disclose all information relevant to a user’s understanding in your business's financial statements or accompanying notes and disclosures.
• Matching principle: Recorded expenses in the same period as the revenues they helped generate. This principle is a core element in accrual accounting. 
• Revenue recognition principle: Record revenue when the business earned it, regardless of when you received the cash. This principle is another essential element in accrual accounting.

This review covers only a few of the essential accounting rules. You can check the full updated guidelines on the FASB’s website.

Accounting methods: cash vs. accrual

There are two different accounting methods: cash basis and accrual basis. Each method operates with a slightly different set of rules and has significant advantages and disadvantages. Here is a quick overview of the key differences between these two accounting options. 

Cash basis accounting

Cash basis is an accounting method focusing on your business’s cash flow. You record revenue when you receive it, and expenses when you pay them. For example, if a customer pays for a product in December that you don't deliver until January, you still record the revenue in December. 

While cash basis accounting is simple, it may not give you an accurate picture of your profitability. This is because it uses single-entry recording instead of double-entry, better matching revenue and expenses. As your business grows, cash basis accounting may no longer be feasible and may be prohibited by the IRS.

Accrual basis accounting

Accrual basis accounting focuses on recording revenue and expenses when they are earned/incurred. For instance, if a vendor bills you for materials in March, and you pay the bill in May, the expense is still recorded in March even though you have not yet paid. 

Not only does the accrual method of accounting give you a full picture of your business’s overall financial performance, but it is also necessary for complying with GAAP. Additionally, the IRS may require you to use accrual accounting if your business maintains an inventory or has more than $29 million in annual revenue (for the last three years).

The accounting cycle

The accounting cycle is a six-step process for identifying, analyzing, and recording a company's financial transactions during a set period. The process begins when the transaction occurs and ends once the books are closed and the activity appears on your financial reports.

1. Analyzing and recording transactions

The accounting cycle starts with identifying and recording your business transactions. Financial documents like invoices, receipts, statements, etc., should be gathered and analyzed to determine which account they affect and how. 

All financial activities should then be recorded as debits and credits in your general journal. 

2. Posting to the ledger

For step two, you’ll need to transfer journal entries to the general ledger. For double-entry accounting, transactions are added to the T-account (general ledger account), which groups financial activities together by account. 

If you are using cash basis accounting, then transactions will be posted to your cash ledger. 

3. The trial balance

After journal entries have been posted to your general ledger, an unadjusted trial balance should be prepared to verify that your debit and credit totals are equal. 

Next, review the worksheet listing each account's individual debits and credits. This can help you identify discrepancies or errors that need to be addressed before you generate your financial statements.

4. Adjusting entries

If you found any issues during your review, the next step is to address them. Accounting entries may be off because of things like depreciation, deferred revenue, prepaid expenses, and human error. 

Wait to make adjustments until the end of your next accounting period, and be sure to list a reason for the adjustment on your worksheet. 

5. Preparing financial statements

Once you’ve verified your general ledger entries are accurate, you can prepare your adjusted trial balance. With this, you can now generate financial documents like your income statement, statement of retained earnings, and balance sheet. You can also prepare a cash flow statement. 

6. Closing the books

The final step in the accounting cycle process is to close out your books. Using closing entries, you can zero out your temporary accounts and transfer your next income (or loss) to retained earnings.

Once this is done, you should prepare a post-closing balance to ensure your debits and credits are balanced and temporary accounts have been zeroed out. 

Key financial statements

The accounting process can help illustrate how a business is performing and help pinpoint issues that may need to be addressed. Let’s review the essential financial reports you can use to evaluate your business. 

The balance sheet

A company’s balance sheet shows its financial position at any given time. Using the accounting formula, your balance sheet provides a snapshot of your business’s financial health. 

Usually run at the end of a reporting period (e.g., quarter), your balance sheet should include the following:

• Assets - current assets like cash, accounts receivable, and inventory, as well as noncurrent assets like equipment and property. 
• Liabilities - current liabilities like salaries and accounts payable, plus noncurrent liabilities like long-term loans.
• Equity - all ownership and equity totals like common stock, retained earnings, and dividends. 

In the sample balance sheet below, you can see how all of the liabilities and equity total up to the value of the assets.

The income statement (P&L)

Your profit and loss statement, or profit and loss (P&L) statement, will show your company’s financial performance over a set period of time (e.g., month, quarter, year). This financial document shows your net income (or net loss), which is calculated as:

Revenues - Expenses = Net Income 

Looking at your P&L statement, revenues will consist of sales of products or services, as well as other gains (i.e., interest earnings). Expenses will include the cost of goods sold (COGS), which is used to calculate your gross profit, operating expenses, and other losses. Whatever value remains is your net income.  

The statement of cash flows

Using basic accounting and balance sheets can be a good way to review your business’s overall financial health, but it won’t tell you much about your cash flow situation. To do this, you need a cash flow statement. 

Your cash flow statement summarizes your incoming and outgoing cash flow activities over a set period of time. This document is broken down into three key sections: 

• Operating activities (cash flows from normal business operations)
• Investing activities (cash flows from buying/selling long-term assets)
• Financing activities (cash flows from debt, equity, and dividends).

The cash flow statement shows you a clear view of how your cash flow changes over time. It can also be a useful tool for determining your liquidity, and is a document often requested by investors and creditors to make informed financial decisions.

Basic financial ratio analysis

With the data from your financial statements, you can gain insight into your business's health and performance using a few basic financial ratios. These metrics measure things like profitability, liquidity, leverage, and efficiency. Let’s explore how a few of these ratios work. 

Current ratio

The current ratio is a type of liquidity ratio that measures your ability to pay off short-term liabilities with your current assets. Short-term (current) liabilities consist of expenses like accounts payable, salaries owed, and lease payments. 

To calculate this ratio, the formula takes the sum of your current assets and divides it by your current liabilities:

Current ratio = Current Assets ÷ Current Liabilities

Assets like accounts receivable, inventory, and cash all qualify as current assets. Having a high current ratio indicates that your company has more than enough to pay off your short-term debts and other liabilities. 

However, it can also indicate that you are holding onto too much inventory or need to invest in growth. 

Inversely, having a low current ratio suggests that you may have trouble meeting your short-term financial commitments. But it can also reflect normal seasonal changes, low inventory, and other temporary issues.

Debt-to-equity ratio

The debt-to-equity ratio is a type of solvency or leverage ratio that looks at the proportion of your operations that are financed through debt versus equity. The formula looks like this: 

Debt-To-Equity Ratio = Total Liabilities ÷ Total Equity

When your business has a high debt-to-equity ratio, it indicates you are relying heavily on debt to fund operations. While this is often tax-advantageous, it can put you at high risk during economic downturns and make it harder to apply for future financing. 

Having a low debt-to-income ratio suggests you are relying more on equity than debt. This makes your business more attractive to inventors and can give you flexibility in managing future financial opportunities and obstacles. However, it can also indicate that you are missing out on growth opportunities. 

Net profit margin

The net profit margin is a profitability ratio that measures how much profit your business generates as a percentage. Essentially, it illustrates how much of each dollar you earn translates into profit for your business. 

The formula used for this metric is:

Net Profit Margin = (Net Income ÷ Total Revenue) * 100%

Having a high net profit margin indicates your business is very profitable, which gives you the flexibility to invest in growth. 

A low net profit margin, on the other hand, indicates you don’t turn much profit. This can be the result of having stiff competition or high operating expenses. Either way, it makes your business less attractive to investors.

Practical accounting tips

Accounting can seem daunting, but it doesn’t have to be. By following these practical accounting 101 tips, you can ensure you get started on the right foot and maintain good recordkeeping.

Setting up your chart of accounts (COA)

A chart of accounts is a numbered list of all the financial accounts a business uses to record transactions. These accounts will appear in your general ledger. 

A COA is essential for organizing your company’s transactions, managing finances, and generating insightful reports. It is also necessary for GAAP compliance. To get started, define the accounts you need and choose a numbering scheme. 

A typical account list might look like this:

This example offers a solid starting point, but your COA should be tailored to your specific business and accounting needs. 

Software vs. manual bookkeeping

You have options when it comes to recording and tracking your small business’s financial transactions. Choosing the best option depends on the size of your business, your accounting needs, and your preferences. 

Generally speaking, manual bookkeeping is best for very small businesses, sole proprietors, businesses without inventory, and newer businesses. For all other small business owners, software is likely the better choice.

Popular accounting software options like QuickBooks, FreshBooks, and Xero all offer similar features which allow you to track expenses, profit, invoices, and more on an easy-to-use platform. These programs take care of the heavy lifting when it comes to accounting, letting you focus on running and growing your business. 

Importance of record-keeping

Regardless of whether you use account software or opt for manual bookkeeping, the key is to keep accurate, organized, and timely records of all your business transactions. Be sure to save copies of all receipts, invoices, and bills, and reconcile your accounts regularly.

Not only can doing this help you measure your business’s performance, accurate record-keeping can also help you detect fraud, secure loans, make informed decisions, comply with IRS requirements, and promote audit readiness. 

When to hire a professional

As a small business owner, saving money by handling the accounting process yourself is appealing. But, there are occasions where hiring an accounting professional proves to be more than worth the cost. 

Some of these situations include: 

• Business is expanding faster than you can keep up
• Financial transactions are growing more complex
• You lack the time or expertise to manage books accurately
• Help with tax planning and filing
• Facing an audit
• Need financial analysis and strategic advice.
• You are starting a new business or seeking funding

There are many types of financial professionals, each specializing in a different area. A bookkeeper can help you with daily recording, an accountant can help with overall analysis and reporting, and a CPA is the go-to when trying to prevent or deal with an audit. 

Streamlining your accounting and save time

Accounting can be a complex and time-consuming process, but it doesn’t have to be. There are many tools, resources, and experts you can use to help you with your accounting process. Seeking help when you need it is accounting 101. 

Our easy-to-use program and automation options can help streamline your process. Keep accurate records and track your business’s growth and profitability with accounting software like QuickBooks Online.