The Accounting System and Accounting Basics

Accounting for the results of your business activities requires keeping your records in an organized and consistent fashion. While businesses differ tremendously, the basics of accounting critical to running any business remain the same.

Before you can

• set up your accounting records
• dive into your day-to-day transactions
• and get your books ready for end-of-month or end-of-year reporting

you must gain an understanding of basic accounting concepts.

Accounting, simply defined, is the method in which financial information is gathered, processed and summarized into financial statements and reports. An accounting system can be represented by the following graphic, which is explained below.

1. Every accounting entry is based on a business transaction, which is usually evidenced by a business document, such as a check or a sales invoice.
2. A journal is a place to record the transactions of a business. The typical journals used to record the chronological, day-to-day transactions are sales and cash receipts journals and a cash disbursements journal. A general journal is used to record special entries at the end of an accounting period.
3. While a journal records transactions as they happen, a ledger groups transactions according to their type, based on the accounts they affect. The general ledger functions as a collection of all balance sheet, income and expense accounts used to keep a business's accounting records. At the end of an accounting period, all journal entries are summarized and transferred to the general ledger accounts. This procedure is called "posting."
4. A trial balance is prepared at the end of an accounting period by adding up all the account balances in your general ledger. The sum of the debit balances should equal the sum of the credit balances. If total debits don't equal total credits, you must track down the errors.
5. Finally, financial statements are prepared from the information in your trial balance.

Your accounting records are vitally important because the resulting financial statements and reports help you plan and make decisions. These statements and reports may be used by some third parties like bankers, investors or creditors, and are needed to provide information to government agencies, such as the IRS.

For a more in-depth explanation of the accounting system, take a look at the essential categories.

Familiarizing Yourself with Accounting Basics

If you understand the definition and goals of an accounting system, you are ready to learn the following accounting concepts and definitions.

• Assets: Things of value held by you business. Assets are balance sheet accounts. Examples of assets are cash, accounts receivable and furniture and fixtures.
• Liabilities: What your business owes creditors. Liabilities are balance sheet accounts. Examples are accounts payable, payroll taxes payable and loans payable.
• Equity: The net worth of your company. Also called owner's equity or capital. Equity comes from investment in the business by the owners, plus accumulated net profits of the business that have not been paid out to the owners. It essentially represents amounts owed to the owners. Equity accounts are balance sheet accounts.
• The Accounting Equation: Assets = liabilities + owner's equity. The financial statement called the balance sheet is based on the "accounting equation." Note that assets are on the left-hand side of the equation, and liabilities and equities are on the right-hand side of the equation. Similarly, some balance sheets are presented so that assets are on the left, liabilities and owner's equity are on the right.
• Balance Sheet: Also called a statement of financial position, a balance sheet is a financial "snapshot" of your business at a given date in time. It lists your assets, your liabilities and the difference between the two, which is your equity, or net worth. The balance sheet is a real-life example of the accounting equation because it shows that assets = liabilities + owner's equity.

The above represent the overarching umbrella of accounting concepts. Once you master them, you are ready to tackle what day-to-day accounting involves.

•  Debits: At least one component of every accounting transaction (journal entry) is a debit amount. Debits increase assets and decrease liabilities and equity. For this reason, you will sometimes see debits entered on the left-hand side (the asset side of the accounting equation) of a two-column journal or ledger.
• Credits: At least one component of every accounting transaction (journal entry) is a credit amount. Credits increase liabilities and equity and decrease assets. For this reason, you will sometimes see credits entered on the right-hand side (the liability and equity side of the accounting equation) of a two-column journal or ledger.

Considering a Double-Entry Accounting System

In double-entry accounting, every transaction has two journal entries: a debit and a credit. Debits must always equal credits. Think of Newton's third law of motion: For every action (debit) there is an equal and opposite reaction (credit).

Because debits equal credits, double-entry accounting prevents some common bookkeeping errors. Errors that do occur are easier to find. For this and myriad other reasons, double-entry accounting serves as the basis of a true accounting system.

Every transaction in a double-entry accounting system affects at least two accounts because at least one debit and one credit for each transaction. Usually, at least one of the accounts is a balance sheet account. Entries that are not made to a balance sheet account are made to an income or expense account. Income and expenses affect the net profit of the business, which ultimately affects owner's equity. Each transaction (journal entry) is a real-life example of the accounting equation (assets = liabilities + owner's equity).

Some simple accounting systems do not use the double-entry system. You will have to choose between double-entry and single-entry accounting. Because of the benefits described above, we recommend double-entry accounting. Many accounting programs for the computer are based on a double-entry system, but are designed so that you enter each transaction once, and the computer makes the corresponding second entry for you. The double-entry part goes on "behind the scenes," so to speak.

You also need to decide whether you will be using the cash or accrual accounting method. We recommend the accrual method because it provides a more accurate picture of your financial situation.

Definitions of Common Accounting Terms

As you plunge head first into accounting, you'll come across terms used by accountants, in accounting software and, in fact, throughout our website you may have never encountered. To help you familiarize yourself with this new world of numbers and figures, we've compiled the most common accounting terms in a single article. 

• Accounting Equation: Assets = liabilities + owner's equity. The accounting equation is the basis for the financial statement called the balance sheet.
• Accounts Payable: Also called A/P, accounts payable are the bills your business owes to suppliers.
• Accounts Receivable: Also called A/R, accounts receivable are the amounts owed to you by your customers.
• Accrual Method of Accounting: With the accrual method, you record income when the sale occurs, not necessarily when you receive payment. You record an expense when you receive goods or services, even though you may not pay for them until later.
• Adjusting Entries: Special accounting entries that must be made when you close the books at the end of an accounting period. Adjusting entries are necessary to update your accounts for items that are not recorded in your daily transactions.
• Aging Report: An aging report list customers' accounts receivable amounts and their due dates. It alerts you to any slow-paying customers. You can also prepare an aging report for your accounts payable, which will help you manage your outstanding bills.
• Allowance for Bad Debts: Also called reserve for bad debts, it is an estimate of uncollectable customer accounts. Often dubbed a "contra" account because it is listed with the assets, it will have a credit balance instead of a debit balance. For balance sheet purposes, it is a reduction of accounts receivable.
• Assets: Things of value held by the business. Assets are balance sheet accounts. Examples of assets include cash, accounts receivable and furniture and fixtures.
• Balance Sheet: Also called a statement of financial position, this accounting must-have provides a financial "snapshot" of your business at a given date in time. It lists your assets, your liabilities and the difference between the two, which is your equity (or net worth).
• Capital: Money invested in the business by the owners. Also called equity.
• Cash Method of Accounting: If you use the cash method, you record income only when you receive cash from your customers. You record an expense only when you write the check to the vendor.
• Chart of Accounts: The list of account titles you use to keep your accounting records.
• Closing: Closing the books refers to procedures that take place at the end of an accounting period. Adjusting entries are made, and then the income and expense accounts are "closed." The net profit that results from the closing of the income and expense accounts is transferred to an equity account such as retained earnings.
• Corporation: A legal entity, formed by the issuance of a charter from the state. A corporation is owned by one or more stockholders.
• Cost of Goods Sold: Cost of inventory items sold to your customers. It may consist of several cost components, such as merchandise purchase costs, freight and manufacturing costs.
• Credit Memo: The process of writing off all or part of a customer's account balance. A credit memo would be required, for example, when a customer who bought merchandise on account returned some merchandise, or overpaid on their account.
• Credits: At least one component of every accounting transaction (journal entry) is a credit. Credits increase liabilities and equity and decrease assets.
• Current Assets: Assets in the form of cash or will generally be converted to cash or used up within one year. Examples include accounts receivable and inventory.
• Current Liabilities: Liabilities payable within one year. Examples are accounts payable and payroll taxes payable.
• Debit Memo: Used when billing a customer again. A debit memo would be required, for example, when a customer has made a payment on their account by check, but the check bounced.
• Debits: At least one component of every accounting transaction (journal entry) is a debit. Debits increase assets and decrease liabilities and equity.
• Depreciation: An annual write-off of a portion of the cost of fixed assets, such as vehicles and equipment. Depreciation is listed among the expenses on the income statement.
• Double-Entry Accounting: In double-entry accounting, every transaction has two journal entries: a debit and a credit. Debits must always equal credits. Double-entry accounting serves as the basis of a true accounting system.
• Drawing Account: A general ledger account used by some sole proprietorships and partnerships to keep track of amounts drawn out of the business by an owner.
• Equity: The net worth of your company. Also called owner's equity or capital. Equity comes from investment in the business by the owners, plus accumulated net profits of the business that have not been paid out to the owners. Equity accounts are balance sheet accounts.
• Expense Accounts: Accounts you use to keep track of the costs of doing business. Examples are advertising, payroll taxes and wages expense accounts. Expenses are income statement accounts.
• Fixed Assets: Assets generally not converted to cash within one year, such as equipment and vehicles.
• Foot: To total the amounts in a column, such as a column in a journal or a ledger.
• General Ledger: A general ledger is the collection of all balance sheet, income, and expense accounts used to keep the accounting records of a business.
• Income Accounts: Accounts you use to keep track of your sources of income. Examples are merchandise sales, consulting revenue and interest income.
• Income Statement: Also called a profit and loss statement or a "P&L." It lists your income, expenses and net profit (or loss). The net profit (or loss) is equal to your income minus your expenses.
• Inventory: Goods you hold for sale to customers. Inventory can be merchandise you buy for resale, or it can be merchandise you manufacture or process, selling the end product to the customer.
• Journal: The chronological, day-to-day transactions of a business are recorded in sales, cash receipts and cash disbursements journals. A general journal is used to enter period end adjusting and closing entries and other special transactions not entered in the other journals. In a traditional, manual accounting system, each of these journals is a collection of multi-column spreadsheets usually contained in a hardcover binder.
• Liabilities: What your business owes creditors. Liabilities are balance sheet accounts. Examples are accounts payable, payroll taxes payable and loans payable.
• Long-Term Liabilities: Liabilities not due within one year. An example would be a mortgage payable.
• Merchandise Inventory: Goods held for sale to customers.
• Net Income: Also called profit or net profit, it is equal to income minus expenses. Net income is the bottom line of the income statement (also called the profit and loss statement).
• Partnership: An unincorporated business with two or more owners.
• Post: To summarize all journal entries and transfer them to the general ledger accounts at the end of an accounting period.
• Prepaid Expenses: Amounts you have paid in advance to a vendor or creditor for goods or services. A prepaid expense is actually an asset of your business because your vendor or supplier owes you the goods or services. An example would be the unexpired portion of an annual insurance premium.
• Prepaid Income: Also called unearned revenue, it represents money you have received in advance of providing a service to your customer. Prepaid income is actually a liability of your business because you still owe the service to the customer. An example would be an advance payment to you for some consulting services you will be performing in the future.
• Profit and Loss Statement: Also called an income statement or "P&L." It lists your income, expenses and net profit (or loss). The net profit (or loss) will equal your income minus your expenses.
• Proprietorship: An unincorporated business with only one owner.
• Reserve for Bad Debts: Also called allowance for bad debts, this estimate of uncollectable customer accounts is also referred to as a "contra" account because it is listed with the assets, but it will have a credit balance instead of a debit balance. For balance sheet purposes, it is a reduction of accounts receivable.
• Retained Earnings: Profits of the business that have not been paid to the owners and have been "retained" in the business. Retained earnings are stored in an "equity" account that is presented on the balance sheet and on the statement of changes in owners' equity.
• Sole Proprietorship: An unincorporated business with only one owner.
• Trial Balance: Prepared at the end of an accounting period by adding up all the account balances in your general ledger. The debit balances should equal the credit balances.
• Unearned Revenue: Also called prepaid income, it represents money you have received in advance of providing a service to your customer. While it may sound like an asset, unearned revenue is actually a liability of your business because you still owe the service to the customer. An example would be an advance payment to you for some consulting services you will be performing in the future.

Comparing the Cash Method and the Accrual Method

As a business owner, you'll have to make an executive decision about something you probably never considered: whether you'll use a cash or accrual accounting system. In some instances, you may be forced to use one or the other.

You'll want to consider both methods and how they apply to your business before committing to one over the other.

The Cash Method

If you use the cash method of accounting, you record income only when you receive cash from your customers. You record an expense only when you write the check to the vendor. 

Most individuals use the cash method for their personal finances because it's simpler and less time-consuming. However, this method can distort your income and expenses, especially if you extend credit to your customers, if you buy on credit from your suppliers, or you keep an inventory of the products you sell.

The Accrual Method

With the accrual method, you record income when the sale occurs, whether it be the delivery of a product or the rendering of a service on your part, regardless of when you get paid. 

You record an expense when you receive goods or services, even though you may not pay for them until later. The accrual method gives you a more accurate picture of your financial situation than the cash method because you record income on the books when it is truly earned, and you record expenses when they are incurred. Income earned in one period is accurately matched against the expenses that correspond to that period so you see a clearer picture of your net profits for each period.

Weighing the Pros and Cons

The cash method is easier to maintain because you don't record income until you receive the cash, and you don't record an expense until the cash is paid out. With the accrual method, you will typically record more transactions. For example, if you make a sale on account (or, on credit), you would record the transaction at the time of the sale, with an entry to the receivables account. Then, when the customer pays the bill, you will record the receipt on account as another transaction. With the cash method, the only transaction that is recorded is when the customer pays the bill. If you are using software for your accounting, the program automates much of the extra effort required by the accrual method.

Of course, there are always taxes to consider. For your own sanity, you'll probably want to use the same method for your internal reporting that you use for tax purposes. However, the IRS permits you to use a different method for tax purposes. Some businesses can use the cash method for tax purposes. If you maintain an inventory, you will have to use the accrual method, at least for sales and purchases of inventory for resale.

We recommend the accrual method for all businesses, even if the IRS permits the cash method, because accrual gives you a clearer picture of the financial status of your business. You probably need to keep a record of accounts receivable and accounts payable anyway, so you are already keeping track of all the information needed to do your books on the accrual basis. If you are using a software system, there really isn't much extra effort involved in using the accrual method.

Who Can Use the Cash Method?

Although the IRS allows all businesses to use the accrual method of accounting, most small businesses can instead use the cash method for tax purposes. The cash method can offer more flexibility in tax planning because you can sometimes time your receipt of revenue or payments of expenses to shift these items from one tax year to another.

However, some that are not S corporations and partnerships that have at least one corporation (other than an S corporation) must use the accrual method. Some exceptions are made for farming businesses and entities (including corporations) with average annual gross receipts of less than five million dollars for all prior years.

Tax shelters may never use the cash method. If your business has inventories, you must use the accrual method, at least for sales and merchandise purchases.

If you are thinking about using the cash method of accounting for tax purposes, you should discuss these rules with your accountant.

Deciding on a Single- or Double-Entry System

Once you've decided upon cash or accrual accounting, there's one more crucial step to consider: a single- or double-entry system.

The double-entry system provides checks and balances to ensure that your books are always in balance. Every transaction has two journal entries: a debit and a credit. Debits must always equal credits. Because debits equal credits, double-entry accounting prevents some common bookkeeping errors. Errors that aren't prevented are easier to find. You can probably see why most accountants consider double-entry accounting the basis of a true accounting system.

With double-entry accounting, every transaction comprises at least one debit and one credit. Usually, one of the accounts is a balance sheet account. Entries that are not made to a balance sheet account are made to an income account or expense account. Income and expenses affect the net income of the business, which ultimately affects your equity. Each transaction (journal entry) is a real life example of the accounting equation (assets = liabilities + owner's equity).

These entries show that your accounts receivable (a balance sheet account) has increased by $1,500, and your consulting revenue (an income statement account) has also increased by $1,500.

These entries show that your cash (a balance sheet account) has increased by $1,500, and your accounts receivable have decreased by $1,500.

The Single-Entry System

Rather than dealing with debits and credits, some businesses just record one side of the transaction, hence the term single-entry accounting system. In the above example, you would simply record the revenue amount of $1,500 in your sales journal. However, you would also want to make a separate entry in your accounts receivable ledger so you keep track of all customers that owe you money.

We recommend the double-entry accounting system because it will result in more accurate financial records. Because debits must always equal credits, a double-entry system will help you find common bookkeeping errors, including:

• an amount entered incorrectly
• forgetting to record a transaction
• improperly copying an amount from one page to another
• transposition errors

If your accounts don't balance—total debits don't equal total credits—you know you've made an error that must be investigated.

This may sound like copious amounts of work compared to single-entry, but your accounting software will allow you to make a single entry for a transaction then automatically make the second entry on your behalf.