If you've ever wanted to learn how to do accounting with no nonsense, fluff or frills, then please keep reading on...
We're assuming that you've just started your very first accounting course, or perhaps this specific blog post "technically speaking" is your very first accounting course. Either way, you probably have ZERO exposure to accounting, whatsoever. By the end of this blog post, we'll have you looking at the books of a fortune 500 company, and guarantee that you'll know what you're looking at.
The beautiful thing about accounting is that, believe it or not, the math is very simple. It's not like calculus or trigonometry, where you need a scientific calculator to determine an answer that is simply just a number. Accounting only requires your basic four function calculator. In fact, you don't even need multiplication or division functions to do accounting. So we're really not kidding around when we say that it is simpler than you might think.
The most important formula in the world of accounting is this one:
⬇ ACCOUNTING ⬇
ASSETS = LIABILITIES + EQUITY
This diagram represents the formula being converted into three conceptual boxes. On the left, we have a box that represents the value of assets. The boxes on the right represent the value of liabilities and equity.
In the diagram above, notice how the boxes are completely lined up. This means that the ASSETS box can never be larger than the combined LIABILITIES and EQUITY box. One of the most important rules of accounting is to make sure all of the numbers balance evenly before closing the books.
Still with us? Let's dive into the first step of accounting...
(Accounting STEP 1): Debits & Credits
Accountants use the terms Debit and Credit as a way of saying they're increasing or decreasing an account. An account could be for example, an asset account such as cash, or it could be a liability account, such as accounts payable.
Now this part you MUST remember...
- Asset accounts must always have a DEBIT balance.
- The Liability & Equity accounts must always have a CREDIT balance.
Remember, when adding up the value of your assets in the left box, they must always be equal to the value of the liabilities and equity on the right boxes. If not, then there is usually cause for concern. When we populate these boxes with numbers to create a report, we call this report a "BALANCE SHEET".
Let's just put some numbers in a sample balance sheet for fun, to help you connect a conceptual model with reality:
The accounts on the left represent our DEBIT balances, and the numbers on the right represent our CREDIT balances.
Notice how the Total assets (total debits) and Total liabilities and equity (total credits) match perfectly? This is an example of a balance sheet that was well prepared. This is just a brief lesson on how debits and credits look when preparing them on a balance sheet. To learn more about this subject, please checkout our full-length video of step one below. ⬇
(Accounting STEP 2): Journal Entries
Journal entries identify the accounts that get posted for any transaction. Think of an account as a bucket of transactions. For example, the cash account accumulates all the transactions that track money coming in and out of the bank account. The Travel Expense account tracks all the spending on travel costs.
Journal entries have two sides - the debit side and the credit side. One side is no better or worse than the other, but in double-entry bookkeeping, to have your balance sheet balance, you must have an equal number of debits and credits.
Here is an example of how both sides should look after a capital transaction:
For this example, let's say that "Simon" incorporates a company name Simon AC Ltd. and opens a bank account. He put $5,000 into the account and is issued 5,000 common shares return.
When we debit an account, it depends on the nature of the account of whether it increases or decreases. Asset accounts are always in a debit balance and to increase them, you debit them, say in the case of when you deposit cash in your bank account this is a debit to cash. You can also credit your bank account when you withdraw cash and this lowers the amount of the debit balance.
Expense accounts are typically debit balances as well, because when you pay travel expenses, you debit the travel expense bucket and you credit the bank account.
Here, Simon receives an invoice from his friend for the $700 owed for helping out with an installation.
Liabilities are always credits and so are revenue accounts. Let's say you receive an invoice from a supplier for some inventory you purchased. You would debit inventory, which is an asset account, and credit accounts payable for the amount owing to your supplier.
When you sell that inventory and receive cash, the journal entry is to debit the bank account, because you need to debit Cash and credit Revenue.
Is this enough to give you a sense of journal entries? If you want to learn more, why not check out our lesson...
(Accounting STEP 3): Posting Entries to a Trial Balance
A trial balance lists all the accounts in your chart of accounts. Recall that an account is a bucket that accumulates like transactions. For example, all the cash transactions - deposits and withdrawals are accumulated in the cash account. All the travel costs are accumulated in the travel expense account and so on and so on.
A trial balance is so called because it too balances. The total value of all the debit accounts must equal the total value of all the credit accounts.
This happens because all the journal entries follow a rigorous discipline of balancing debits and credits.
Most accounting software will post these debits and credits without you needing to worry about it. However, you can just as easily post journal entries using a spreadsheet. Once you understand debits and credits, tracking the various accounts and accumulating the balances into a trial balance is easy.
Want to see how, why not check out our lesson...
(Accounting STEP 4): Preparing Financial Statements
In the final step, once you have a trial balance (that balances), preparing your financial statements is a relatively easy.
From a trial balance, you will always be able to prepare two primary statements that make up a set of financial statements - the income statement and balance sheet.
The start with, recognize that the accounts listed on the trial balance are either balance sheet or income statement accounts. Balance sheet accounts are those that are assets, liabilities or equity accounts. Those that are income statement accounts relate to revenue and expenses.
I like to start with the income statement accounts. Revenue accounts are typically listed first followed by the expense accounts. The difference between these two accounts is either net income or a net loss. Net income represents a net credit that increases retained earnings at the end of the year. A net loss represents a net debit that decreases retained earnings at the end of the year.
Here is a sample income statement:
This diagram shows where credits and debits should properly be place on an income statement. Income Statements are typically reported for a period of time, like a month, quarter, or year.
The balance sheet groups the various asset accounts, typically separated between current and long term. Current assets are those that can be realized within one year, for instance, cash, inventory, accounts receivable. All the rest are long term. Liabilities are categorized similarly between current and long-term.
Shareholders' equity is typically composed of capital stock, which comes right off the trial balance, and retained earnings. The retained earnings on the trial balance represents the balance of retained earnings at the beginning of the year so to get your balance sheet to balance, you need to add to it net income or subtract from it the net loss incurred during the year.
Here is a sample statement of changes in owners equity:
Want to see it in action? Why not check out our tutorial....
Would you like to practice your journal entries in accounting more? At Executive Finance, we've literally got an app for that...
Download General Ledger©, an innovative game to learn accounting, to your electronic device today. It also connects you to the resources on our website. Have some fun with it and in no time at all, you'll be a master with debits and credits, journal entries, trial balances, and preparing financial statements.