Debits and Credits
These are the backbone of any accounting system. Understand how debits and credits work and you’ll understand the whole system. Every accounting entry in the general ledger contains both a debit and a credit. Further, all debits must equal all credits. If they don’t, the entry is out of balance. That’s not good. Out-of-balance entries throw your balance sheet out of balance. Therefore, the accounting system must have a mechanism to ensure that all entries balance. Indeed, most automated accounting systems won’t let you enter an out-of-balance entry-they’ll just beep at you until you fix your error. Depending on what type of account you are dealing with, a debit or credit will either increase or decrease the balance in another account. That’s it. Accounting doesn’t really get much harder. Everything else is just a variation on the same theme.
Assets and Liabilities
Assets and liabilities are balance sheet accounts. Assets are items of value the company owns (think of your banking accounts and equipment, for example). Liabilities are debts the company owes (think of loans used to purchase equipment, for example). When we set up your chart of accounts, there will be separate sections for the assets and liabilities that make up the balance sheet.
Simply stated, assets are those things of value that your company owns. The cash in your bank account is an asset. So is the company car you drive. Assets are the objects, rights and claims owned by and having value for the firm. Since your company has a right to the future collection of money, accounts receivable are an asset-probably a major asset, at that. If your firm owns machinery, real estate or other tangible property, those are considered assets as well. If you were a bank, the loans you make would be considered assets since they represent a right of future collection. There may also be intangible assets owned by your company. Patents, the exclusive right to use a trademark, and goodwill from the acquisition of another company are such intangible assets. Their value can be somewhat hazy. Generally, the value of intangible assets is whatever both parties agree to when the assets are created. In the case of a patent, the value is often linked to its development costs. Goodwill is often the difference between the purchase price of a company and the value of the assets acquired (net of accumulated depreciation).
Think of liabilities as the opposite of assets. These are the obligations of one company to another. Accounts payable are liabilities, since they represent your company’s future duty to pay a vendor. So is the loan you took from your bank. We separate liabilities into short-term and long-term categories on the balance sheet. This division is nothing more than separating those liabilities scheduled for payment within the next accounting period (usually the next twelve months) from those not to be paid off until later. We often separate debt like this. It gives readers a clearer picture of how much the company owes and when.
After the liability section in both the chart of accounts and the balance sheet comes owner's equity. This is the difference between assets and liabilities. Hopefully, it’s positive - assets exceed liabilities and we have a positive owner's equity. In this section we’ll put in things like partners’ capital accounts, stock and retained earnings. Retained earnings are the accumulated profits from prior years. At the end of one accounting year, all the income and expense accounts are netted against one another, and a single number (profit or loss for the year) is moved into the retained earnings account. This is what belongs to the company’s owners-that’s why it’s in the owner's equity section. The income and expense accounts go to zero. That’s how we’re able to begin the new year with a clean slate against which to track income and expense. The balance sheet, on the other hand, does not get zeroed out at year-end. The balance in each asset, liability, and owners’ equity account rolls into the next year. So the ending balance of one year becomes the beginning balance of the next. Think of the balance sheet as today’s snapshot of the assets and liabilities the company has acquired since the first day of business. The income statement, in contrast, is an accumulation of the income and expenses from the first day of this accounting period (probably from the beginning of this fiscal year).
Income and Expenses
Further down in the chart of accounts (usually after the owners’ equity section) come the income and expense accounts. Most companies want to keep track of just where they get income and where it goes, and these accounts tell you.
If you have several lines of business, you’ll probably want to establish an income account for each. In that way, you can identify exactly where your income is coming from. Adding them together yields total revenue. Most companies have only a few income accounts. That’s really the way you want it. Too many accounts are a burden for the accounting department and probably doesn't tell management what it wants to know. Nevertheless, if there’s a source of income you want to track, create an account for it in the chart of accounts and use it.
Most companies have a separate account for each type of expense they incur. Your company probably incurs pretty much the same expenses month after month, so once they are established, the expense accounts won’t vary much from month to month. Typical expense accounts include payroll, telephone, office supplies, rent, etc.