Key Accounting Concepts

Key Accounting Concepts

The two fundamental accounting concepts which were developed centuries ago but remain central to the accounting process are:

• The accounting equation

• Double-entry bookkeeping

The Accounting Equation

Now let us discuss the accounting equation, which keeps all the business accounts in balance. We will create this equation in steps to clarify your understanding of this concept. In order to start a business, the owner usually has to put some money down to finance the business operations. Since the owner provides this money, it is called Owner’s equity. In addition, this money is an Asset for the company. This can be represented by the equation:

ASSETS = OWNER’S EQUITY

If the owner of the business were to close down this business, he would receive all its assets. Let’s say that owner decides to accept a loan from the bank. When the business decides to accept the loan, their Assets would increase by the amount of the loan. In addition, this loan is also a Liability for the company. This can be represented by the equation:

Assets = Liabilities + Owner’s Equity

Now the Assets of the company consist of the money invested by the owner, (i.e. Owner’s Equity), and the loan taken from the bank, (i.e. a Liability). The company’s liabilities are placed before the owners’ equity because creditors have first claim on assets.

If the business were to close down, after the liabilities are paid off, anything left over (assets) would belong to the owner.

The Double Entry System

As we had mentioned earlier that today’s accounting principles are based on the system created by an Italian Monk Fra Luca Pacioli. He developed this system over 500 years ago. Pacioli had devised this method of keeping books, which is today known as the Double Entry system of accounting. He explained that every time a transaction took place whether it was a sale or a collection – there were two offsetting sides. The entry required a two-part “give-and-get” entry for each transaction.

Here is a simple explanation of the double entry system. Say you took a loan from the bank for $5,000. Now if you can recall in an earlier discussion we had mentioned that:

ASSETS = LIABILITIES + OWNER’S EQUITY

Since the company borrowed money from the bank, the $5,000 is a liability for the company. In addition, now that the company has the extra $5,000, this money is an asset for the company. If we were to record this information in our accounts, we would put $5,000 in an account called Loan Taken from the Bank, and $5,000 in an account called Cash Saved in the Bank. The former account will be a Liability and the second account would be an Asset. As you can see, we created two entries. The first one is to show from where the money was received (i.e. the source of the money). The second entry is to show where the money was sent (i.e. the destination of the money received).

In a double entry accounting system, every transaction is recorded in the form of debits and credits. Even for the simplest double entry, transaction there will be a debit and a credit. In simpler terms, a debit is the application of money, and credit is the source of money.

Let us discuss some examples to help you understand the concept of debits and credits:

Example 1

Let’s say you wrote a check for $100 to purchase some stationary. This transaction would be recorded as a Credit of $100 to the Cash in Bank account, and a Debit of $100 to the Stationary account. In this case, we made a credit to the Cash in Bank, as it was the source of the money. The Stationary account was debited, as it was the application of the money.

Example 2

Let’s say you received $200 cash for services rendered to a client. This transaction would be recorded as a Credit of $200 to the Income from Services account, and a Debit of $200 to the Cash in Bank account. In this case, we made a credit to the Income from Services, as it was the source of the money. The Cash in Bank account was debited, as it was the application of the money.

Example 3

Let’s say you received a $10,000 loan from a bank. This transaction would be recorded as a Credit of $10,000 to the Loan Payable account, and a Debit of $10,000 to the Cash in Bank account. In this case, we made a credit to Loan Payable, as it was the source of the money. The Cash in Bank account was debited, as it was the application of the money.

Example 4

Let’s say you made out a payroll check to an employee for $300. This transaction would be recorded as a Credit of $300 to the Cash in Bank account, and a Debit of $300 to the Payroll Expense account. In this case, we made a credit to the Cash in Bank, as it was the source of the money. The Payroll Expense account was debited, as it was the application of the money.

Example 5

Let’s say you invested $10,000 in starting a new business. This transaction would be recorded as a Credit of $10,000 to the Owner’s equity account, and a Debit of $10,000 to the Cash in Bank account. In this case, we made a credit to the Owner’s equity, as it was the source of the money. The Cash in Bank account was debited, as it was the application of the money.

You may remember from our discussion earlier that in order to start a business, the owner usually has to put some money down to finance the business operations. Since the owner provides this money, it is called Owner’s Equity.

Overview

The previous examples illustrated some of the transactions that are recorded in a double entry accounting system. These transactions are also referred to as Journal Entries. Your accounting application automatically creates the journal entries for you. In example 1 above, you would create a check in the system, and on the check you would give the expense account number for stationary. The checkbook program would then automatically credit the cash account, and debit the stationary expense account.