To get the most out of accounting, you need to understand the rules of the game. This chapter gives you the 50,000 foot view of what accounting is all about and why you should care. We start by (briefly) talking about why accounting is important. We'll then delve into "accounts" which house the basic structure for everything you do in accounting. We'll finish up by discussing how you record stuff (i.e., via journal entries).
Note that throughout this chapter we will be talking about "accrual accounting" rather than "cash accounting." You can think of cash accounting as what you do when you record entries in a checkbook. Accrual accounting is a bit more sophisticated, but provides much better information for decision making. It's not that much harder to understand once we learn a few basic rules, but the additional effort will give you a significant advantage when you are trying to analyze your business (this guide can be useful for your personal finances as well, but is geared towards business finances).
The 1913 Webster's dictionary1 describes an accountant as a "reckoner." I like that definition because it makes an accountant sound kind of like a bad-ass, but I think of an accountant more as a scorekeeper. They follow you (and everyone in your business) around everywhere you go and record the financial impact of everything you do. If you buy some equipment, they record it on a ledger. If you sell some stuff, they record it. If you pay someone, they record it. It doesn't matter when you pay for something (or get paid for something) — it's all about the fact that it happened. And this is a very good thing! Sometimes people will forget to pay your invoice; that's ok, because your accountant recorded it and can remind you later that you need to follow-up for payment. When you buy something and your supplier forgets to send you an invoice, you won't be surprised in a few months when they do send it to you beacuse your accountant already recorded it! It takes a lot of work for an accountant to make sure they capture everything, so they have shortcuts to estimate when they need to (which will happen a lot more than you think!).
In addition to being a scorekeeper, they are also a bit like a teacher. At the end of every "period" (oftentimes at the end of a month, a quarter, or a year), they can help you evaluate your score so that you can see why you are winning or losing in the game called business. Unfortunately business doesn't have a scoreboard as simple as the one you'd see in a soccer game or any other sport. There are some metrics that get close like "net profit," but business is much more complicated than that. For example, you may record $1 million in net profit, but if you had to sell $1 billion of stuff to generate that net profit, it could be good or bad (e.g., if you conscientiously kept margins low to grow your business, a $1 billion dollar business is probably great and growing ... if wanted to make a 10% margin generating $100 million in profit but only made $1 million, you probably have challenges!). So rather than a kindergarden teacher helping you understand results from a simple game, accountants are more like college professors helping you understand something quite a bit more complex.
So the primary benefits you get from good accounting are:
It's not all roses, though. You need to understand how everything fits together before you can start making good decisions. But that's what this guide will help you with!
We know that accountants help us keep score and understand how to improve our score. But how do they do that? Let's start with how they keep score. The first thing they need to know (or be able to estimate) is the monetary value of the activity they are trying to track. For example, if you deposited $100 into your bank account, the monetary value is $100. Easy. But how do they record that transaction? You could just fire up an Excel spreadsheet and put $100 in some random cell, but that won't tell you much a month from now when you are trying to figure out what that $100 relates to. Rather than just recording the number 100 in a spreadsheet, you could attach a label to it (e.g., "Deposited at bank"). This is better, but still not quite good enough. What would happen if you recorded a $50 deposit later as "Bank Deposit." rather than "Deposited at bank?" We need a consistent way to label things, so instead we'll use a standard label called "Bank Account." And rather than use the word "label," we're going to use the word "account" instead. While the word "label" might be a bit more intuitive, you will rarely (never?) hear someone refer to a label when referring to something that could also be referred to as an account in accounting. So we'll stick with it because it will make communicating with others easier going forward.
So, we now have an account (i.e., a "label") called "Bank Account" that we can use when recording transactions/activity. By using this label (i.e., account) whenever we record activity that happened in our actual bank account, we can use it to analyze all of our transactions. For example, we can filter them so that we can see every transaction that happened in our bank account. We can summarize them to see what our current balance in our bank account is. We can compare the transactions to the transactions our bank recorded and make sure that we didn't miss anything (and that our bank didn't miss anything!). If we make a deposit, we can record it in our spreadsheet. If we make a withdrawal, we can record it and use a negative number instead of a positive one to reflect an outflow rather than an inflow. Even with this amazing label, we still don't have enough information, though. Why did we deposit $100 in the first place? Did someone loan it to us so we could pay a bill (in which case we would need to pay them back)? Did we sell something that we previously bought for $75 (so we made a profit)? Did we deposit money we saved up from our job over the last few years so that we could start a business? We need to somehow record this additional information so that we know why we deposited money into the account.
One way to do this is to record another line item in our spreadsheet that relates to the $100 line we wrote down recording the bank deposit. When we record this new line, we can attach a different label (i.e., account) to the second line so that we can track where the money came from (so to speak). If we also record the amount as a negative (so that it "offsets" the first line), we've just stumbled on to the greatest tricks that accounting has up its sleeve (and one of the greatest tricks ever devised by mankind): "double-entry accounting." Each line item is an "entry" because you are "entering it" in some type of record-keeping system (historically a book or more technically a "ledger"). So you are recording an "entry in your ledger." It is called "double-entry" accounting because you always record at least two entries in your ledger whenever you record anything. Each entry should contain:
Each ledger will contain two columns:
We'll learn why you would record something in the credit column or the debit column for soon, but the final rule of double-entry accounting is that the sum of all your debits must equal the sum of all your credits (i.e., the entry must balance). This rule can never be violated! In our situation, we would record $100 in the debit column of the "Bank Account" entry line item. The second line item of the entry might refer to:
Each of these would tell you something different if you analyzed them at the end of the month. But you don't want to have to think about every account's purpose when you are analyzing results — you want to be able to aggregate similar accounts for analysis purposes. So let's talk about account types.
While accounts are accounting's basic building blocks, financial statements are the ultimate scoreboard. We'll talk about financial statements in more detail later, but before we get there let's start with one of the basic questions in all of finance (personal or business): how much are you worth? To answer this question, you only need to know three things:
These are the three basic types of accounts (assets, liabilites, and equity) and give you the building blocks for the fundamental accounting equation:
Assets = Liabilities + Equity
It is called "fundamental" because it will always be true no matter what, no
exceptions. You might find it easier to understand when you think about it as
Assets - Liabilities = Equity, but with a little bit of math, you can see
that it's the same exact thing. This is the information you'll find on a
balance sheet, which is one of the reports you will review every month. The
balance sheet always shows your assets on the left and your liabilities and
equity on the right which explains why the fundamental accounting equation is
written in the order that it is. We can now also start to explain why
accountants use debits and credits rather than positive and negative: debits
increase amounts on the left side of the balance sheet (i.e., assets) and
credits decrease amounts on the left. For example, a debit will increase the
balance of your bank account while a credit will reduce the balance of your
Conversely, credits increase amounts on the right side and debits decrease amounts on the right side. For example, a credit will increase the balance of your credit card account while a debit will reduce the balance of your credit card account. Since equity is on the right-hand side of the balance sheet, you would credit equity to increase your net worth. We'll come back to this in a few paragraphs.
Now that we've covered the basics of how much you're worth, you may also want to see how much money you earned for the month (i.e., how much did your net worth change?). For that, you need two more types of accounts:
When you subtract expenses from revenue, you are left with net income which you will find on your profit and loss (or "P&L") statement. We can now finally explain the rationale behind showing equity on the right-hand side of the balance sheet (and why we use credits to increase equity balances). We'll get there by thinking about what needs to happen when you sell a product. Pretend you own a retail store and sell candy. The parents that buy the candy for their kids pay in cash. Double-entry accounting requires us to always have two rows for every entry in our ledger. We already know that at least one row must contain a debit, and at least one other row must contain a credit. We also know that the sum of all the debits must equal the sum of all the credits. Since the parents pay in cash, cash must be one one of the rows. Since cash is something we "own," it is an asset. The fundamental accounting equation tells us that we debit assets to increase their balance. Since we are receiving cash, the first line in our entry must be a debit to cash. What should the credit be so that the entry balances? The only account that makes sense is revenue (remember, we sold something). So in order for this to make sense, a credit to revenue must increase our revenue balance. Our entry now balances, but we're still missing one thing: didn't we just violate the fundamental equation of accounting? We know that assets must equal liabilities + equity, but we credited revenue - how does that fit into the fundamental equation of accounting?
We've now found our final trick! Accountants treat P&L accounts as a subset of equity, so the credit that we made to revenue implicitly is a credit to a special equity account called "retained earnings." This is not completely accurate (usually accountants make a journal entry at the end of a period to transfer P&L balances to retained earnings), but it is true enough for us to think of about it this way. This is why we credit equity to increase its balance on the balance sheet.
Now that we have some background material, we can start to see how it applies to business. We'll try to develop a framework describing how a business "works" from an accounting standpoint. When you start a business, you have nothing. No brand, no team, no product. Just an idea. In order to turn that idea into reality, you need to invest either your time, your money, or both:
Capital. A term accountants use to refer to the value (usually money) invested in a business.In accounting, you can think of this as your "starting capital." If you invested your own money to get started, you would debit (DR) cash and credit (CR) equity. If you borrowed the money to get started, you would still DR cash, but you would CR debt instead of equity. You don't need to record an entry for "sweat equity." You theoretically could, but figuring out the asset is a bit tricker (e.g., maybe you could DR capitalized software ... but that's a bit too advanced for this guide, so we won't record anything). You'll then use this investment to start to build something of value for your customers. It might be a software application, a product you can sell to consumers, or maybe it is just a service that you will offer to your clients. In all cases you are starting to build something before you are paid for it:
How you record these transactions can get a bit complicated, but the easiest thing to do is to expense it by default (CR Cash, DR Expense). You can make exceptions to this rule when the thing you bought has future value (and the future value is big enough to warrant "capitalizing it"). To "capitalize" something just means to record an entry that only impacts the balance sheet (no revenue/expense accounts involved). Examples should help:
Now that you have a product or service that you think people will be willing to buy, you need to start doing a few more things:
Both these tasks are what accounting would consider "selling, general, and administrative" expenses. They don't directly relate to the products you are selling, but they are absolutely necessary to make the business work. And they happen continuously throughout the life of the business. Unless you want the business to fizzle out, you'll continue to invest time and money into the business to help it succeed. As you spend money on these activities, you'll CR cash (which will reduce your cash balance on your balance sheet) and DR an expense (which will reduce your equity):
You now have a product or service you can sell, you've done the administrative work necessary to have a functioning business, and you've marketed to your customers so they know what you are selling and why they might want to buy it. They respond to your marketing and purchase something, so you now need to execute the order by shipping them their product, delivering their service, etc. Sometimes you won't need to do as much marketing if your customers will buy from you again, but that doesn't happen in all businesses.
Recording purchases of things you intend to sell (and then recording revenue for the things you actually sold) follows the same logic as we discussed above. If the things you buy have future value, you can capitalize it. If not, you should expense it. For example:
In this example, we will have inventory left over at the end of the month. When we sell that inventory, we can record entries similar to the 2nd and 3rd entry when that happens. Eventually our inventory will be depleted and we can start over. Like most other things in accounting, inventory can get more complicated (e.g., what do you do when you still have some inventory that you bought at $10 per unit but you now buy more inventory at $15 per unit?), but the basic concepts are still the same. We won't worry about those items in this guide, but if you want to learn more, check out Wikipedia's FIFO/LIFO guide or write to me at firstname.lastname@example.org and I'm happy to try to help.
This chart will be useful throughout this book, so we'll be referring back to it when it makes sense.
In summary, accounting is important because:
In order to maintain an accurate scoreboard, you need to:
Assets = Liabilities + Equity) will
always be true. Assets are always on the left, and liabilities and equity are
always on the right. We debit asset accounts to increase their balance, but
we credit liability or equity accounts to increase their balance. P&L
accounts (revenue and expenses) are like equity accounts, so we normally
credit revenue since it increases our equity/net worth, and debit expenses
since they normally reduce our equity/net worth.