Welcome to Scout's Really Exciting Accounting articles. I'm going to start at the very beginning and go from there. I'm also going to try to work in how I use my current accounting software, Xero. They don't pay me, I just really like their product. I highly recommend hiring a CPA if you don't have one. I received a recommendation through a neighbor. Ask a few small business owners you respect for a referral.
Ok, the following few paragraphs contain a bunch of pretty dry stuff, and that's by accounting standards. If your already familiar, you can skip it. Otherwise, you should probably become familiar with the concepts before moving on.
Revenue is basically the amount of cash a company receives. It is the "gross income" figure from which costs are subtracted to determine “net income”. This is the money you receive from a client in exchange for walking their dog(s).An Expense is quite simply a cash outlay. Examples include wages, utilities, contractors, cell phone, and insurance to name a few.
An Asset is a resource with economic value that an individual or corporation controls with the expectation that it will provide future benefit. Cash and inventory are considered assets. Let’s say you sell leashes to your clients. When you receive those leashes into your possession, you would record them as an asset.
A Liability means that you are legally responsible for something, in the case of a business, that would be money you owe someone or another business. This is all of your payables. Any item or service you have received but not yet paid for. Lets use the leash example again. You purchase the leashes from your supplier, but you don’t have to pay for them until the end of the month. You would record the purchase price as a liability called accounts payable.
Equity is the amount of the funds contributed by the owners (private or stockholders) plus the earnings (or losses). Basically, this is the amount of money you invested in your company less money taken out, also called a “draw” plus any earnings or less any losses. Let say your just finishing up you first year in business. You opened a bank account and put $1000 into the account. Over the course of the year, you charged $5000 worth of dog walking services to your clients. You spent $2000 of it on various expense such as business registration fees and a bike. Then, you paid yourself $2000 for all your hard work during the year. After all that you have $2000 left in the bank. After your first year, your equity account would equal, $1000 (initial investment) + $5000 (Revenue) - $2000 (Expenses) – $2000 (Draw) = $2000. And just like that you doubled your investment☺ If only it were that easy!
Double entry bookkeeping
Now that we have covered some basic definitions, I want to explain the idea of double entry bookkeeping. As the name implies, every entry you ”book” to an account, must have a corresponding and opposite entry to a different account. The system is based on the financial equation Equity = Assets – Liabilities. This equation is used to detect errors. The basic theory is that the sum of debits and the sum of credits must be equal in value or a mistake has been made. It should be noted that there are still many other errors you can make in bookkeeping, such as debiting or crediting the wrong account by accident.
Debits and Credits
So how do you know which accounts to debit and which accounts to credit? Luckily, there are rules. If the account you “booking” to is an Expense or Asset account, a debit increases the value of the account while a credit decreases it. If it’s a Revenue or Liability account, a debit decrease the value of the account while a credit increases it.
As we begin using more complex examples we will use journal entries to log various financial transactions in the associated accounts. Debits are offset to the left, and credits are offset to the he right.Most people don’t know that famed “Crunk” rapper and producer, Little John, really wrote his hit song about accounting; however, record executives felt the subject matter wasn’t marketable. The original lyrics, in fact, were, “Debits on the left by the window, Credits on the right by the wall, From the window to the wall…” Hopefully this will help you remember.
To help illustrate the use of debits and credits lets use a simple example:
In this example, you receive cash on the counter after each walk. You receive a payment from a client for $100 in dog walking. You have an employee or contractor to whom you pay $50 for completing those services.
Step 1: Record the Sale Dr. Cash $100Cr. Dog Walking Sales $100
Step 2: Record the Expense Dr. Direct Labor $50Cr. Cash $50
Now you know some important concepts and how to record a journal entry. If you find this type of post helpful and you want to see more like it, just let me know by leaving a comment.
This series of articles is in the memory of Beau Parent, the best accounting professor ever.