Accounting Basics — A Guide for Beginners
INTRODUCTION TO ACCOUNTING
Accounting is the language of business. It’s the process of recording, classifying, summarizing and reporting financial transactions of an individual or organization. It provides a clear picture of financial health and performance, helping stakeholders make informed decisions.
Whether you’re running a small business, managing personal finances, or pursuing a career in finance, understanding accounting basics is important.
KEY ACCOUNTING CONCEPTS
1. ASSETS
Assets are resources owned by a company. Assets have economic value.
Examples include:
- Cash
- Inventory
- Equipment
- Buildings
- Accounts receivable
2. LIABILITIES
Liabilities are the company’s financial obligations or debts.
Examples include:
- Loans
- Accounts payable
- Taxes payable
- Wages payable
3. EQUITY
Equity represents the owner’s stake in the company.
It’s calculated as:
ASSETS — LIABILITIES
4. REVENUE
Revenue is the income generated from business operations.
Examples include
- Revenue from selling products or providing a service (operating revenue)
- Interest income (non-operating revenue)
Operating revenue is revenue derived from a company’s core operations. Non-operating revenue is derived from activities unrelated to a business’ core operations.
Interest income, for example, is not considered operating income unless your business is a bank or other financial institution whose core business is lending money to earn interest. If you’re a restaurant, for example, and you earn interest from money deposited at the bank, that interest income is non-operating income, because a restaurant is not in the business of lending money.
5. EXPENSES
Expenses are the costs incurred in generating revenue.
Examples include:
- Rent
- Salaries
- Utilities
- Advertising costs
THE FOUNDATION OF ACCOUNTING IS THE ACCOUNTING EQUATION
ASSETS = LIABILITIES + EQUITY
This is the foundation on which all accounting is built. This equation must always be in balance. If it is not in balance something is wrong with the accounts.
Every transaction affects at least two parts of the equation. For example:
- When you buy inventory with cash, assets change (cash decreases, inventory increases), but the total assets remain the same.
- When you take a loan, both assets (cash) and liabilities (loan) increase.
In both examples, the equation balances.
DOUBLE-ENTRY BOOKKEEPING
Double-Entry bookkeeping is another core accounting principle.
Double-entry is a system used in accounting where every transaction affects at least two accounts. Each transaction has:
- A debit entry (left side of the ledger)
- A credit entry (right side of the ledger)
A ledger is a record of all financial transactions of a business.
The total debits must always equal the total credits, ensuring the accounting equation stays in balance and the ledgers are balanced. If the ledgers are not balanced the financial statements will not be correct.
FINANCIAL STATEMENTS
Financial statements show a company’s financial performance and business activities. Properly prepared financial statements indicate where a company’s money came from, where it went, and where it is currently.
There are four main financial statements.
1. BALANCE SHEET
The balance sheet shows a company’s assets, liabilities, and shareholders’ equity at a specific point in time.
- Assets are listed on the left or top
- Liabilities and equity are listed on the right or bottom
- The total of assets must equal the total of liabilities and equity. The balance sheet best demonstrates the accounting equation.
2. INCOME STATEMENT (PROFIT & LOSS STATEMENT)
The income statement shows the company’s financial performance over a period of time.
- It starts with revenue
- Expenses are then subtracted
- This leaves net income (profit) or net loss
This leaves net income (profit) or net loss
3. CASH FLOW STATEMENT
The cash flow statement shows how changes in balance sheet accounts and income affect cash. It is the amount of cash that flows into or out of a business over a specific period of time.
The cash flow statement is divided into:
- Operating activities
- Investing activities
- Financing activities
4. STATEMENT OF CHANGES IN EQUITY
The fourth financial statement is the Statement of Changes in Equity. It is often lumped with the Income Statement, but is its own financial statement.
This statement measures changes in shareholders’ equity over a specific period.
TYPES OF ACCOUNTING
There are two main types of accounting:
1. FINANCIAL ACCOUNTING
Financial accounting focuses on preparing financial statements for based on Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS).
2. MANAGERIAL ACCOUNTING
Managerial accounting provides internal stakeholders with financial information for decision-making, planning, and control purposes.
ACCOUNTING PRINCIPLES
There are certain principles that govern accounting and make it all work.
1. ACCRUAL BASIS VS. CASH BASIS ACCOUNTING
Accrual Basis
Under accrual basis accounting, revenues and expenses are recorded when they are earned or incurred, regardless of when the actual cash is received or paid. If, for example, a company sells products on credit and won’t receive payment until 30 days, it records the revenue when it makes the sale, although it has not yet received the cash.
In this case the company will pass an entry to debit receivables and credit sales for the amount it has sold. The receivables is an asset on the balance sheet that it will collect after the 30 days, while revenue will be reflected in the income statement.
When cash is received after the 30 days, the company will debit its bank account for the cash and credit receivables, which will cancel out the receivables balance that was recorded when the sales were made.
Cash Basis
Under cash basis accounting, revenues and expenses are recorded only when cash is received or paid.
In the previous example, if cash basis was being used, no entries would be done when the sale was made. Entries would be done only when payment is made after the 30 days. The entry would be to debit bank and credit revenue. No receivables account is used in cash basis accounting.
2. MATCHING PRINCIPLE
The matching principle says that expenses should be recognized in the same period as the revenues they helped generate, ensuring accurate net income measurement.
3. CONSISTENCY PRINCIPLE
The consistency principle says that accounting methods used should be consistent from one period to the next for comparability purposes. If different methods are used the results would not be comparable over different periods.
4. MATERIALITY PRINCIPLE
The materiality principle says that you should only disclose information that would impact users’ decisions. Whether a financial statement amount is material or not depends on its size and impact relative to the financial statements as a whole.
CHART OF ACCOUNTS
The chart of accounts is an organized list of all accounts used by a company. Below is an example of a chart of accounts with account numbers.
- Asset accounts (101–199)
- Liability accounts (201–299)
- Equity accounts (301–399)
- Revenue accounts (401–499)
- Expense accounts (501–599)
Each account is assigned a unique number for easy identification and categorization. Companies can choose whatever numbering system they wish to use.
DEBITS AND CREDITS
Another cornerstone of accounting is the use of debits and credits. Understanding debits and credits is crucial in double-entry bookkeeping. Debits and credits tell you whether an account will be increased or decreased for a particular entry.
Accounts are increased or decreased for debits and credits as follows:
For Asset and Expense accounts:
Debit increases the balance
Credit decreases the balance
For Liability, Equity, and Revenue accounts:
Debit decreases the balance
Credit increases the balance
REMEMBER: THE TOTAL DEBITS MUST ALWAYS EQUAL THE TOTAL CREDITS IN ANY TRANSACTION
THE ACCOUNTING CYCLE
The accounting cycle is the process accountants follow to record transactions and create financial statements for a specific period of time.
Steps in the accounting cycle may vary, but a typical cycle may be as follows:
- Identify the transactions
- Record the transactions in a journal
- Post the transactions from the journal to the ledger
- Prepare an unadjusted trial balance
- Make adjusting entries
- Prepare an adjusted trial balance
- Prepare the financial statements
- Close the temporary accounts
ACCOUNTING PRINCIPLES AND ETHICS
Accountants follow generally accepted accounting principles (GAAP) in the U.S. or International Financial Reporting Standards (IFRS) elsewhere.
These standards provide guidelines for:
- Consistency in reporting
- Full disclosure of financial information
- Materiality (focusing on significant items)
- Conservatism when making accounting estimates
ETHICS IN ACCOUNTING IS IMPORTANT
Accountants must:
- Maintain integrity and objectivity
- Avoid conflicts of interest
- Protect client confidentiality
- Comply with relevant laws and regulations
BASIC ACCOUNTING SOFTWARE
While not necessary for understanding accounting principles, familiarity with accounting software can be helpful. Popular options for beginners include:
- QuickBooks
- Xero
- Wave (free for basic features)
These tools can automate accounting tasks, but understanding the underlying principles is important.
CONCLUSION
Accounting might seem daunting at first, but with practice, these concepts will become second nature. Remember, good accounting practices are essential for making informed business decisions, securing financing, and complying with tax laws.