Accounting 101: The Basics You Need to Know

Do you understand double-entry accounting? Struggling to recall debits vs. credits? The Blueprint takes you through accounting 101.

Mary Girsch-Bock

Accounting Specialist

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Updated December 9, 2020

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The thought of learning and understanding a bunch of seemingly complicated accounting concepts can strike fear into the hearts of small business owners.

However, if you take a little time to familiarize yourself with the basics of accounting, you’ll likely find it’s not as difficult as you may have imagined. We’re here to show you some important accounting basics every small business owner should know and understand.

At a glance: The accounting basics small business owners should know

• Bookkeepers record financial transactions, while accountants provide analysis of what those transactions mean. As a business owner, you’ll likely be doing a bit of both.

• Double-entry accounting is the best way to ensure that your accounts remain in balance.

• Debits and credits are the heart of accounting. These entries can both either increase or decrease an account balance, depending on the type of account.

• Financial statements provide you with the information needed to make both short-term and long-term decisions about your business.

Accounting definition and glossary

While accounting may appear to be intimidating to business owners, just about anyone can easily understand bookkeeping basics.

Familiarizing yourself with common accounting terms can go a long way towards making you much more comfortable with the entire accounting process.

1. Double-entry accounting

Double-entry accounting means every transaction entered into your accounting system or ledger will affect at least two accounts. For every debit entry you make, you will need to make a corresponding credit entry.

Likewise, if you’re making a credit entry, you will have to make a corresponding debit entry. This ensures that your accounts remain in balance. While sole proprietors and freelancers may not need to employ double-entry accounting, small and growing businesses will be better served by doing so.

2. Debits and credits

Debits and credits are used to record all of your small business bookkeeping and accounting transactions. The effect that a debit or credit has on a particular account is largely dependent on the account type being affected.

TYPES OF ACCOUNT

INCREASES BALANCE

DECREASES BALANCE

Assets

Debit

Credit

Liabilities

Credit

Debit

Revenue

Credit

Debit

Expenses

Debit

Credit

Equity

Credit

Debit

For instance, if you post a debit transaction to an asset account, it will increase the balance of that account, while if you post a debit to a liability account, the balance of that account will be decreased.

A debit is always on the left side of any accounting transaction, while a credit is always on the right side of the transaction.

3. Chart of accounts

Your chart of accounts is the heart of any accounting system and lists all of the accounts found in your general ledger, which is where all of your accounting entries reside.

You should create the chart of accounts prior to recording any financial transactions. Fortunately, most small business accounting programs include a default chart of accounts that the majority of small businesses can use, with the ability to add more accounts if necessary.

4. Cash accounting method

After setting up your chart of accounts, you will need to decide what type of accounting method you will use. Many freelancers and sole proprietors use the cash accounting method, which records cash when it is received and expenses when they are paid, and it does not keep track of accounts payable or receivable balances.

5. Accrual accounting method

If you have employees or you sell products, you should be using the accrual accounting method. This method records all revenue/income and expenses as they occur, not when your customer pays or you write a check for a bill.

Accrual accounting provides a much clearer picture of both income and expenses for a specific period of time, but it can make it more difficult to manage cash flow properly.

6. Assets

An asset is anything of value that your business owns. Assets can include the cash in your bank account, your accounts receivable balance, the building you own, inventory, supplies, computer equipment, and furniture. Assets can also be intangible, such as intellectual property.

7. Liabilities

Liabilities are anything your business owes. Your accounts payable balances are considered liabilities because that’s what you currently owe your vendors. Loans are also considered a liability.

8. Revenue and income

Revenue, or income, is any monies received during the course of conducting business, whether that’s selling products or services.

9. Expenses

Everything from paying your employees to paying your electric bill is considered an expense. For instance, when you enter an electric bill to be paid next month, that’s recorded as an expense. An expense report helps you track your business expenses so you can know where your money is going

10. Equity

Equity represents your current financial interest in your business and is derived from subtracting your total liabilities from your total assets.

11. Accounts payable (A/P)

Accounts payable is a record of bills that have been entered into ledger or accounting software, but have not yet been paid. Once a vendor has been paid, the A/P balance is reduced by that amount.

DATE

ACCOUNT

DEBIT

CREDIT

10-25-19

Utility Expense

200

10-25-19

Accounts Payable

200

When the electric bill is paid the following month, the entry would be:

DATE

ACCOUNT

DEBIT

CREDIT

10-25-19

Accounts Payable

200

10-25-19

Cash Account

200

You can see that the initial entry in A/P is a credit, which increases the balance of that account. Once that bill has been paid, A/P is reduced by the amount of the payment, while your cash account is reduced as well.

12. Accounts receivable (A/R)

Accounts receivable is where all of the funds currently owed to your business are recorded until paid by your customers. Once a customer pays their bill, the A/R balance is reduced. You can use A/R to acquire insight into your business operations by calculating the accounts receivable turnover ratio.

13. Aging

Both A/P and A/R accounts include aging, which is simply a way to manage monies coming in or monies going out. A/P aging displays a list of all bills currently owed vendors and suppliers, tracking due dates and advising you when a payment is due, or when it is late.

A/R provides the same information for outstanding customer payments, again advising you when a customer payment is late. Once you have multiple customers or vendors, aging reports can become invaluable to your business.

14. Journal entries

While your accounting software will likely handle the majority of the entries needed for your business, there may be occasions when you will need to enter a journal entry.

This can happen for things such as bank charges that you may find when you reconcile your bank account at the end of the month. Or, it can be for depreciation entries if you’re recording depreciation for big-ticket items (such as building purchases, expensive computer systems, or the purchase of a company vehicle).

All of these transactions will need to be entered into your accounting software by making a journal entry.

How to set up an accounting system for your small business

Fortunately, today’s small business accounting software applications such as QuickBooks Online, Xero, and FreshBooks are designed to make it easy to set up your business.

While small business owners can use spreadsheet software, it’s really in your best interest to find accounting software that you’re comfortable using, and begin setting up your business.

Many accounting software applications such as FreshBooks offer expedited setup. Source: FreshBooks software.

Step 1: Create a chart of accounts

Again, using accounting software, this process is usually automated and quite painless, with most small business owners able to use the default chart of accounts provided in the software.

Accounting software applications like

Kashoo offer a default chart of accounts to use. Source: Kashoo software.

Step 2: Determine your accounting method

Prior to entering transactions, you will need to determine if you want to use the simplified cash accounting method or the more comprehensive accrual method. Remember, if you have employees or manage a lot of inventory, accrual should be your preferred method.

Step 3: Set up beginning balances, if any

If you’re a new business owner, you won’t have beginning balances, but those transitioning from spreadsheet software or another accounting application will need to enter their beginning balances into the appropriate general ledger accounts.

Step 4: Begin entering transactions

Once you’ve created your chart of accounts, chosen your accounting method, and entered your beginning balances into your current software application, then you can begin to enter your financial transactions.

Ways accounting software can help with your financials

Years ago, small business owners often found themselves completely lost when it came to understanding and navigating accounting software.

Today, these applications have made the entire process much easier, using intuitive data-entry screens while replacing outdated terms with familiar vocabulary that most of us are already familiar with.

In fact, using accounting software can result in the following:

• A reduction in errors: Accounting software is designed to accurately capture your financial transactions, such as expenses and writing invoices, and reduce input errors. While it’s easy to forget to enter the second part of a transaction in a spreadsheet, using accounting software, you’ll be immediately prompted should you forget.

• More free time: Inputting all of your transactions in a spreadsheet can be time-consuming. Entering this information manually in separate ledgers can be even worse. When using accounting software, you’ll find that you actually have more free time to spend on your business, instead of doing accounting work.

• Access to comprehensive financial reports: Creating financial statements from spreadsheets is a recipe for disaster. Instead, it takes about 30 seconds to create a comprehensive set of financial statements such as a balance sheet, income statement, and cash flow statement using accounting software.

Accounting Basics

(Explanation)

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1. Part 1

2. Introduction to Accounting Basics, A Story for Relating to Accounting Basics

3. Part 2

4. Income Statement

5. Part 3

6. Balance Sheet – Assets

7. Part 4

8. Balance Sheet – Liabilities and Stockholders' Equity

9. Part 5

10. Statement of Cash Flows, Double-Entry System, Sample Transaction #1

11. Part 6

12. Sample Transactions #2 - #3

13. Part 7

14. Sample Transactions #4 - #6

Introduction to Accounting Basics

Did you know? To make accounting even easier to understand, we created a collection of premium materials called AccountingCoach PRO. Our PRO users get lifetime access to our visual tutorials, video training, cheat sheets, flashcards, quick tests, quick tests with coaching, business forms, and more.

This explanation of accounting basics will introduce you to some basic accounting principles, accounting concepts, and accounting terminology. Once you become familiar with some of these terms and concepts, you will feel comfortable navigating through the explanations, quizzes, quick tests, video training, and other features on AccountingCoach.com.

Some of the basic accounting terms that you will learn include revenues, expenses, assets, liabilities, income statement, balance sheet, and statement of cash flows. You will become familiar with accounting debits and credits as we show you how to record transactions. You will also see why two basic accounting principles, the revenue recognition principle and the matching principle, assure that a company's income statement reports a company's profitability.

In this explanation of accounting basics, and throughout all of the free materials and the PRO materials—we will often omit some accounting details and complexities in order to present clear and concise explanations. This means that you should always seek professional advice for your specific circumstances.

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A Story for Relating to Accounting Basics

We will present the basics of accounting through a story of a person starting a new business. The person is Joe Perez—a savvy man who sees the need for a parcel delivery service in his community. Joe has researched his idea and has prepared a business plan that documents the viability of his new business.

Joe has also met with an attorney to discuss the form of business he should use. Given his specific situation, they concluded that a corporation will be best. Joe decides that the name for his corporation will be Direct Delivery, Inc. The attorney also advises Joe on the various permits and government identification numbers that will be needed for the new corporation.

Joe is a hard worker and a smart man, but admits he is not comfortable with matters of accounting. He assumes he will use some accounting software, but wants to meet with a professional accountant before making his selection. He asks his banker to recommend a professional accountant who is also skilled in explaining accounting to someone without an accounting background. Joe wants to understand the financial statements and wants to keep on top of his new business. His banker recommends Marilyn, an accountant who has helped many of the bank's small business customers.

Note: To learn about the roles of accountants and CPAs visit our topic Accounting Careers.

At his first meeting with Marilyn, Joe asks her for an overview of accounting, financial statements, and the need for accounting software. Based on Joe's business plan, Marilyn sees that there will likely be thousands of transactions each year. She states that accounting software will allow for the electronic recording, storing, and retrieval of those many transactions. Accounting software will permit Joe to generate the financial statements and other reports that he will need for running his business.

Joe seems puzzled by the term transaction, so Marilyn gives him five examples of transactions that Direct Delivery, Inc. will need to record:

• Joe will no doubt start his business by putting some of his own personal money into it. In effect, he is buying shares of Direct Delivery's common stock.

• Direct Delivery will need to buy a sturdy, dependable delivery vehicle.

• The business will begin earning fees and billing clients for delivering their parcels.

• The business will be collecting the fees that were earned.

• The business will incur expenses in operating the business, such as a salary for Joe, expenses associated with the delivery vehicle, advertising, etc.

With thousands of such transactions in a given year, Joe is smart to start using accounting software right from the beginning. Accounting software will generate sales invoices and accounting entries simultaneously, prepare statements for customers with no additional work, write checks, automatically update accounting records, etc.

By getting into the habit of entering all of the day's business transactions into his computer, Joe will be rewarded with fast and easy access to the specific information he will need to make sound business decisions. Marilyn tells Joe that accounting's "transaction approach" is useful, reliable, and informative. She has worked with other small business owners who think it is enough to simply "know" their company made $30,000 during the year (based only on the fact that it owns $30,000 more than it did on January 1). Those are the people who start off on the wrong foot and end up in Marilyn's office looking for financial advice.

If Joe enters all of Direct Delivery's transactions into his computer, good accounting software will allow Joe to print out his financial statements with a click of a button. In Parts 2 through 7 Marilyn will explain the content and purpose of the three main financial statements:

• Income Statement

• Balance Sheet

• Statement of Cash Flows

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