Basic Concepts of Accounting for Small Businesses
If you are working with an accountant or CPA, there are a few things that you need to know and understand in order to make the establishment of your business’ accounting system somewhat easier. The basic concepts of accounting for small businesses that are addressed in this article will make the things that your accountant say to you make more sense, and give you an edge in understanding what your accountant is talking about!
Debits and Credits
The backbone of the accounting system is debits and credits. If you understand how debits and credits work, then you can understand the entire accounting system. Every entry in your ledger will contain a debit and a credit. And the total of all debits must equal the total of all credits. If the two are unequal, then the books are not balanced. An out of balance entry will throw off your balance sheet. Thus, an accounting system must have a mechanism in place that ensures that all entries will balance. Most automated or computerized accounting systems will not let you enter an entry that is out of balance. Until the error is fixed, you’ll be stuck on that entry.
Depending on the type of account that you are working with, a debit or a credit can either increase or decrease the balance of the account. For instance, with a liabilities account, a debit will decrease the account balance while a credit will increase it. For an expenses account, a debit will increase the account balance while a credit will decrease it. But for every increase in one account, there is an equal and opposite decrease in another! That keeps the entry within balance.
Liabilities and Assets
The liabilities and assets of the business make up the balance sheet. When your chart of accounts is set up, there will be distinct sections and ways of numbering for liabilities and assets that will make up your balance sheet. Debits increase assets and credits decrease them. Credits increase liabilities and debits decrease them.
Identification of Assets
Assets are things that your company owns that are of value. The money that your company has in the bank is an asset, and so is the car that is registered under your company’s name. Assets can be objects, claims, and rights – basically anything that has value and that belongs to your company.
Because your company also has the right to money that is collected in the future, accounts receivable are also assets. In fact, they are probably a major asset for most companies. The machinery and equipment that you use in your business or for your business are also assets, and any real or tangible property that your company owns are also assets. If your business is a loan company, then the loans that you make are also assets because they are representative of money that you will collection in the future.
Some assets are intangible, but they are assets nonetheless. For instance, things like patents are intangible and their value is hard to determine, but they are still considered assets. Typically, the value of an intangible asset like a patent is the cost of researching and developing it.
Identification of Liability
On the other spectrum from assets are liabilities. They are the opposite of assets. A liability is an obligation of one company to pay another company. Accounts payable are always liabilities because they are representative of your company’s future promise to pay someone. Loans are liabilities because you owe the bank money. If your company were a bank, the deposits that customers make with you are liabilities because they are representative of claims that can be made against the bank in the future.
Liabilities are segregated into short-term and long-term on the balance sheet. This simply means that some liabilities are scheduled to be repaid within the next accounting period (typically within the next twelve months), while others (long-term) are not scheduled for repayment until later on.