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Basic
Accounting Principles
Basic
accounting
principles amount to the general knowledge of how information gets to
the income statement and balance sheet. We'll look at each
ingredient and step along the way.
To begin with, the very basic
equation of accounting is:
- Assets
= Liabilities + Owners Equity
Let's
look at each ingredient of this equation:
- Assets
are the things used in a business that have value. For
example: machinery, furniture, inventory, building, money, etc
- Liabilities
are debts or obligations of the business. For
example: loans, mortgages, amounts due to suppliers, etc
- Owner's
Equity is the amount that the owner of a business can say
is his. For example, by using basic algebra we can modify our
accounting equation to say:
- Assets - Liabilities = Owner's Equity
What we have just described above is the Balance Sheet of a business.
The balance sheet will list assets on top, with liabilities next, and
Owner's equity on the bottom. The balance sheet is a report
that gives us an idea of the health of the business.
- If the business has a large amount of assets
with few liabilities, it can be said to be in good financial shape.
- If however, the business has a large amount of
liabilities compared to assets, this may result in Owner's equity of a
small amount or even a negative amount.
Now,
we can look at the Income Statement of a business as it relates to the
basic accounting principles. The income statement
report includes revenues and expenses:
- Revenue
is the amount the business receives for its services or products.
- Expenses
are the costs that a business incurs while earning revenue. Expenses
are rent, wages, taxes, etc
Now in order to create balance sheets and income statements,
transactions are created for each event that occurs.
Transactions are recorded as journal entries.
Journal entries create amounts in accounts, and the account amounts are
reported on the income statement and balance sheet. The flow
looks like this:
- A journal
entry is made when an event occurs
- The journal entry adds to or subtracts from
amounts in an account.
- The activity for a period of time in an account
is reported on the income statement.
- The activity for a period of time and the
ending balance of the account are reported on the balance sheet.
The accounts of a business are numbered. Each journal entry
records a debit
or credit
amount to accounts. The numbered accounts are part of what is
called the Chart
of Accounts.
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