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:
  1. A journal entry is made when an event occurs

  2. The journal entry adds to or subtracts from amounts in an account.

  3. The activity for a period of time in an account is reported on the income statement.

  4. 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.