Understanding the basic terms in accounting will make it much easier to grasp more advanced accounting concepts, because everything revolves around these 7 building blocks of accounting.
These are the basic terms that one should become familiar with in accounting:
- Owner's Equity
Income and Expenses
An income is a one-time transaction that gives you money. An example of an income is the wage that an employee receives at the end of a month. An income account looks something like this:
|Sales Revenue from Product for the Month of March||$1000|
|Sales Revenue from Services Provided for the Month of March||$500|
|Rent Collected from Tenant for the Month of March||$300|
An expense is a one-time transaction that takes money away from you. An example of an expense is buying a loaf of bread from the store. An expenses account looks something like this:
|Payment of Utility Bills for the Month of March||$200|
|Employee Wages for the Month of March||$600|
|Purchase of New Machinery||$800|
Assets and Liabilities
An asset is simply anything of value that you own. So, what constitutes value? Something is of value when it can be exchanged for money, or when it can generate money or contribute in some way to income. Something is also of value when it can prevent you from losing money.
For example, your house is an asset and so is your car, because both of these can be exchanged (or sold) for money. The machinery in a newspaper company is an asset because they produce newspapers that can be sold for money. The loan that you take from a bank is the bank's asset because the bank will earn an interest from you. A patent on your new invention is an asset because it can prevent your competitors from copying your ideas, thus leading to potential income loss.
In other words, an asset is anything that contributes to income. An asset account looks something like this:
A liability is the opposite of an asset. It is anything that you own that takes money away from you. For example, your utility bill is a liability because you lose money as a result of paying the bill.
In other words, a liability is anything that you own that will cause you to incur an expense. A liability account looks like this:
|Money Payable to Supplier for 500 sheets of paper.||$500|
|Monthly Wages Payable to Employees||$700|
|Taxes Payable to Government for Year 2006||$400|
The owner's equity is the amount of company assets that belongs to the owner of the company. It is calculated as the difference between the values of a person's assets and liabilities. The following formula best describes owner's equity:
Owner's Equity = Assets - Liabilities
Hence, if the value of your assets is greater than the value of your liabilities, then you have positive owner's equity. If the value of your assets is less than the value of your liabilities, then you have negative owner's equity.
Debit and Credit
Debits and credits describe transactions. For every transaction, there is an equal and opposite Debit/Credit entry. It is important to remember that debits or credits are neither positive nor negative values. The entry under an account is a debit or a credit, not a positive or a negative value.
Asset and expense accounts increase in value when debited and decrease when credited. Liability, equity, and revenue accounts decrease in value when debited and increase when credited.
How do we know when to use credit or debit? We use the following table as a guideline:
Hence, with reference to the above table, when there is an increase in an asset item, we record that as a debit entry (value is placed under the debit column). Vice versa, a decrease in an asset item would be recorded under the credit column.
An example of recording the transaction of paying a bill is shown as follows:
|Paying the Utilities Bill for the Month of March|
|Utility Bill for the Month of March||$200|
Here is another example involving receiving payment for selling a product:
|Sales Revenue from Services Provided for the Month of March|
And a final example on purchasing some new machinery:
|Purchase of Some New Machinery|
Once you understand these basic concepts, you will then be ready to learn more advanced accounting principles.