Debits and Credits
Debits and Credits can be very confusing when it comes to accounting terminology. This is because we all have a Debit Card and a Credit Card. When we use our debit card, money is taken out of our account, when we use a credit card, money is added to our debt owed. We must think of debits and credits in the opposite manner for accounting. Remember our definitions for credits and debits?
Credit - an account entry with a negative value for assets, and positive value for liabilities and equity. (Value removed.)
Debit - an account entry with a positive value for assets, and negative value for liabilities and equity. (Value added.)
Debits are transactions of value added to an account. Credits are a value removed from an account. Using your business checking account as an example, if you were to deposit a check from a client or customer, it would be considered a debit. Why? Because it has a positive value toward your assets. If you were to write a check for office supplies, it would be considered a credit to the same account because it has a negative value towards your assets. (We’ll wait while you read that through again…)
Types of Accounts
Assets, Liabilities, Equity, Revenue, and Expenses (These are called your Chart of Accounts)
Your accounting software will utilize all five of these accounts.
• Assets are accounts that add worth to your business.
• Liabilities are accounts that remove worth or value from your business.
• Equity is used to define the contribution of money or non-cash items that you’ve invested into your business.
• Revenue is the account that tracks all income generated from business operations.
• Expenses are all of the financial transactions that occur necessary to generate income.
You own a handmade jewelry business. You need a lot of gold chain and gemstones as inventory to make product.
• If you own the gold and gemstones, that would be an asset. It has a dollar value attached to it and adds to the worth of your business. You can easily turn the gold and gemstones into liquid cash by selling it.
• If you financed the inventory, your loan would be considered a liability. You owe this money back to the lender.
• The equity you have in your inventory would be any money you put down on the purchase.
• The money you generate from your business would be considered revenue.
• The money you use to operate the business would be considered an expense.
Revenue – Expenses = Profit or Net Income. Remember, revenue and profit are two different things.
Your financial statements give a financial picture of your business. According to U.S. GAAP (Generally Accepted Accounting Practices), all three of these statements are required to get a full overview of the financial health of your business.
Your financial statements include all accounts in your Chart of Accounts and consist of:
1. Balance Sheet
2. Income Statement
3. Statement of Cash Flows
Your balance sheet will hold:
Your Income Statement will hold:
To comply with GAAP your balance sheet and income statement should always accompany one another.
• The Balance Sheet is a snapshot in time. It will be prepared for a certain date.
• The Income Statement shows the accumulation of revenue and expenses over a given period of time such as monthly or quarterly.
The Cash Flow Statement shows the inflows and outflows of cash over a period of time. There are three types of cash flow (CF).
1. Operating – CF generated by business operations
2. Investing – CF from buying/selling assets: buildings, equipment, real estate, etc.
3. Financing – CF from investors or long-term creditors.
When someone says your “books are balanced,” what they are really saying is “per the
accounting equation (Assets = Liabilities + Equity) the accounts equal each other.” This is the case when you are using double entry bookkeeping. Whichever accounting software you decide to utilize, it should be able to prepare these statements for you.
Think of it this way:
You are buying your inventory for your handmade jewelry business. The value of the gold chain and gemstones is $15,000 (asset), you put down $5,000 of your own money (equity) and get a loan for $10,000 (liability). As you can see, this is balanced. $15,000 Asset = $10,000 Liability + $5,000 Equity.
If you pay off $2,000 on the loan, it needs to be recorded in your books and you can see the equation is still balanced. $15,000 Asset = $8,000 Liability + $7,000 equity.
Again, your accounting software will prepare these statements for you, but you need to be able to read them.