A Relatively Painless Guide to Accounting

Contrary to what that accounting guide with 30 chapters may have you believe, accounting doesn’t have to be difficult. Whether you are curious about accounting but got freaked out by the mess of articles online, or just want to refresh your memory after a class, hopefully the article will live up to its title.

Table of Contents

  1. What is Accounting?
  2. Basic Terms
  3. Types of Accounts
  4. Accounting Concepts
  5. Financial Statements
  6. Resources

*Note: For the sake of simplicity, some assertions were made and more complex topics such as GAAP and the accounting cycle have been omitted.


What is Accounting?

  • The process of recording and analyzing the financial transactions of a business
  • Used to track operations, meet legal obligations, and make decisions

Basic Terms

  • Account: A record in an accounting system that tracks transactions on a specific asset, liability, equity, revenue, or expense
  • Accounting period: The period of time covered by a company’s financial statements, which could usually be monthly, quarterly (every three months), or yearly
  • General Ledger: A database that stores a complete record of all accounts

Types of Accounts

There are five main types of accounts, with a variety of sub-accounts under each category. Let’s take a look at each classification.

  • Revenue: The total amount of money a business collects from selling its goods/services
    • This is the amount before any expenses are subtracted, so it’s not the same as profit, which is revenue after deducting expenses
  • Expenses: The total amount of money a business spends in order to generate revenue
    • One sub-account is the cost of goods sold (COGS), which is the cost of resources used to produce other goods, like raw materials, labor, and electricity
  • Assets: Any resources that produce financial value for a business
    • One sub-account is the Accounts Receivable, which is money that other people owe a business
    • Assets can appreciate (increase in value) or depreciate (decrease in value) for a variety of reasons
  • Liabilities: Any financial debts or obligations
    • One sub-account is the Accounts Payable, which is money that the business owes other people
  • Equity: The value of assets after liabilities are deducted. In other words, Equity = Assets – Liabilities.
    • Equity is neither an asset nor liability, so what is it then? Two different things:
      • Capital Contributions: The value of the owner(s) or shareholders’ investment in the business
      • Accumulated Profits: Profit that the business saves for future use
        • The portion of the profit used to pay owner(s) or shareholders is called withdrawals, which does not count as accumulated profits

Note: A business can be a sole proprietorship (owned by one person), partnership (owned by two or more people), or a corporation (owned by shareholders). This is important to remember because the terms used to describe equity change based on who owns the business.

Capital ContributionsAccumulated ProfitsWithdrawals
Sole proprietorshipOwner’s EquityRetained EarningsOwner’s Drawings
PartnershipPartner’s EquityRetained EarningsPartnership Drawings
CorporationShareholder’s EquityRetained EarningsDividends
Refer to this chart for how each term changes based on the type of company ownership.

Accounting Concepts

A. Types of Accounting

  1. Cash Accounting: Records transactions when the money changes hands (it only recognizes immediate transactions)
  2. Accrual Accounting: Records transactions when the transaction happens, even if no money changes hands at the time (it recognizes both immediate and anticipated transactions)

B. Debit & Credit

  • T-account: A general ledger that looks like a t-chart, with debit recorded on the left side and credit recorded on the right side
    • Debit: Anything that allows a business to spend their money now but save later
      • Think of debit as debit cards, where you spend money from your own pocket without needing to repay anyone. Your expenses would increase right now, but your liabilities would decrease.
    • Credit: Anything that allows a business to save their money now but spend later
      • Think of credit as credit cards, where you borrow money from a bank to spend, but you have to repay it later. Your expenses would decrease right now, but your liabilities would increase.
    • Note: Technically, there is no real definition of debit and credit. All they do is signal an increase or decrease in an account. The above information is just to help you remember what they generally do.
Refer to this chart to see how debit and credit affects each of the five accounts.

C. Accounting Equation & Double-entry Accounting

Recall from earlier that Equity = Assets – Liabilities. Rearrange that and we get the accounting equation: Assets = Liabilities + Equity.

Mathematically, that makes sense. But the real reason why the accounting equation exists is because every financial transaction has equal and opposite effects in at least two different accounts. In other words, if a company wants to increase its assets, it must also increase its liabilities or equity.

For example, if a business gets a $100 loan, the debit side gets $100 because the business can spend it. But since it’s a loan, the credit side also gets $100 because the business must repay it.

Essentially, just remember that things you own = things you owe. This is the most important principle a business has to follow in accounting. An accounting method which satisfies the accounting equation is double-entry accounting. That means for every debit entry a business makes on the left, it will need to make a corresponding credit entry on the right. 


Financial Statements

Financial statements are written records that convey the financial performance of a business. This is a simplified version, so just pay attention to the contents of each document and the timeframe that the document tracks. 

  • Income Statement: Shows revenue and expenses over an accounting period (it demonstrates how much the business has made or lost)
  • Balance Sheet: Shows assets, liabilities, and equity at a single point in time (it’s a snapshot of the current financial standing of a business)
  • Cash flow statement: Shows how and where a business is receiving and spending cash over an accounting period 
    • Can be used to determine liquidity, which shows how easily assets can be converted into cash. 
      • Liquid assets save time, which is nice because the faster a business can repay its liabilities, the less interest they have to pay. In other words, liquidity measures the ability of a company to meet its current liabilities using its current assets
  • Retained earnings statement: Shows changes in retained earnings over an accounting period (it shows the amount of income left over after the business has paid dividends to its shareholders)
    • When profits on the income statement are transferred to a balance sheet, it can either be recorded as assets (ie. retained earnings for the business) or equity (ie. dividends to shareholders). In other words, this document is a bridge between the income statement and balance sheet. 
DocumentWhat it showsTimeframe it looks at
Income statementProfitability of a businessAccounting period
Balance sheetTotal value of a businessA single point in time
Cash flow statementLiquidity of a businessAccounting period
Retained earnings statementDistribution of business profitsAccounting period
Refer to this chart for a summary of the differences between the documents

Resources

What Is Basic Accounting? | Indeed.com

ACCOUNTING BASICS: a Guide to (Almost) Everything – YouTube

Types of Accounts in Accounting | Assets, Expenses, Liabilities, & More (patriotsoftware.com)

What Are Assets, Liabilities, and Equity? | Bench Accounting

What Does Equity ACTUALLY Mean? – YouTube

What Is a Debit and Credit? Bookkeeping Basics Explained (freshbooks.com)

The four basic financial statements — AccountingTools

Accounting 101: The Basics – AccountingVerse

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