If you ever wondered what the whole idea of business accounting was all about (but were afraid to ask) now is the time to learn. Most accounting terminology is complicated and scares off those who are not trained in the field. Acronyms and jargon abound, just like in any field, but the basics are really just logic and common sense. So even if you don’t know your EBIT from your working capital, you can understand the basic concepts of how a company keeps (or is supposed to keep) its books.
The “books” of a company were, at one time, literally that. Each company had a book in which it would tally money coming in and money going out. That is the essential premise of a basic accounting system. What was left over after the money came in and the expenses went out was the owner’s capital or equity. He always had a choice of putting that money in his pocket (withdrawing his equity) or leaving it in a bank account or buying more equipment or products for his company (building assets). If, in any given period, his business expenses exceeded his income, he would have to put more money in to cover the difference (inject capital or equity).
Double Entry Bookkeeping
In order to keep track of things, a company will establish a chart of accounts to put each of the entries into. The chart of accounts will list income items, expense items and asset and liability items. The way of keeping track of income and expenses is the “double entry” bookkeeping system, which record debits and credits. In this system, each transaction has a balancing transaction. A debit is what you got, and the credit is the source of the item you received. When you set up your business, you put your personal money in a business bank account. You debit that bank account and credit your owner’s equity account because that bank account now owes you money, the amount you put in it. If you buy a ream of paper to send out sales letters, you debit your “stationary” expense account and you credit your bank account with the amount of the purchase. The bank account balance has gone down, so the bank account owes you (in the form of your owner’s equity) less. You own a ream of paper worth that amount of money instead.
When you have a few sales resulting from your fabulous sales letter, you will deposit money and debit the business bank account. That bank account now owes you more money again. Most items in running a business are “expensed” in this way, but many times an item might be used over and over again, such as a computer or a machine. The money you spent on the paper is gone once the sales letters have gone out. Those funds are “expensed”. But the computer that you typed them on stays to do more work. You need to account for such an item in a different way. That item is “capitalized” and listed in your books as an asset. The bank account that you used to pay for it was credited, and an asset account is debited. This asset will not last forever, so this asset account is reduced a little bit each year to reflect the fact that the computer is getting older and is not worth as much. Theoretically, after about five years, you will want to buy a new computer, so the cost of this computer should be spread out over five years until it is fully “amortized”. The other “double entry” side of this is that one fifth of the cost of the computer is expensed each year. You can then throw out that computer, get a new one and start all over.
To better understand the workings of an accounting system such as this, it is helpful to pretend that the company goes out of business at the end of each year. Whatever is left at the end goes back to the owner as his equity. Suppose after one year, our fictional sales business owner closed up shop. His business would be worth $4,100. His bank account has $12,500 in it. (He put in $10,000, spent $500 on paper for sales letters and $2000 for a computer, and earned $5,000 in sales.) He still has a computer that is worth $1,600 because it was worth $2,000 and decreased in value by $400 a year. His total assets-short term assets in the bank and long term assets in the computer-are worth $14,100. His only liability against these assets is his own initial investment (if he never borrowed any money). So, even though the business is worth $14,100, if he kept his double entry books right, the business owes him the owners equity of $10,000 and is therefore worth $4,100.