Back To CourseBasics of Accounting
2 chapters | 11 lessons
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Douglas has two master's degrees (MPA & MBA) and is currently working on his PhD in Higher Education Administration.
The most basic accounting terms can be found in what is called the accounting equation. The accounting equation is: assets - liabilities = owners' equity.
In addition to the three terms that will help us understand that equation, we'll also talk about debits, credits, and cash flow. But first, let's start with the first term of the equation: assets.
Assets are simply physical goods that carry monetary value. You can easily identify assets you own or assets that are owned by a business. All the cars in the lot of your local used car dealer are assets. Your computer, TV, car, home, and anything else you own are your assets.
Next, let's look a the liabilities, which are the financial commitments and debts you owe. Any debt you have is a liability, as are any financial commitments you have made. Bills aren't financial commitments until you accrue them, meaning that next month's electric bill isn't a financial commitment, because you haven't used the electricity yet. The exception to this rule is when you have a contractual obligation, such as a cell phone contract.
For individuals, if you calculate all their assets and subtract all of their liabilities, you'll be calculating their net worth. That's basically the same number you would come up with if you sold everything you could and paid off all of your debt. In the corporate world, that number is called owner's equity and represents the value of the company's assets that the owners actually own.
Now that we've gone over the basic accounting equation, let's talk debits and credits. Accounting is all about tracking the financial transactions of an individual or business. When you balance your checkbook, you are accounting for your personal finances. Corporate accounting is more complex. While you may have a checking and savings account and use those funds to pay bills, companies need to track accounts receivable, cash, inventory, and other types of financial transactions.
Keeping track of all these transactions can be difficult, so accountants rely on double-entry accounting. Double-entry accounting means that each transaction has two sides, a debit and a credit. The goal of double-entry accounting is to keep the accounting formula (assets - liabilities = owners' equity) in balance. Look at that formula carefully; with double-entry accounting, if assets increase, liabilities or owners' equity will also need to increase. These transactions and ideas will make more sense in just a minute. To help organize these transactions, accountants use the terms debits and credits.
Debits are transactions that increase assets or decrease liabilities. When a company sells some of their product and collects cash, that transaction includes a debit to the cash account, increasing the amount of cash. But, it also means that their inventory - another asset account - went down.
Credits are transactions that decrease assets or increase liabilities. So, in the transaction we just talked about - a company selling some of their inventory - they debited their cash account because they received cash from a customer, and they would credit their inventory account, since selling inventory decreases the amount of inventory available.
Pause and think about that for a second. Is that the end of the accounting entry? If that local car dealer with all that inventory on its lot sells a car for $10,000 cash, they debit their cash account to increase it by $10,000, but how much do they credit their inventory? Probably not $10,000.
Most companies value their inventory based on cost of production or cost to obtain the asset. The car dealer probably bought the car from an auction for $7,000, and that's how it is recorded in their inventory account. So, if cash increases by $10,000 but inventory only decreases by $7,000, how do you balance the books?
When a company sells inventory for cash and realizes a profit, the total value of their assets increases, like in our car example. Since their liabilities didn't change, owners' equity increased. Remember that accounting formula: assets - liabilities = owners' equity? That formula should make more sense when you think about the sale of the car.
The sale of the car is a good example of another important accounting term: cash flow. Cash flow is the amount of cash brought in and paid out during a stated period. Typically, accounting reports are generated monthly or quarterly, so a cash flow amount would reflect all the cash that came in minus all the cash that was paid out. Hopefully it's a positive number, for businesses and individuals. It's an important number, because even if a company sells a lot of inventory, if they extend credit to their customers and don't collect cash, they'll have a hard time paying out their liabilities.
Many of the principles of corporate accounting can be applied on a personal financial level as well, so it's a good idea for everyone to know the fundamental terms and phrases in accounting. In this lesson, we discussed the components of the accounting formula: assets, liabilities, and owners' equity. All corporate accounting is based on that formula.
To take it a step further, we introduced the terms debits, credits, and cash flow. Debits and credits are terms used to describe different kinds of accounting entries to help keep many different asset and liability accounts organized. Finally, cash flow is an important accounting metric that reflects how much actual cash is brought in and paid out during a given period. As you organize your own finances and observe how your workplace operates, you can look for ways to apply this knowledge to further your understanding of how you can use accounting concepts to improve your own financial health and increase your skill set in the workplace.
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Back To CourseBasics of Accounting
2 chapters | 11 lessons