Top 5 Financial Concepts in Accounting 101

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December 9, 2016

Top 5 Financial Concepts in Accounting 101

Our explanation is meant to introduce some basic accounting terminology, accounting principles, and accounting concepts. Some of the basic accounting terminology will include terms such as assets, liabilities, revenues, and expenses. You will also understand the difference between debits and credits and how to record business transactions to ultimately create financial statements that would include an income statement, a balance sheet, and a statement of cash flows.

It does not matter if you were not planning on pursuing a career in accounting or finance. It is very useful for small business owners to know some fundamentals of accounting. This article is designed to help small business owners get some fundamentals in accounting to ultimately help them run their businesses effectively.
There are five basic concepts that will better help you understand the world of accounting.

1. Accounting Equation
2. Debits versus Credits
3. Generally accepted accounting principles (GAAP)
4. Financial Statements
5. Cash versus Accrual Basis

1) The most important equation that will be helpful for you with your bookkeeping and accounting:
Assets = Liabilities + Owner’s Equity
To explain this equation in more detail, imagine buying a house. Let’s say you bought house sold for $300K with an 80% mortgage ($240K) a 20% down payment ($60K).
$300K house (asset) = $240K mortgage (liability) + $60K down payment (owner’s equity)
Double-entry accounting is a system that requires every financial transaction to have an equal and opposite effect in two different accounts. Those two different equal and opposite effects are used to satisfy this equation: Assets = Liabilities + Equity

2) Debits versus Credits
The double-entry accounting system is recognized as the most accurate for businesses of all sizes. This system is based on the idea that every financial transaction that occurs has an equal and opposite effect in at least two of a business’s different accounts. As such, transactions are recorded as either debits or credits, and the two will always offset one another.
We mentioned that in double entry accounting, there are two effects that equal and opposite in at least two of the various business accounts. One financial transaction is going to be have both a debit and a credit with debit being on the left side of a general ledger account and a credit being on the right side of a general ledger account. Debits will do one of the following: a) increase asset or expense accounts or b) decrease liability or equity accounts. Credits will do one of the following: a) increase liability or equity account or b) decrease asset or expense accounts. The table below is a summary illustrating how debits and credits impact various types of business accounts.

Assets Liability & Owner Equity
Debit Credit Debit Credit
↑ Increase ↓ Decrease ↓ Decrease ↑ Increase

Expenses Revenue
Debit Credit Debit Credit
↑ Increase ↓ Decrease ↓ Decrease ↑ Increase

3) Generally accepted accounting principles (GAAP)
GAAP is a set of accounting principles and standards that have been deemed acceptable for creating financial statements. GAAP helps create uniformity and consistency of financial reporting that companies should be adhering to regardless of size or industry.

4) Financial statements
As mentioned before financial statements are prepared using GAAP. Business owners should have some understanding on reading them and they are of interest to investors, lenders, and tax or other government entities. All of this bookkeeping and accounting is done to prepare these three main financial statements:
a) Balance Sheet – A snapshot in time of what a company’s assets, liabilities and owner’s equity are on a given date
b) Income Statement – A summary of a company’s revenue and expenses during the course of a period (in contrast with balance sheet which is a snapshot in time)
c) Statement of Cash Flows – Changes in company’s cash flows during the course of period

5) Cash vs. Accrual accounting methods
These are two different methods of recognizing revenues and expenses. Under the cash method, revenue is recognized when received and expenses are recognized when paid. Under the accrual method, revenue is recognized when earned and expenses are recognized when incurred. Most publicly traded companies use accrual basis but small businesses can adopt either accounting method as there are advantages and disadvantages to each of the two methods.