ProductivityDecember 19, 2022

Bookkeeping and Accounting Basics

Ted Wozniak, Enrolled Agent

In this article, we'll be covering the fundamental concepts of bookkeeping and accounting. We'll start by explaining the difference between cash and accrual basis accounting, and how to set up a chart of accounts. We'll also delve into double-entry bookkeeping, the system that underlies all modern accounting practices.

Whether you're just starting out in business or you're an experienced entrepreneur, we hope you'll find these posts useful in helping you understand the basics of bookkeeping and accounting. So let's get started!

Cash and Accrual Basis Accounting

In accounting, the cash basis and the accrual basis are two methods of recognizing revenue and expenses.

Under the cash basis of accounting, revenue is recognized when it is received in the form of cash or cash equivalents, and expenses are recognized when they are paid. This method is simple and easy to understand, but it can lead to inconsistencies in the timing of revenue and expense recognition. For example, if a business performs a service in December but doesn't receive payment until January, the revenue would not be recognized until January under the cash basis.

Under the accrual basis of accounting, revenue is recognized when it is earned, regardless of when payment is received. Similarly, expenses are recognized when they are incurred, regardless of when they are paid. This method provides a more accurate picture of a business's financial performance, as it recognizes revenue and expenses in the period in which they are earned or incurred, rather than in the period in which payment is received or made.

Which method of accounting a business uses depends on its size, industry, and other factors. The cash basis is generally more suitable for small businesses and organizations with simple financial transactions, while the accrual basis is more suitable for larger businesses and organizations with more complex financial transactions.

Chart of Accounts

A chart of accounts is a list of all the financial accounts in a business's general ledger, with each account being represented by a unique number. The chart of accounts is used to categorize a business's financial transactions into specific accounts, such as assets, liabilities, and equity.

To set up a chart of accounts, follow these steps:

1. Determine the financial accounts you need: The types of accounts you need will depend on your business's industry, size, and financial needs. Common types of accounts include asset accounts (such as cash, accounts receivable, and inventory), liability accounts (such as accounts payable and loans), equity accounts (such as owner's equity and retained earnings), and expense accounts (such as rent, utilities, and salaries).

2. Assign a unique number to each account: The numbering system you use is up to you, but it's important to be consistent and logical. For example, you might assign asset accounts numbers in the 100-199 range, liability accounts numbers in the 200-299 range, and equity accounts numbers in the 300-399 range.

3. Create a list of your financial accounts: Use a spreadsheet or accounting software to create a list of all your financial accounts, including the account number and account name for each account.

4. Set up your general ledger: Your general ledger is a record of all your financial transactions, organized by account. Use your chart of accounts to set up the accounts in your general ledger.

By setting up a chart of accounts and organizing your financial transactions into specific accounts, you can get a clear and organized view of your business's financial performance. It's a good idea to review your chart of accounts periodically to ensure that it is still relevant and accurate for your business.

Double-Entry Bookkeeping

Double-entry bookkeeping is a method of accounting that involves recording financial transactions in two accounts: a debit account and a credit account. The concept of double-entry bookkeeping is based on the idea that every financial transaction has two equal and opposite effects on a business's financial accounts.

For example, when a business sells a product, it receives cash (an asset) and increases its revenue (an equity account). To record this transaction, the business would debit the cash account and credit the revenue account. This ensures that the total debits and credits in the financial records remain in balance.

Double-entry bookkeeping provides a system of checks and balances that helps ensure the accuracy and completeness of a business's financial records. It also enables a business to easily track the flow of money in and out of the business, which can help with financial planning and decision-making.

To use double-entry bookkeeping, a business will typically use a general ledger, which is a record of all the financial accounts in the business, organized by account. Each financial transaction is recorded in the appropriate accounts in the general ledger, with the corresponding debits and credits being recorded in the appropriate columns. The general ledger is then used to prepare financial statements such as the balance sheet and income statement.

Summary

In conclusion, cash and accrual basis accounting, chart of accounts, and double-entry bookkeeping are all important concepts in the field of accounting. Understanding these concepts and how to apply them can help you better manage your business's financial affairs and make informed financial decisions.

Cash basis accounting is a simple method of recognizing revenue and expenses when cash is received or paid, while accrual basis accounting recognizes revenue and expenses when they are earned or incurred, regardless of when payment is received or made. The method of accounting you choose will depend on your business's size, industry, and financial needs.

A chart of accounts is a list of all the financial accounts in a business's general ledger, with each account being represented by a unique number. Setting up a chart of accounts can help you organize your financial transactions into specific accounts and get a clear and organized view of your business's financial performance.

Double-entry bookkeeping is a method of accounting that involves recording financial transactions in two accounts: a debit account and a credit account. This method provides a system of checks and balances that helps ensure the accuracy and completeness of a business's financial records and enables a business to track the flow of money in and out of the business.

By understanding these concepts and how to apply them, you can effectively manage your business's financial affairs and make informed financial decisions. If you have any questions or need further guidance, don't hesitate to reach out to us for more curated solutions.

In future posts we'll move on to more advanced topics, such as how to prepare financial statements, how to manage payroll, and how to handle common accounting tasks such as reconciling bank statements and processing vendor invoices.