As small business owners, even if you aren’t going to handle your own accounting, it’s important to understand the basics of your finances so that you can determine how your business is performing. Let’s start with some accounting language and terminology.
Your accounting records are kept in what is called the general ledger. The general ledger is made up of several ledger accounts (also known as accounts or G/L accounts). Each ledger account is populated by journal entries. Each journal entry must balance to zero.
A journal entry is created for every transaction in your business, and each account is either debited (abbr: DR) or credited (abbr: CR).
Each ledger account is classified into one of five account types: Assets, Liabilities, Equities, Revenues, or Expenses. These account types all have natural balances that are debits or credits. The total of all of your G/L accounts must balance to zero.
The natural balances of each account type are:
Don’t think of debits and credits as additions and subtractions. Simply think of debits and credits as increases and decreases to the natural balance of an account.
A debit will always be a positive number. A credit will always be a negative number. Negative numbers are generally presented in parentheses. The total of the debits and credits in a journal entry will always balance to zero. This insures that you have recorded all aspects of the transaction appropriately.
Confused yet? Let’s do some examples from our everyday lives.
You go to Whole Foods and spend entirely too much money on baked goods (oh wait, is that just me?). You pay cash.
Grocery expenses are increasing, because a debit increases the natural balance of an expense account, and cash is decreasing, because a credit decreases the natural balance of an asset account.
You find your dream home and go to the bank for a loan. The home costs $150,000 and you pay a $20,000 cash down payment.
|Credit||Payable to Bank||(130,000)|
You are increasing an asset, your real estate account, by $150,000. But you now have a liability to the bank for $130,000 (remember, credits increase liabilities) and your cash balance decreased by $20,000.
You sold someone a book for $20, they paid with cash.
Assets, with a natural debit balance, and revenues, with a natural credit balance, are both increasing in this transaction.
So what do you think—are debits and credits starting to make sense? Next up in this series, we’re going to chat about financial statements (excited yet?).