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The Basics of Accounting

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Last editedJun 20212 min read

It may not be the flashiest department, but basic accounting forms the foundation of any business. No matter what industry you work in, you’ll need to adequately record and report all business transactions so that you’re able to generate financial reports for analysis. Whether or not you have a head for numbers, the basics of small business accounting are straightforward and easy to master.

Understanding basic accounting

At its most basic level, accounting simply refers to the process of recording financial transactions. There are several components to this which we’ll break down in greater detail below. By recording, summarising, and reporting your transactions you’ll be able to gain a greater understanding of your company’s financial health.

In a nutshell, basic accounting records and reveals cash flows and operations. It divides all business transactions into credits and debits. The definitions of these are somewhat counterintuitive in financial accounting:

Debits increase asset or expense accounts and decrease liability or equity accounts
Credits increase liability or equity accounts and decrease asset or expense accounts

Normally, you’d expect credits to increase your balance and debits to create a decrease, similar to a personal bank account. However, the opposite is true in accounting and finance which is one of the fundamental basics to understand. It’s important to understand the relationship between debits and credits as they relate to the accounting equation. This is written out as:

Assets = Liabilities + Equity

When you record transactions and balance your credit and debit accounts, you’ll be using the accounting equation as a guide. Accountants track expenses as well as profits and losses, ensuring transactions are balanced. This basic accounting information is then used by managers to make business decisions, whether it’s creating a budget or investing in a new project.

Accounting and finance record-keeping

Record-keeping is the first component of small business accounting. Before you even make your first sale, you should set up accounts to record all financial information. These details are classified as follows:

Assets: Includes everything purchased or acquired, such as inventory and accounts receivable
Liabilities: Includes all obligations to be paid by the business, such as debts and accounts payable
Equity: This equals assets minus liabilities in line with the accounting equation and includes company shares
Revenue: Includes what you bill customers in exchange for goods and services
Expenses: This includes any assets consumed during the accounting period, such as utilities and wages

How to handle basic accounting transactions

The second component of basic financial accounting is transactions. Accountants must record all transactions in the accounts mentioned above. Examples of typical transactions include:

Purchases: Includes the purchase of inventory, materials, and services
Sales: Includes the sale of goods and services to customers
Receipts: Includes the receipt of payment for any sales made
Compensation: Includes payments made to employees for their hours worked

Financial accounting reports

The transactions listed above should all be recorded with accurate debits and credits in the appropriate accounts. The information from these accounts is then reformatted at the conclusion of the accounting period into three key documents. These are called the company financial statements, including:

Income statement: This lists all revenues minus expenses incurred to show the business’s net profit or loss for the accounting period. It shows how well the company is attracting customers and generating income.
Balance sheet: The balance sheet compiles all assets, liabilities, and equity throughout the reporting period. These must be balanced according to the accounting equation, showing how well the company is able to meet its financial obligations.
Cash flow statement: This document lists all cash inflows and outflows throughout the accounting period. A positive cash flow means the company takes in more money than it spends. A negative cash flow shows the company is spending more than it receives.

The importance of accounting

There are multiple reasons why accounting is so important, no matter the size of your business. Basic record-keeping is vital for more complex accounting procedures including internal audits and tax planning. Not only does basic accounting give you a detailed record of all transactions for future reference, organising this information into financial statements assists with analysis. In turn, business owners are better able to make profit-driven business decisions based on fact.

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