expenses when they’re actually incurred. He also records the income when he completes the job on December 31, 2008, even though he doesn’t get the cash payment until 2009. His net income is increased by this job, and so is his tax hit. Chapter 7 covers the ins and outs of reporting income on the income statement.
Understanding Debits and Credits
You probably think of the word debit as a reduction in your cash. Most non-accountants see debits only when they’re taken out of their banking account.
Credits likely have a more positive connotation in your mind. You see them most frequently when you’ve returned an item and your account is credited.
Forget everything you think you know about debits and credits! You’re going to have to erase these assumptions from your mind in order to understand double-entry accounting, which is the basis of most accounting done in the business world.
Both cash-basis and accrual accounting use this method, in which a credit may be added to or subtracted from an account, depending on the type of account. The same is true with debits; sometimes they add to an account, and sometimes they subtract from an account.
Chapter 4: Digging into Accounting Basics
47
Double-entry accounting
When you buy something, you do two things: You get something new (say, a chair), and you have to give up something to get it (most likely, cash or your credit line). Companies that use double-entry accounting show both sides of every transaction in their books, and those sides must be equal.
Probably at least 95 percent of businesses in the U.S. use double-entry accounting, whether they use the cash-basis or accrual accounting method.
It’s the only way a business can be certain that it has considered both sides of every transaction.
For example, if a company buys office supplies with cash, the value of the office supplies account increases, while the value of the cash account decreases. If the company purchases $100 in office supplies, here’s how it records the transaction on its books:
Account
Debit
Credit
Office supplies
$100
Cash
$100
In this case, the debit increases the value of the office supplies account and decreases the value of the cash account. Both accounts are asset accounts, which means both accounts represent things the company owns that are shown on the balance sheet. (The balance sheet is the financial statement that gives you a snapshot of the assets, liabilities, and shareholders’ equity as of a particular date. I cover balance sheets in greater detail in Chapter 6.) The assets are balanced or offset by the liabilities (claims made against the company’s assets by creditors, such as loans) and the equity (claims made against the company’s assets, such as shares of stock held by shareholders).
Double-entry accounting seeks to balance these assets and claims against these assets. In fact, the balance sheet of a company is developed using this formula:
Assets = Liabilities + Owner’s equity
Profit and loss statements
In addition to establishing accounts to develop the balance sheet and make entries in the double-entry accounting system, companies must also set up accounts that they use to develop the income statement (also known as the profit and loss statement, or P&L ), which shows a company’s revenue and 48 Part I: Getting Down to Financial Reporting Basics expenses over a set period of time. (See Chapter 7 for more on revenue and expenses.) The double-entry accounting method impacts not only the way assets and liabilities are entered but also the way revenue and expenses are entered.
The effect of debits and credits on sales
If you’re a sales manager tracking how your department is doing for the year, you want to be able to decipher debits and credits. If you think an error may exist, your ability to read reports and understand the impact of debits and credits is critical. For example, anytime you think the income statement doesn’t accurately reflect your
Understanding Debits and Credits
You probably think of the word debit as a reduction in your cash. Most non-accountants see debits only when they’re taken out of their banking account.
Credits likely have a more positive connotation in your mind. You see them most frequently when you’ve returned an item and your account is credited.
Forget everything you think you know about debits and credits! You’re going to have to erase these assumptions from your mind in order to understand double-entry accounting, which is the basis of most accounting done in the business world.
Both cash-basis and accrual accounting use this method, in which a credit may be added to or subtracted from an account, depending on the type of account. The same is true with debits; sometimes they add to an account, and sometimes they subtract from an account.
Chapter 4: Digging into Accounting Basics
47
Double-entry accounting
When you buy something, you do two things: You get something new (say, a chair), and you have to give up something to get it (most likely, cash or your credit line). Companies that use double-entry accounting show both sides of every transaction in their books, and those sides must be equal.
Probably at least 95 percent of businesses in the U.S. use double-entry accounting, whether they use the cash-basis or accrual accounting method.
It’s the only way a business can be certain that it has considered both sides of every transaction.
For example, if a company buys office supplies with cash, the value of the office supplies account increases, while the value of the cash account decreases. If the company purchases $100 in office supplies, here’s how it records the transaction on its books:
Account
Debit
Credit
Office supplies
$100
Cash
$100
In this case, the debit increases the value of the office supplies account and decreases the value of the cash account. Both accounts are asset accounts, which means both accounts represent things the company owns that are shown on the balance sheet. (The balance sheet is the financial statement that gives you a snapshot of the assets, liabilities, and shareholders’ equity as of a particular date. I cover balance sheets in greater detail in Chapter 6.) The assets are balanced or offset by the liabilities (claims made against the company’s assets by creditors, such as loans) and the equity (claims made against the company’s assets, such as shares of stock held by shareholders).
Double-entry accounting seeks to balance these assets and claims against these assets. In fact, the balance sheet of a company is developed using this formula:
Assets = Liabilities + Owner’s equity
Profit and loss statements
In addition to establishing accounts to develop the balance sheet and make entries in the double-entry accounting system, companies must also set up accounts that they use to develop the income statement (also known as the profit and loss statement, or P&L ), which shows a company’s revenue and 48 Part I: Getting Down to Financial Reporting Basics expenses over a set period of time. (See Chapter 7 for more on revenue and expenses.) The double-entry accounting method impacts not only the way assets and liabilities are entered but also the way revenue and expenses are entered.
The effect of debits and credits on sales
If you’re a sales manager tracking how your department is doing for the year, you want to be able to decipher debits and credits. If you think an error may exist, your ability to read reports and understand the impact of debits and credits is critical. For example, anytime you think the income statement doesn’t accurately reflect your
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