If you think balancing your books is simply the process of recording money received from customers and payments of business expenditures, you may be in for problems.
Accounting that isn’t truly balanced isn’t just useless; it’s dangerous. It will lead to uninformed decisions based on fictitious data. Without drawing on the full repertoire of accounting principles, you can’t understand the key elements of balanced books. And this is crucial to managing your business.
Most business owners struggle to grasp the meaning of debits and credits. However, an easier-to-comprehend approach is to remember that accounting consists of a double-entry method. That is, every transaction has a combination of debits and credits. Think of transactions as posted to a general ledger comprising all the company’s accounts: Debits to some accounts are always equal to credits for other accounts.
In understanding the double-entry concept, you’ll quickly realize that it’s impossible to simply add an expense or remove an asset from your books. You need to balance it with its equal (offsetting) component.
Understand the Rules
The general ledger has five main types of accounts: assets, liabilities, equity, revenues, and expenses. Each account category has specific rules for handling debits and credits. A debit will increase the amount in some account types and decrease the total of other types. And you need to know the difference. Understand these rules and you’ll be making the best decisions based on accurate financial records.
Thinking in terms of debits and credits is better than referring to “increases” and “decreases.” A given transaction, for instance, may consist entirely of increases. That happens when all the account types affected include higher amounts in both the debits and credits. The accounts are simply on opposite sides of the balance sheet financial statement. Another transaction may comprise all decreases.
The rule for asset and expense accounts is that they are increased with debits. Every time you incur a cost of doing business, one of your expense accounts increases. This is realized by a debit. When an enterprise acquires equipment or deposits money in the bank, an asset is increased. These results are accomplished with debits to asset accounts.
A different rule applies to liability, equity, and revenue accounts. These types are increased with credits. Borrowing money, contributing owner capital, or making a sale adds to these accounts. Credits record those additions.
Take, for example, a $500 sale and the resulting bank deposit. Revenue increases, but so does your bank balance. The books should record a $500 credit to a revenue account and a $500 debit to the bank asset account.
Circumstances are a little more complex when you buy a $700 computer with the company credit card. You’ve increased your equipment assets as well as your credit card liability. The books have a $700 debit to the equipment account and a $700 credit to the credit card account.
Master these basic bookkeeping steps and you begin to visualize the purpose and usefulness of balanced books.