Accounting 101 - Part 2

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Each Tuesday, our new series ‘Accounting Tips Tuesday’, brought to you by Zoho Books, will present articles that fit into one of two categories.

First, the theory behind basic, and even not so basic, accounting concepts with practical applications including the old ‘debits and credits’ appropriate to the situation. Second, we will go beyond the practical theory and actually cover fundamental software use in the proper recording of these types of transactions using Zoho Books.

Today's article continues a mini-series on basic accounting. While we will focus on use of Zoho Books, the concepts within this article apply regardless of the accounting software you are using.

In part 1 of this mini-series we looked at the fundamental equation:

and applied it to a simulated scenario.  So you don't have to look back at part 1, let me restate that example.

Let’s assume you manufacture ‘dongles’ (don’t ask me what a ‘dongle’ is, I just like the sound of it.) You decide to go into business by opening a checking account with $1000.00 in cash from your personal savings.  You now purchase one dongle-maker at a cost of $1000.00, but you don’t want to use all of your cash, so you pay for half of the dongle-maker, and the maker of the dongle-maker gives you an interest-free loan for the remaining $500.00.  You also spend $250.00 on the materials you need to manufacture your first run of dongles. At the end of the first month you actually have sold $2500.00 worth of dongles and so your bank balance has $2750.00 in it. Since you haven’t made another payment on the dongle-maker at month’s close, your liabilities are $500.00, and your Owner’s Equity is $1000.00. Your total equity also includes the value or your revenue $2500.00, less the expenses (your costs of materials) of $250.00.

We then identified how the various numbers within the scenario fit into the accounting equation.

After reviewing the meanings of debit (left) and credit (right), we applied the principles of double-entry accounting and recorded our first transaction in Zoho Books to match the beginning bank account and owner's equity. The old fashioned journal would have been recorded as:

but in Zoho Books we posted the transaction like this:

As important as it was to post this journal entry into our new Zoho Books account, we also learned the principles of debits, credits and journal entries associated with double-entry accounting.

In this segment of our mini-series we want to look at some more of the entries needed to record the transactions outlined in our scenario.

Not long after we opened our business we used some of the funds we deposited into the bank and we paid for half the cost of a $1000.00 dongle-maker, the maker of the dongle-maker gave us an interest-free loan on the balance of the dongle-maker.  So let's look at the specifics of this transaction.

1. We are going to 'pay out' of our bank account $500 in order to purchase the dongle-maker. Last time we learned that a deposit into our bank account was a 'debit' to that asset, so that means that any 'payment from' our bank account must be recorded as a 'credit' to that asset.

2. We are using the $500 to purchase a $1000.00 dongle-maker. Because the dongle-maker 'has value', it also is an asset. So our $500 payment recorded as a credit in our bank account is offset by the $1000.00 dongle-maker asset; but wait a minute, debits and credits must be equal and we have only $500 worth of credits offsetting $1000 worth of debits, that isn't in balance.  You are absolutely right, we have to identify another $500 in credits to off-set the remaining value of the dongle-maker.

3. Our $500 credit comes in the form of an 'increased' liability (actually a totally new liability). This liability is the zero-interest loan that the dongle-maker extended to us.  Because liabilities are totally opposite of assets, a credit increases the liability, while a debit decreases a liability account. 

So let's post this journal entry the old fashioned way first so we can clearly see all of the debits and credits associated with the transaction.

We can certainly record this transaction using a 'New Journal' entry in Zoho Books in a fashion very similar to that used last time. So let's look at how that entry would look.

Of course, we might not want to take the approach of making a journal entry to record this transaction. In the course of day-to-day operations (at least in the future) we might buy $1000 worth of equipment at any given time.  Rather than run down to the bank and get a cashier's check, we would probably record the Vendor's Bill and then write the Vendor 'a check' for the portion of the asset we are paying.  We can actually record this entire transaction simply using a Bill and a Check in Zoho Books, here is how those transactions would look, in lieu of a Journal entry.

Notice that the vendor bill has 2 lines; the first line records the dongle-maker asset value of $1000.00 (it is recorded as a positive amount). The second line is the Loan, we now owe to the Dongle-maker Maker, that $500 is recorded on this Bill as a negative amount, this posts the credit to the Loan (liability) account.  Now we pay the bill using a check (see below).  Don't worry in a future edition of Accounting Tips Tuesday we will look at the step-by-step process of recording both a Vendor Bill and paying that Bill using a Check; today, I simply want to focus on this method as an alternative to record these transactions in lieu of a Journal entry.

Now, let's look at our Balance Sheet after the transactions we posted last time and today.

Do you notice anything?  Our Balance Sheet is perfectly in balance. The value of our assets equals the value of our liabilities & equity.

In today's lesson we learned the fundamental differences between Assets and Liabilities; we learned that Debits increase Assets, and Credits decrease Assets; on the other hand, we learned that Debits decrease Liabilities and Credits increase Liabilities. And we confirmed that the Balance Sheet should ALWAYS be in balance and conform to our fundamental accounting equation.

This 'accounting stuff' really isn't so hard after all, is it?  When you take time to understand the basics, post out the debits and credits (the old fashioned way) and then see how modern accounting software gives you one or more ways of recording the transactions, the principles of accounting become much easier to understand.

In Part 3 of this mini-series, we will look at some of the other transactions associated with our new Dongle-maker business. Until then, may all your Debits and Credits be equal, and may your Balance Sheets balance.