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Accounting 101: Basic Accounting Terms and Concepts

Updated on December 19, 2013

Accounting Equation

Everyone can benefit from understanding a few basic accounting concepts. Even if you don’t have any desire to one day become a CPA (certified public accountant), a basic understanding of accounting can go a long way in making business and personal finance decisions. Also, if you ever need to hire an accountant, you will have some level of understanding of the work he or she will perform for you.

To get started, we should first define the accounting equation and a few basic accounting terms. The accounting equation is:

Assets = Liabilities + Owner’s Equity

Assets can be thought of as anything of value you or your business owns. This would include items such as: cash, equipment, buildings, and accounts receivables (balances that people or businesses owe you for sales or services).

Liabilities can be thought of as any cash or goods and services that you owe to individuals or people. This would include items such as: bank loans, amounts owed to vendors, outstanding taxes due, unearned revenue or rental income (if someone pays for rent or services in advance it is a liability until the period in which you earn it).

Owner’s Equity represents ownership. If we use algebra to flip the equation above, we can remove liabilities from the right side of the equation and subtract them from assets on the left side. The equation would now read: assets – liabilities = owner’s equity. Or simply stated: what we own minus what we owe equals our ownership.

Accounting Example

Now we can define a few of the accounts that are part of the accounting equation.

Inventory: An asset account which represents the goods on hand the business regularly sells to its customers.
Revenue
: An equity account which represents amounts customers agree to pay you for the sale of goods or services.
Cost of Goods Sold: An equity account which represents the direct and indirect costs it takes to sell goods to customers. This account is made up of: material, labor, and overhead costs.

When an accounting transaction occurs, it must be recorded in a way that balances the accounting equation. When the transaction is recorded there is always a debit and credit.

A debit to an asset account INCREASES the balance while a credit to an asset DECREASES the balance.
A debit to the liability account DECREASES the balance while a credit INCREASES the balance.
A debit to an equity account represents an EXPENSE while a credit represents INCOME.

For example, if a small business sells a widget to a customer for $1,000 and it cost $700 to produce, the accounting transaction would be an increase to cash (assets) by the amount received from the customer, an increase to revenue (owner’s equity) by the same amount, a decrease to inventory (assets) by the amount it cost to produce the widget, and an increase the cost of goods sold expense account (owner’s equity) for the amount it cost to produce the widget.

The transaction would look like:

Cash 1,000 (debit)
Revenue 1,000 (credit)

Cost of Goods Sold 700 (debit)
Inventory 700 (credit)

Once you are able to wrap your head around the accounting equation and the basic accounting terms, recording of the transactions starts to make much more sense.

For more accounting concepts and information on the accounting profession please see: http://www.cpainsider.net/

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