The title “What is in the red and in the black?” refers to the colors used in accounting to indicate negative (red) and positive (black) amounts. This article will explore the meaning behind these colors and provide an overview of accounting fundamentals like debits, credits, and the accounting equation. Understanding these basic concepts is key for anyone looking to learn about accounting and finance.
Debits and Credits
In accounting, debits and credits are used to record increases and decreases to accounts. Debit means left, while credit means right. When an account is debited, it moves left on the accounting worksheet. When an account is credited, it moves right. Here is a quick overview of debits and credits:
| Account Type | Debit (left) | Credit (right) |
|---|---|---|
| Assets | Increase | Decrease |
| Liabilities | Decrease | Increase |
| Equity | Decrease | Increase |
| Revenue | Decrease | Increase |
| Expenses | Increase | Decrease |
So for example, when you debit an asset account like Cash, it increases. When you credit a liability account like Accounts Payable, it increases.
The Accounting Equation
The basis of the system of double-entry accounting is the accounting equation:
Assets = Liabilities + Equity
This formula demonstrates the balance sheet relationship between assets (what a company owns), liabilities (what a company owes) and equity (claims of the owners). Here are some key points about the accounting equation:
– It always balances – the left side equals the right side.
– Increases and decreases in accounts impact either side of the equation.
– It provides the foundation for recording transactions through debits and credits.
Let’s look at an example. If a company takes out a loan of $10,000 cash from the bank, here is how it impacts the accounting equation:
| Starting | Change | Ending | |
|---|---|---|---|
| Assets | $100,000 | + $10,000 | $110,000 |
| Liabilities | $50,000 | + $10,000 | $60,000 |
| Equity | $50,000 | No change | $50,000 |
The loan increased the company’s assets by $10,000 and its liabilities by $10,000, keeping the equation in balance.
Normal Balance
Accounts have a normal balance, meaning they typically carry a debit or credit balance. Here are common account normal balances:
| Account | Normal Balance |
|---|---|
| Assets | Debit |
| Liabilities | Credit |
| Equity | Credit |
| Revenue | Credit |
| Expenses | Debit |
Knowing the normal balance helps understand if an account is expected to have a positive or negative balance. It also assists with detecting errors – if an account balance is the opposite of its normal balance, there may be a problem.
Debit and Credit Rules
There are a few key debit and credit rules that serve as handy reminders when recording transactions:
– Debit what comes in; credit what goes out.
– Debit expenses and losses; credit revenues and gains.
– Debit the asset or expense account receiving the benefit.
– Credit the liability, equity, or revenue account giving the benefit.
For example, when buying inventory with cash:
– Debit Inventory (asset receiving benefit)
– Credit Cash (asset going out)
When billing a client on account:
– Debit Accounts Receivable (asset receiving benefit)
– Credit Revenue (revenue account giving benefit)
Thinking in terms of what accounts are affected, which are increasing or decreasing, and how debits and credits impact normal balances takes practice. But mastering the use of debits and credits is vital for sound accounting.
Chart of Accounts
The chart of accounts is the framework for a company’s entire accounting system. It contains a listing of all accounts used to record transactions grouped into categories like assets, liabilities, equity, revenue and expenses. Here is an example chart of accounts:
| Account Number | Account Title |
|---|---|
| 1000-1099 | Assets |
| 1100 | Cash |
| 1200 | Accounts Receivable |
| 1300 | Inventory |
| 1400 | Prepaid Expenses |
| 1500 | Property and Equipment |
| 2000-2999 | Liabilities |
| 2100 | Accounts Payable |
| 2200 | Credit Card Payable |
| 2300 | Notes Payable |
| 3000-3999 | Equity |
| 3100 | Common Stock |
| 3200 | Retained Earnings |
| 4000-4999 | Revenue |
| 5000-5999 | Expenses |
Well-designed account numbering and titling helps organize the general ledger and financial statements. The chart of accounts provides the foundation for the accounting system.
Recording Journal Entries
Journal entries are used to record business transactions and events and post them to the general ledger accounts. General ledger accounts summarize transactions by account balance.
Journal entries list the accounts impacted by a transaction using debits and credits. They also include the dollar amounts, a description, and a unique transaction number.
Here is an example journal entry to record the sale of inventory on account:
| Account | Debit | Credit |
|---|---|---|
| Accounts Receivable | $500 | |
| Sales Revenue | $500 |
Description: Sold inventory on account for $500.
Journal Entry #57
Posting these entries updates each account’s balance in the general ledger.
The Closing Process
At the end of an accounting period, journal entries are made to close temporary accounts and shift their balances to permanent accounts. This is the closing process.
There are four closing entries, each dated the last day of the period:
Closing Entry #1:
Debit Income Summary
Credit Revenues
Closing Entry #2:
Debit Income Summary
Credit Expenses
Closing Entry #3:
Debit Retained Earnings
Credit Income Summary
Closing Entry #4:
Debit Income Summary
Credit Dividends
These journal entries reset the temporary accounts to begin the next period, while updating the permanent account balances.
The Accounting Cycle
Posting closing entries completes the accounting cycle, which consists of:
1. Recording transactions in a journal
2. Posting journal entries to the general ledger
3. Preparing an unadjusted trial balance
4. Recording adjusting entries
5. Preparing an adjusted trial balance
6. Recording and posting closing entries
7. Preparing the financial statements
This sequence of accounting procedures is then repeated each reporting period.
Accrual vs. Cash Basis Accounting
There are two primary accounting methods:
Cash basis – transactions are recorded when cash actually changes hands.
Accrual basis – transactions are recorded in the period they occur, regardless of cash flow timing.
Accrual accounting matches revenues and expenses to the period where activity occurred. It provides a more accurate picture of financial performance and position.
Cash basis is simpler but does not match income and expenses properly. Overall accrual accounting is preferred in most cases.
Balance Sheet vs. Income Statement
While the accounting equation provides the foundation, the primary financial statements are the balance sheet and income statement.
Balance Sheet – Reports assets, liabilities, and equity at a point in time. Reflects the accounting equation:
Assets = Liabilities + Equity
Income Statement – Reports revenues and expenses over a period of time. Shows the equation:
Revenues – Expenses = Net Income
The balance sheet is a snapshot; the income statement shows performance. Together they provide key information on the financial health of a company.
Generally Accepted Accounting Principles (GAAP)
GAAP refers to the standard framework of guidelines for financial accounting used in any given jurisdiction. It includes:
– Standards: Rules for measurement, assumptions, and presentation
– Conventions: Guidelines for when transactions are recorded
– Principles: Foundational concepts guiding why accounts are used
Adhering to GAAP ensures financial statements are:
– Consistent – allows comparison across accounting periods and other companies
– Reliable – presents accurate depiction of financial position
– Relevant – includes material information useful for decision-making
GAAP aims to guide accountants towards sound financial reporting.
Conclusion
This overview covers key accounting fundamentals including debits and credits, the accounting equation, journal entries, and financial statements. Mastering these core concepts is essential for anyone looking to succeed in accounting and finance roles. Though technical at times, the logical structure of double-entry accounting is designed to provide order and useful information to business stakeholders. Red and black ink helps accountants track and report that vital data. With practice, these accounting conventions that underpin recording and reporting business transactions will become second nature for any aspiring accounting or finance professional.