Accounting Basics
A small primer to get you up to speed on the concepts of accounting.
Let's understand the concept of accounting with the example of an imaginary business that is just starting out.
Owner Investment: Let’s say we’re starting a Home Interior business and we have ₹5,00,000 of capital to start our business.
Bank balance will initially be ₹5,00,000.
First Expense: We will need an operating place where we can work and meet clients. For this, we rent out a co-working space for ₹40,000 per month. This is our first expense.
Bank balance will now be ₹5,00,000 - ₹40,000 = ₹4,60,000.
First Income: We have invested some cash, and we have a working place. Now we make our first sale having a value of ₹30,000. We earned ₹30,000 from our first customer. This is our first income.
Bank balance at this point will be ₹4,60,000 + ₹30,000 = ₹4,90,000.
Accounts Payable: Finally, Let’s say we decided to hire a Web Agency to build a website for us, they charge ₹50,000 which will be paid after 2 months from current date.
At this point we haven’t paid them any money, but we are liable to pay them in the future. This is a liability and will be recorded under Accounts Payable.
Events and Accounts
Let’s list these events down in a table:
| # | Event | Amount |
|---|---|---|
| 1 | Owner Investment | + ₹5,00,000 |
| 2 | Rent | - ₹40,000 |
| 3 | Sales | + ₹30,000 |
| 4 | Accounts Payable | - ₹50,000 |
| 5 | Total | ₹4,40,000 |
Now, let's categorize these into the five types of Accounts and list their final balances:
| # | Account | Amount |
|---|---|---|
| 1 | Asset (Bank) | ₹4,90,000 |
| 2 | Liabilities (Accounts Payable) | ₹50,000 |
| 3 | Equity (Owner Investment) | ₹5,00,000 |
| 4 | Income (Sales) | ₹30,000 |
| 5 | Expense (Rent) | ₹40,000 |
Impact on Accounts
Let’s take a look at each transaction and understand which accounts will get affected, from an accounting point-of-view:
1. Cash Investment
Since you, the owner, invested money into the business, it is a liability. So, Accounts Payable, which is a Liability account, is increased by ₹5,00,000.
Also, the money in the Bank Account, which is an Asset account, is increased by ₹5,00,000.
| Account | Credit | Debit |
|---|---|---|
| Accounts Payable | ₹5,00,000 | 0 |
| Bank Account | 0 | ₹5,00,000 |
2. Rent
Rent is an immediate expense, so it is recorded in the Rent Account, which is an Expense account, it is increased by ₹40,000.
Also, the money is spent from the Bank Account, which is an Asset account, it is decreased by ₹40,000.
| Account | Credit | Debit |
|---|---|---|
| Rent Account | 0 | ₹40,000 |
| Bank Account | ₹40,000 | 0 |
3. First Sale
We got an immediate payment, it is recorded in Sales Account, which is an Income account, the balance is increased by ₹30,000.
Also, we received the money in our Bank Account directly, so it’s balance increases by ₹30,000.
| Account | Credit | Debit |
|---|---|---|
| Income Account | ₹30,000 | 0 |
| Bank Account | 0 | ₹30,000 |
4. Hiring a Web Agency
We hired a Web Agency for some work, and we are liable to pay them in the future. This is recorded in Accounts Payable by increasing the amount by ₹50,000.
Since this is an expense for us, we also increase the balance in the Vendor Expense Account by ₹50,000.
| Account | Credit | Debit |
|---|---|---|
| Accounts Payable | ₹50,000 | 0 |
| Expense Account | 0 | ₹50,000 |
As you might have noticed, every transaction we do in our business affects two accounts. This is the basis of double-entry bookkeeping system.
You can test this out by creating a Sales Invoice in Frappe Books, and then check the General Ledger Report to see which accounts were affected.
Credit and Debit
The words Credit and Debit mean different things when applied to different accounts.
- For Assets and Expense accounts Credit implies a decrease in balance and Debit implies an increase in balance.
- For Liabilities and Income accounts Credit implies an increase in balance and Debit implies and decrease in balance.
::: tip AEDLIC You can remember this by the abbreviation AEDLIC which would stand for:
Assets and Expenses Debit, Liabilities and Income Credit :::