Just like the tech business, accounting uses loads of acronyms and seemingly undecipherable names, but the basics are actually really simple. I’m not saying that accounting in and of itself is simple, but rather that the concept is quite understandable and convenient if you approach it correctly.
The goal of this post is to provide a basic understanding of the basic principles of accounting, which a lot of tech people (particularly in the database business) will at some point encounter.
I’ve tried to keep all of this very general and simple (you might say dumbed down, even), but this would still be a good time for you to get some coffee and put on your headphones. I’ll wait.
The most elementary concept in accounting is the account. In its simplest form, an account, just like a bank account number, represents a logical “balance” of sorts. It could be an asset (like a check or money in the bank) or a liability (like a vendor invoice you haven’t paid yet).
Account numbers are typically four-, five- or even six-digit numbers, sometimes with alphanumeric characters in them. They are more standardized in some countries (like the Nordic countries, France and Spain) and less so in some others, and exactly how accounts are named and numbered varies a great deal across the world, so I won’t actually go into that just yet.
There are two basic types of accounts: those that belong to the balance sheet and those that go in the income statement. You might recognize those two terms if you own stock in publicly traded companies or if you’ve ever attended a homeowners’ association meeting.
The balance sheet
The balance sheet contains assets and liabilities, i.e. what you have and what you owe. It’s essentially the company’s net worth. For example, your bank account is (hopefully) an asset, so are things like machinery, servers, production plants, unpaid client invoices and items in your warehouse. And, to some extent, even trademarks or anything else you could sell for cash.
A liability is when the company owes money. This could be a loan or credit, vendor invoices or taxes you haven’t paid yet or anything that could bring a bill collector to your door some day.
Then there’s equity: Most companies are legal entities that one or more shareholders can own. Shareholders own companies by lending them money in exchange for stocks (a written contract that entitles them to a share of any profits the company makes). If you pay $1000 for stock in a company, the company now has a debt (a liability) of $1000 to you. At some point in the future, you are going to want that money back, so this stock (from the perspective of the company) can be considered a liability.
The income statement
Like the balance sheet, the income statement also has two sides: revenue and expenses.
Revenue is where you make money, like goods or services you sell. Expenses are everyday costs you need to pay in order to keep your business running and the production lines rolling. Typically, expenses are divided into one of a number of categories.
Cost of goods: If you have to buy materials to build a product you can sell, that’s called “cost of goods sold”. This way, you can compare how much your raw materials cost you and how much you sell the result for.
Personnel: Wages, benefits and taxes for staff are usually a large part of any organization’s expenses.
Other expenses: Anything else*. This includes the rent for your fancy offices, taxi fares, office materials, etc.
* Yeah, like I said, vastly simplified.
Debit and credit
Debit and credit are two key concepts that you’ll need to keep track of. Essentially, it means positive and negative, where debit is a positive amount and credit is a negative amount.
Assets increase on the debit/plus side (a positive asset is a good thing) and liabilities and equity increase on the credit/minus side.
But for revenues and expenses, the signage is the other way around, for reasons you’ll see in a minute. Revenues increase on the credit side (negative) and expenses are denoted on the debit side (positive). Here’s why:
Transactions and balances
Everything you do (at least in a financial sense) results in a transaction that touches two or more accounts. This is called double-entry bookkeeping and was invented by merchants in Venice in the 1400s. The derives from the fact that the total amount for each transaction is always zero. No exceptions.
Suppose you send an invoice of $1000 to a client for consulting services.
- You have a revenue of $1000
(credit, i.e. minus, “consulting revenue” by $1000, increasing your sales)
- Because you’re entitled to get $1000 from your client, that’s an asset
(debit, i.e. plus, “accounts receivable” by $1000, increasing your assets)
Account Amount Resulting balance Consulting revenue (revenue) -1000 -1000 Accounts receivable (asset) +1000 +1000 = 0
The total of those two rows is zero. Note how your income statement reflects $1000 of revenue and your balance sheet has $1000 in assets.
A few weeks later, your client pays your invoice by depositing money in your bank account:
- You get $1000 to your bank account
(debit, i.e. increase, “bank account” by $1000)
- The client’s debt to you is now paid, which means that you reduce that asset back to zero
(credit “accounts receivable” by $1000, back to zero)
Account Amount Resulting balance Bank account (asset) +1000 1000 Accounts receivable (asset) -1000 0 = 0
You now have $1000 in your bank account, no unpaid client invoices and so far you’ve sold goods and services to the tune of $1000. Remember the signs are reversed on the income statement, so a negative total of revenue and expenses is actually a good thing.
Complicating it: value-added tax/sales tax
In practice, sales (and purchases) usually involve some type of value-added tax (VAT) or sales tax, depending on where in the world you live. That typically means you get paid money from the client that you’ll, in turn, pay forward to the taxman. Here’s how that same sale works with a 10% tax:
- You have a revenue of $1000
- Also, the client pays you $100 in taxes. This, however, isn’t revenue – it’s a liability (which increases on the credit side) because you know you’ll owe this money to the taxman.
- Because you’re expecting $1100 from your client, that’s an asset
(debit, i.e. plus, “accounts receivable” by $1100)
Account Amount Resulting balance Consulting revenue (revenue) -1000 -1000 Sales tax/VAT (liability) -100 -100 Accounts receivable (asset) +1100 +1100 = 0
Now, if you look at the balance sheet, you have $1100 in assets, $100 in liabilities and revenues are still $1000. Now, let’s pay our taxes:
- Credit the company bank account by $100.
- Debit the tax/VAT account by $100, eliminating the debt to the taxman.
Account Amount Resulting balance Sales tax/VAT (liability) +100 0 Bank account (asset) -100 -100 = 0
The same principle applies when you receive an invoice from a vendor, like for instance your cloud provider. Here’s how that could look:
- Debit cloud services $500
- Credit accounts payable (a liability) $500
Account Amount Resulting balance Cloud services (expenses) +500 500 Accounts payable (liability) -500 -500 = 0
… and when you pay that invoice later on, you’ll reset the accounts payable:
- Debit accounts payable $500
- Credit the company bank account $500
Account Amount Resulting balance Accounts payable (liability) +500 0 Bank account (asset) -500 -500 = 0
Adding it all up, you can see that you’ve had $500 in expenses, you don’t owe the vendor anything (accounts payable is zero), but you’ve gone into the red in your bank account in this case.
Chart of accounts
Typically, account numbers follow the order in which the balance sheets and income statements are presented in their printed forms. The examples below are not universal truths, but rather rough guides to give you an idea of the general layout.
- 12…: Inventory and depreciation
- 15…: Accounts receivable
- 17…: Prepaid expenses
- 19…: Cash, bank accounts
- Liabilities and equity
- 20…: Equity and retained earnings
- 24…: Short-term debts, accounts payable
- 25…: Tax liabilities
- 30-34…: Sales
- 35-39…: Other income
- 4…: Cost of goods
- 5-6…: External costs
- 7…: Personnel costs
- 8…: Financial results
- 10…: Inventory
- 11…: Accounts receivable
- 12…: Cash, bank accounts
- 2…: Liabilities
- 3…: Equity
- 4…: Sales
- 5…: Cost of goods
- 60..: Personnel
- 61-79…: Other costs
- 80…: Depreciation
- 10…: Cash, bank accounts
- 11…: Accounts receivable
- 12…: Inventory
- 18…: Equipment and depreciation
- 19…: Prepaid expenses
- 20…: Accounts payable
- 25…: Sales taxes
- 30…: Capital and retained earnings
- 4….: Sales
- 5….: Personnel costs
- 6….: Other expenses
- 7…: Depreciation
France, Spain, Netherlands, Belgium
- Equity, liabilities
- 1…: Equity and long-term debt
- 2…: Inventory and other assets
- 3…: Goods for sale
- 50-53..: Cash, banks
- 7….: Sales
- 6….: Costs
- 64…: Personnel costs
- 69…: Depreciation
Every transaction happens on a specific date. For instance, you can send an invoice today and get paid 30 days from now, and those are two different transactions on two different dates. There are however a number of types of transactions that need to span multiple accounting periods or even multiple fiscal years. Like, for instance, if you get an invoice from your office landlord in January for a quarter’s worth of rent, say $1000 per month.
From a balance sheet perspective, all that money leaves your bank account at once. But from an income statement perspective, only $1000 is related to this month. You’ve actually prepaid $2000 for the next two months, which is what’s known as an accrual.
In theory, if you sell or close the company in January, you could sell or get back the $2000 – that’s why this accrual is viewed as an asset.
January: Account Amount Resulting balance Accounts payable (liability) -3000 -3000 Office rent (expenses) +1000 +1000 Prepaid rent (asset) +2000 +2000 = 0
The $2000 is an asset because you’ve paid for something you haven’t yet received or used up. And when February comes around, you’re turning your prepayment into an expense, like this:
February: Account Amount Resulting balance Office rent (expenses) +1000 +2000 Prepaid rent (asset) -1000 +1000 = 0
.. and the same thing happens again in March:
March: Account Amount Resulting balance Office rent (expenses) +1000 +3000 Prepaid rent (asset) -1000 +0 = 0
This way, your office lease is $1000 for January, February and March each; not $3000 for January. This is important when you want to compare how your business is doing from month to month or year to year!
Nothing is forever, and this is true in an economic sense too. If you buy expensive office furniture or a really nice rack server, it’ll be worth a lot less in a few years than it is today. In financial terms, this is called depreciation, and because your inventories are assets, depreciation is a cost that gradually decreases (depreciates) the asset value of those inventories.
Some things, like printer paper or red staplers are just expenses. You don’t see them as inventories, but rather just as stuff you use up. So when you buy them, it looks something like this:
Account Amount Resulting balance Red staplers (expenses) +20 +20 Credit card bill (liabilities) -20 -20 = 0
There’s no depreciation happening here, the expense happens when you buy the stapler, and after that it is (in a financial sense) worthless.
But if you buy a copy machine, there’s no expense involved, at least no initially. You could think of it as trading one asset (your money) for another asset (an inventory).
Account Amount Resulting balance Machinery (assets) +2500 +2500 Accounts payable (liabilities) -2500 -2500 = 0
At this point, your purchase of a big copy machine doesn’t affect your income statement, only your balance sheet. If you think of it, you could probably turn around and sell that same brand-new copy machine at about the same price. That’s why it stays in the balance sheet.
However, as the months go by, your machine won’t be worth as much if you try to sell it. And to reflect that, we’ll depreciate it:
Account Amount Resulting balance Machinery (assets) 2500 Depreciation, machinery (assets) -250 -250 Depreciation, machinery (expenses) +250 +250 = 0
Did you catch that? There are two matching depreciation accounts; one asset account and one expense account, and they balance each other out. This makes sense, because no actual money changes hands, it’s all a bookkeeping trick.
The reason the depreciation balance account is an asset (although it has a negative balance) is that we want to keep the total of the inventories and their respective depreciations together, in order to avoid “inflating” the balance sheet.
If you’re still awake, you’ll also note how this looks a lot like acccruals – that’s no accident. If you buy a copy machine with an expected (financial) service life of ten years, that’s an expense that should impact your income statement for the next ten years, not just on the date you bought it. That’s why you account for the purchase as an inventory and then write it off over the next ten years.
This has tax implications as well. Your profit decreases not by how much cash you’ve spent, but rather by how much your inventory has depreciated during the fiscal year.
Now, let’s say you want to sell the copier after a few years. Suppose it cost you $2500 to buy, and you’ve depreciated it by $750 so far. In a financial sense, the copier is still worth $1750. If you manage to sell it for $2000, you’ve made a pretty good deal because you’ve earned $250 compared to its asset value.
Here’s how it breaks down. We’ll revert the asset accounts so their balances return to zero. The remainder from the sales price is your profit or loss for this inventory:
Account Amount Resulting balance Machinery (assets) -2500 0 Depreciation, machinery (assets) +750 0 Depreciation, machinery (expenses) 750 Bank account (assets) +2000 2000 Gains, machinery (revenue) -250 -250 = 0
In this example, you’ll end up with no inventories and no depreciations, but $2000 in the bank and a neat little profit of $250 from the deal.
Again, you can’t just depreciate things as you please, because a depreciation incurs an expense which reduces your net result, which in turn reduces your corporate tax. So there are laws that regulate exactly what and how much you can depreciate, and they’re most probably wildly different between juristictions.
Closing the books (end of year)
The year-end process compiles the company’s annual report and consists of a number of technical accounting operations, including depreciations and accruals, but also bookings related to companies that your company owns or is owned by, tax adjustments, and a lot of other things I won’t go into.
But in the simplest scenario, the net total of the income statement is “balanced”, i.e. transferred from the income statement to the balance sheet.
Account Amount Resulting balance Consulting services (revenue) -100000 Salaries (expenses) 80000 Office rent (expenses) 12000 Profit or loss (expenses) +8000 8000 Retained earnings (equity) -8000 -8000 = 0
The net total of the income statement is a profit of $8000. We’ll “zero out” the income statement by adding an expense of $8000, which corresponds to an increase in equity (retained earnings) of $8000. This increase in equity means that because the company posted a profit, it now owes that profit to its shareholders.
“Retained earnings” increases if the company posts a profit and decreases either if the company posts a net loss or of it pays out dividends to its shareholders.
With every new fiscal year, the income statement accounts start over at zero, but the balance accounts just roll forward their balances. This makes sense, if you think about it. The balance sheet reflects how much money is in your bank account, how much your assets are worth, your outstanding debts, etc, and none of those things changed just because a new year started. The income statement, however, resets every year.
The net total of the balance sheet, once a fiscal year is closed properly, is always zero: the assets are equal to the liabilities and equity once the year’s profit or loss has been moved to “retained earnings”.
Accounting is one of those areas you should probably have a decent understanding of, even if you never do any actual accounting work. A lot of applications and most reports and business intelligence solutions feed on, or produce, accounting data. Understanding the basic principles will give you a head start, whether you’re developing software or troubleshooting reports.
Here are some vaguely accounting-related posts you might also find useful: