In this article, I am going to discuss the foundation accounting knowledge for recording financial transactions. The better you understand this foundation accounting knowledge, the easier it will be to continue with the later articles. I am going to use a service business as the example here, but I will discuss trading businesses in later articles. I will also translate this information into household bookkeeping like I always do.
Foundation Accounting Knowledge is lesson 5 in my free online bookkeeping course. Please note that the $ sign does not represent a specific currency in this article, but rather represents money in general. Therefore some of the amounts of money used in examples may appear unrealistic.
Foundation Accounting Knowledge – Definitions
Before we continue, I am going to define a few accounting terms and concepts you will need to be familiar with if you are not already familiar with them.
- Accounting – Recording of monetary values of financial transactions of individuals and businesses and reporting the results with the main purpose of supplying financial information by submitting statements as basis for decision making. i.e. the process of recording the financial transactions, and creating reports to give the reader the big picture of what is going on with the finances.
- Bookkeeping – The system of recording transactions, usually on a daily basis.
- Loss – Opposite of profit, i.e. the amount of money that was spent that is more than the income.
- Profit (income) – Difference between amount received from selling goods, or providing a service, and amount paid for goods (including all expenses incurred) or amount spent on providing a service. i.e. the amount of money that came in that was more than the expenses.
- Transaction – each action that takes place in relation to the finances of the business.
Basic Accounting Concepts in detail
When a business event takes place in which money changes hands, it is called a transaction. When a transaction takes place it must be recorded in the bookkeeping of the business. Some examples of transactions include:
- The owner supplies the starting funds of the business (e.g. $50,000)
- Equipment is purchased (e.g. $10,000)
- Bills are paid (e.g. $500)
- Wages are paid (e.g. $900)
Some examples of transactions in a household scenario include:
- Money is deposited into the bank account
- Groceries are bought
- Bills are paid
- Spending allowances are given to members of the household.
Transactions are always recorded on the date of the transaction.
Whenever money is received by a business or deposited in the current bank account of the business we call it a receipt. It is called a receipt whether a receipt document was issued or not. This is also true with regards to household finances. Every time money is received to be used within the household, it is called a receipt.
Any money taken out of the current bank account of a business or household is called a payment.
Capital contribution and owner’s equity
The money that is given to a business by the owner is called the capital contribution. It gives the owner an investment in the business called the owner’s equity. It is very important to understand that a business and the owner are separate entities. The owner’s personal transaction and those of the business are kept separate and should NEVER be mixed. When an owner gives a capital contribution, it is called a receipt for the business.
In the case of a household, the capital contribution may be the household savings that you already have at the time you start the bookkeeping (e.g. an emergency fund) or the amount of money each member of the household puts into the household bank account to start off the household bookkeeping process. It is very important that personal transactions are kept separate from household transactions, unless you plan to live by a form of socialism within your household, in which case the household members are all working as a team to pay off each other’s debts. In this case their is no such thing as your money or my money, it is ALL the household’s money. You will need to decide if you will be able to live like this or not.
An individual or household has possessions, such as a bicycle, computer, house, money etc. A business also has possessions, such as motor vehicles, filing cabinets, desks, computers, cash etc. The possessions of a business are called assets. When we do the bookkeeping, we usually separate the assets into vehicles, equipment, furniture and bank.
In the book Rich Dad, Poor Dad the author describes an asset as anything that makes you money, whereas a liability is anything that costs you money. In accounting practices an asset is anything that you will be able to resell at a later stage if the business goes bunkrupt.
When buying assets, it is important to keep in mind the Rich Dad, Poor Dad definition. Work on buying items that can make you money, or will assist you in making money. By keeping this definition in mind, you will be well on your way to not overspending and making a profit.
Like with a business, the household assets are the possessions within the household that are communal, for example the television in the living room. However the cell-phones of individual members of the household would be their own private assets and not included in the household bookkeeping.
Effect of assets on owner’s equity
Assets – liabilities = owners equity.
So if you have $15,000 in equipment (which is an asset), but you owe the bank $10,000 for that equipment because you bought it on credit, then what is the owners equity?
$15,000 (asset) – $10,000 (liability) = $5,000 (owners equity)
By the calculation above, the owners equity is $5,000. The owners equity is the value of the owner’s investment in the business, or the value of the business. In a household, the Owner’s Equity would be the value of your household.
Example of Assets and Owners Equity
Let’s leave out the liabilities for now, just to make the explanation a little simpler.
A. Johnson deposits $70,000 into the bank account of his business, Johnson Mechanics. What is the effect on assets and owner’s equity?
A. Johnson then buys equipment for his business to the value of $20,000. What is the effect on assets and owners equity?
Notice how there has been no effect on owner’s equity at this step. This is because money left the bank account, but equipment (which is also an asset) increased.
A. Johnson then bought a vehicle for his business. The vehicle is valued at $10,000. What is the effect on assets and owners equity?
Now, when we calculate the owners equity, using the formula, you will see that the owner’s equity remains unchanged:
Assets = $40,000 (cash) + $20,000 (equipment) + $10,000 (vehicles)
Therefore: Assets = $70,000
$70,000 (Assets) – $0 (Liabilities) = $70,000 (Owner’s Equity)
Effect of expenses on owner’s equity
An expense is any payment where you do not have an asset to show for it. For example, buying a trading license or buying groceries are expenses. An expense is the purchase of anything that will run out or wear out and will need to be paid for again soon. Water and Electricity are also examples of expenses, so is rent and property tax.
Example of expenses on owner’s equity
Continuing with our example above, A. Johnson pays $1,000 rent a month. The rent on his workshop is an expense because he doesn’t own the workshop. What is the effect on assets and owner’s equity?
Now, when we calculate the owners equity, using the formula, you will notice that the owner’s equity has now changed:
Assets = $39,000 (cash) + $20,000 (equipment) + $10,000 (vehicles)
Therefore: Assets = $69,000
$69,000 (assets) – $0 (Liabilities) = $69,000 (Owner’s Equity)
You can see by the above example that expenses decrease the owner’s equity
Effect of income on owner’s equity
Service businesses render services in exchange for money. The money is received for the services the business has provided and is deposited in the bank account. This is called a receipt.
Money that is received for services increases the cash asset of the business. In the case of services, there are no goods being sold, so there is no asset to decrease. Therefore the owner’s equity increases by the same amount.
When a receipt increases the owner’s equity, it is called an income.
Example of income on owners equity
In our Johnson Mechanics example, let’s say that Johnson Mechanics has been working for a week, and vehicles come in for a services. Johnson Mechanics makes $3500 for the servicing vehicles during that week. What is the effect on Assets and Owner’s Equity?
When we calculate the owners equity, using the formula, you will once again notice that the owner’s equity has changed:
Assets = $42,500 (cash) + $20,000 (equipment) + $10,000 (vehicles)
Therefore: Assets = $72,500
$72,500 (assets) – $0 (Liabilities) = $72,500 (Owner’s Equity)
What is a Profit?
Since the main objective of a business is to make a profit, it is logical to say that the goal for an owner is to increase his investment in his business (his Owner’s Equity).
After going through the above examples, it is clear that buying assets does not increase owner’s equity, UNLESS you are earning an income from those assets (for example, if you buy a property and rent it out).
It should also be clear that paying expenses decreases owner’s equity and an income increases the owner’s equity.
The profit is the amount by which the owner’s equity increases over a given period of time. As per the example above, the Owner’s Equity started out at $70,000, and finished with $72,500. Therefore the profit is the finishing amount, minus the starting amount:
$72,500 – $70,000 = $2,500 (profit)
OR you could also say that the profit is the income earned, minus the expenses:
$3,500 (income) – $1,000 (expenses) = $2,500 (profit)
Conclusion and Tasks
It is important that you understand what the owners equity is (it is the owner’s investment in the business), and how assets, expenses and incomes effect the owner’s equity before you carry onto the next section. If you don’t understand these concepts please research them some more, or leave a comment below and I will try to explain these concepts in another way.
Here are some tasks for you to get your household bookkeeping off the ground:
- 1. Pull out your asset register and calculate the total value of the assets of your household. You can download my Free Asset Register if you haven’t already done so.
- 2. Create a list of all your liabilities (money you owe) and calculate the total
- 3. Calculate the owner’s equity of your household. Don’t forget to include the cash you have in investments and bank accounts when you calculate your assets!
Here is my household’s Owner’s Equity Calculation, please note that this is a rough estimate and I have changed the decimal place and currency for confidentiality:
Assets = $775 (Property) + $120 (Vehicles) + $30 (Furniture) + $20 (Equipment) + $95 (Investment) + $3 (Cash)
Therefore: Assets = $1043
Liabilities = $20 (Loan)
$1043 (Assets) – $20 (Liabilities) = $1023 (Owner’s Equity)
It is important that your Liabilities are NOT more than your assets, it is also important that your monthly expenses never exceeds your income.