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Accounting Basics (Liz)

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ACCOUNTING BASICS

If you plan to build a well and charge for the water in terms of storage, accessibility, well maintenance, or any other reason, it will likely be necessary to keep track of your finances through accounting. Accounting is an important part of running a business for two main reasons: first, it helps you manage your income and expenses, giving you a better chance of making a profit; second, it keeps your records in order for any tax reporting you may have to do ([1]). While it may seem challenging at first, accounting is not terribly difficult. In fact, it is based on double-entry bookkeeping, which is a concept from the Middle Ages ([2]). The information for this section on accounting basics comes from Ed Zimmer’s website, www.tenonline.com, which is dedicated to helping entrepreneurs at a grass roots level. This section has been adapted from his Zimmer’s chapter on accounting basics. Here is some background information that is useful to keep in mind:

• The five types of accounts used in accounting are assets, liabilities, equity, accumulated revenue, and expense • Every financial transaction affects at least two accounts • Every transaction sums to zero, which means that the sum of all transactions is zero

Here are definitions of the five types of accounts: • Assets – what you own • Liabilities – what you owe • Equity – net worth • Revenue – what you get in • Expense – what you pay out

This type of bookkeeping, known as double entry, can be explained by the accounting equation. A more detailed version of the following discussion, which will explain how the accounts function, can be found at [3]. The accounting equation is as follows:

assets = liabilities + equity

For a particular time period, the equation becomes:

assets = liabilities + equity + (revenue – expenses)

Finally, this equation may be rearranged algebraically as follows:

assets + expenses = liabilities + equity + revenue

In order to more fully understand what types of entries go where, it is helpful to get an overview of debits and credits, and also the T account. Debits and credits are defined by [www.wikipedia.org] as follows:

• Debit: an increase in one of the accounts with a normal balance of debit or a decrease in one of the accounts with a normal balance of credit. A debit is recorded on the left hand side of the T account

• Credit: an increase in one of the accounts with a normal balance of credit or a decrease in one of the accounts with a normal balance of debit. A credit balance is recorded on the right hand side of the T account

• Debit accounts: assets and expenses (also debit money received into bank accounts

• Credit accounts: Gains (income) and liabilities (also credit money paid out of bank accounts

The following accounts have a normal balance of debit:

• Assets • Accounts receivable: debts promised by other entities but not yet paid • Drawings by the owners on equity • Expenses • Losses (that is, when expenses exceed revenue)

The following accounts have a normal balance of credit:

• Liabilities • Accounts payable and taxes, notes, or loans payable: debts promised to outsiders but not yet paid • Revenue • Profit (that is, when revenue exceeds expenses)

The following table summarizes the basic accounts. A “+” indicates an increase, and a “-“ indicates a decrease.

Debit/credit Account Debit Credit Assets + − Expenses + − Liabilities - + Shareholder Equity − + Revenue − +

Let’s take an example of a few transactions that may occur in your well business’s accounts. Imagine you start a company for your well and put $10 into the bank. This transaction would impact the cash and equity accounts. Now imagine someone pays you $2 for water access. This transaction would impact the cash and revenue accounts. Now suppose you have to buy a piece of equipment for your well for $3. This would impact the cash and expense accounts. Each account (i.e. assets, liabilities, etc) has a separate T account. Let’s put the above transactions into the appropriate T account.

CASH Debits Credits

10	 
2	 
	3 

EQUITY Debits Credits

	 10

REVENUE Debits Credits

	 2

EXPENSE Debits Credits

3	

Notice if you add each of these T accounts together, you end up with zero, which is a great check to ensure you have not made a mistake. Keeping this basic accounting lesson in mind will help you to manage the finances of your business more effectively.

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