The Accounting Model – Accounting’s Rosetta Stone
As a small business owner/manager you must have an understanding of the financial end of your business. Certainly, you have a decent grasp of how the business operates, but are you able to visualize an accounting framework that your transactions fit into? To do this requires becoming familiar with how your financial statements are structured and knowing the rules for recording transactions.
Financial statements consist of a Balance Sheet and Profit & Loss Statement. These two reports act as a “container” for all your business transactions. Each transaction is recorded according to a set of rules called “The Accounting Model”.
The Accounting Model is made up of three very simple parts:
The first part is a ledger page with a line drawn down the middle (like a big T) automatically creating a left and right side of the dividing line. However, in accounting language the word “debit” is used instead of “left” and the word “credit” is used instead of “right”. The trick here is to not make this anymore complicated than it really is. Don’t try to use the words debit and credit to mean increase or decrease like you see on your bank statement. You can do this later when you fully understand how to work with these terms.
The second part is that there are five of these ledger T’s that relate to the five sections found in a set of financial statements. They are: 1) Assets; 2) Liabilities; 3) Equity; 4) Revenue; 5) Expense. The first three relate to the Balance Sheet and last two relate to the Profit & Loss Statement.
The third part is a rule that states: Any transaction that pertains to a section (Assets, Liabilities, etc.) that results in an increase or decrease has to be recorded on either the left or right side of the ledger page.
The next step is to memorize the model so you can visualize where transactions are to be recorded. Have you ever tried to learn how to use a ten-key calculator or computer keyboard? At some time you have to stop looking at the keys and allow your mind to memorize the keyboard. That’s when you get fast and efficient. Memorizing the accounting model is no different.
Let’s try a sample transaction so you can see how this works. A great technique is to think about what actually happened “physically” in a transaction. This is an important step because doing this will tell you what you need to know in order to convert the physical event into an accounting transaction.
For example, let’s say in your business you had a customer who walked in the door, bought some merchandise and handed you a check for $100. You deposited the $100 check in your bank account and recorded the sale in your sales journal. Keep in mind that each transaction has two parts, a debit (left side) and a credit (right side), and that double-entry accounting requires each side of the ledger to equal each other when the transaction is completed.
The first step is to identify the parts of the transaction and determine in which of the five sections each part belongs. For instance, you know that your $100 cash received is an Asset and your sale is Revenue.
The second step is to identify whether the transaction resulted in an increase or decrease to cash and the sale. In the sample transaction, it is obvious that cash was increased and sales were increased.
The third step is to look at the accounting model and let it tell you on which side of the ledger to record the transaction. Try it now. The model tells you that cash, being an Asset, goes on the left (debit) side when increased, and sales, being Revenue, goes on the right (credit) side when increased.
Since the debits equal the credits the books are said to be “in balance”. This gives you a brief idea about how the Accounting Model is used as a cipher to tell you where to record transactions in your general ledger (GL). All you have to do next is to practice using this system so that you become familiar with all of your GL accounts. Then the day will come when you become aware that you are no longer looking at the “keyboard” and realize that the accounting framework is fully integrated into your thinking process.