Introduction to Accounting using ERPNext

8 min readJan 17, 2019

You have to know accounting. It’s the language of practical business life. Double entry bookkeeping was a hell of an invention. — Charlie Munger, vice chairman of Berkshire Hathaway.

When I started leading one of the largest ERPNext implementations in my previous organization, I didn’t like accounting at first as it seemed cryptic. But just like so many other instances, I grew fond of accounting over time. While no single article can explain accounting, principles are few. Let’s try and learn the principles of accounting!

Accounting is especially fun when you use a highly visual and easy-to-use tool like ERPNext.

1. Accrual Basis Accounting

Let’s say you are interested in investing $50,000 and you are assessing two businesses, ABC Inc and XYZ Inc. You visit ABC Inc and find out that it has $20,000 in cash and is based in a big office. Then you visit XYZ Inc which has only $1,000 in cash and is based in a small office. You are impressed with ABC Inc in general.

But you are a smart investor and you dig deeper for more information. You find out that ABC Inc had not only borrowed all of that $20,000 from a bank but also owes a huge amount to the landlord toward office rent. And XYZ Inc does not owe anyone any money and also the $1000 in cash was earned by providing a highly profitable service to a customer.

Now you are impressed with XYZ Inc and decide to invest in them.

So (just) cash is not king!

This is the reason almost all businesses use accrual basis accounting, not cash basis accounting.

In accrual basis accounting you recognize and record changes in your expense, income, asset, and liability as soon as they occur instead of waiting for an actual cash transaction to happen.

2. The concept of Assets, Liabilities, Incomes, and Expenses

So information on just assets does not give you the full picture. You need to know what are the liabilities. And similarly information on income is not sufficient, you need to know what are the expenses.

Anyone running a business must keep a tab on all four things.

What you earn i.e your “Income”
What you spend i.e your “Expenses”
What you own i.e your “Assets”
What you owe i.e your “Liabilities”

Income: In a business, you earn in many different ways. They can be mainly categorized into two groups. Direct and Indirect. When you sell your product or service to your customer, you earn direct income. The interest you earn on fixed deposit or the income earned when you sell a fixed asset like old furniture or computer is indirect income.

Expense: Your business will incur many types of expenses. They can be mainly categorized into two groups. Direct and Indirect. Let’s say you bought an item for $100 and sold it for $200, so the direct expense is $100. Money spent on your office rent, electricity etc is an indirect expense.

Asset: Asset is what you own. Cash in hand, balance in your bank account are your assets. Assets are mainly classified into fixed assets(like furniture, machines, buildings) and current assets(cash, bank balance, stock etc).

The money that your customer owes you is also an asset.

Liability: Liability is what you owe. If you got a loan from a bank that’s a liability. Liabilities are mainly classified into Current liabilities(short term) and long term liabilities.

If you received a product or service from a supplier and you are yet to pay him, that’s a liability.

(Equity: When you register a business, you and your business are recognized as two separate legal entities. When you invest $20k, the business you registered owes you that $20k. If you decide to close this business immediately after the registration the business is expected to return you the $20k you invested. Equity is a special type of liability.)

3. The Chart of Accounts

So you need to create an accounting head or a ledger under the four main categories explained above.

When you create groups and ledgers, you create a ‘Chart of Accounts’. When you complete the installation of ERPNext, many of these ledgers are already created for you. You can further create additional ledgers as and when you need them.

This is how the chart of accounts look like.

Let’s say that you start a business here in India on the 1st of April 2018. You go on adding your incomes and expenses till 31st March 2019 and next day you reset both to zero and start all over again. This is the reason why accounts under income and expense are called temporary accounts.

However, this resetting is not applicable to assets and liabilities. If you have $500 in cash on 31st March 2019, you carry over the cash as it is to the next financial year. This is the reason accounts under asset and liability group are called permanent accounts or real accounts.

4. The double entry accounting system

[Transaction 1] Let’s say you open an account with a bank and apply for $500 loan to start your business. And the bank grants you the loan and deposits $500 in your bank account. Now your business owns $500 in bank balance and at the same time, your business owes $500 to the bank.
[Transaction 2] Out of that $500 in your bank account, you withdraw $100 in cash. Now the cash you own increases by $100 and the bank balance you own reduces by the same amount.
[Transaction 3] Let’s say a customer paid you $100 in cash as an advance. Now you own $100 additional in cash and at the same time, you owe a product/service worth $100 to the customer. Even though you own the cash, you have not earned it!
[Transaction 4] Let’s say you supplied a service worth $200 to your customer and he/she paid you immediately in cash. Now you own $200 cash but this time you have earned $200 as an income.
[Transaction 5] On the last day of the month, you receive a bill of $100 from your telephone service provider. Even though you have not paid the cash, you still recognize and record that you have spent the $100 and you owe that to the service provider.
[Transaction 6] Let’s say you paid $50 cash towards your telephone bill. Now you have spent $50 and also the cash you own reduces by $50.

So you see the pattern!

Any accounting transactions will always affect at least two ledgers!

5. Debits and Credits

Now you have $400 in your bank account. End of the quarter bank charges you $20 for their service leaving your account balance at $380. For some reason, you withdraw all of that money and your bank account has no balance now. After another three months bank would like to charge you $20 for their service but your bank account has zero balance. Instead of waiting for you to deposit $20, bank charges you that amount immediately. Now your effective bank balance is -$20!! So it’s not enough if you say if your bank balance is $380 or $20. You have to also mention if you own that much amount or you owe that amount!

So if you own $380 balance, you say that your bank account has $380 debit balance. And if you owe $20 to the bank you say your bank account has $20 credit balance.

All assets are expected to have a debit balance and liabilities a credit balance. And all incomes are expected to have a credit balance and all expenses debit balance.

Also when you create an accounting entry you debit a ledger and credit another.

In any accounting transaction, the total debit is equal to the total credit!

6. Sales Invoice, Purchase Invoice and Journal Entry

In accounting, these three types of transactions are posted.

When you sell your product/service to your customer, you earn income. So you need to register this income by creating a sales invoice.

When you purchase a service you can record this expense by creating a purchase invoice. If you purchase stock and store it in your warehouse, its an asset for you.

You can also record the changes in asset, liability, income, and expenses by creating a journal entry. Indirect income and expenses are posted via journal entry.

7. Assets are always equal to the sum of Liabilities and Equity!!!

When you start a business, you as the owner of the business are taking all the decisions. You are constantly thinking about your business. You are inseparable from your business! Well, that's not the case from a legal and accounting perspective! You, the owner is separate and the business you registered is separate.

ERPNext is a free and open source software and you can make money by providing services around it. Let's say you like ERPNext and you start a consulting business. You don't raise any money from an investor or borrow any money from the bank, instead, you go to a customer on the day you start your business and make a cool $100 in profit! Awesome! Now that $100 profit is owed by your business to you, the owner!

Let's see where your assets and liabilities stand when you posted each of the transactions described in section 4 above.

[Transaction 1] Amount of asset your business owns in cash $500 is equal to the amount your business owes to bank $500.
[Transaction 2] Sum of assets your business owns, $100 in cash and $400 in bank balance is equal to the amount your business owes to bank $500.
[Transaction 3] Sum of assets your business owns, $200 in cash and $400 in bank balance is equal to the sum of the amount your business owes, 500 to bank and $100 to the customer.

Yes, another pattern!

Assets = Liabilities + Equity

8. Financial Statements

Now that you have recorded all the information, you can check where your business stands using the financial statements.

1. Profit and Loss Statement: Profit and loss statement reports a company’s revenues, expenses, and most of the gains and losses which occurred during the period of time specified in its heading.

2. Balance Sheet: Balance sheet report shows a company’s assets, its liabilities, and its stockholders’ equity.

3. Cash Flow: The cash flow statement reports a company’s major sources and uses of cash.

You can configure ERPNext to deliver these reports to your email inbox on a daily/weekly/monthly basis via Auto Email Reports!

Now you know the principles of Accounting! But it’s not enough if you just know the accounting, you must do the accounting!

You can start practicing accounting and more in less than two minutes by signing up for 14 days free plan at https://erpnext.com/

Please read our easy-to-understand manual for further learning.

Happy Accounting!

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