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Important! Every business and not-for-profit entity needs a reliable bookkeeping system based on
established accounting principles. Keep in mind that accounting is a much broader term than
bookkeeping. Bookkeeping refers mainly to the record-keeping aspects of accounting; it's essentially
the process of recording all the information regarding the transactions and financial activities of a
business.
Defining bookkeeping
Bookkeeping is an indispensable subset of accounting. Bookkeeping refers to the process of
accumulating, organizing, storing, and accessing the financial information base of an entity, which is
needed for two basic purposes:
Bookkeeping (also called recordkeeping) can be thought of as the financial information infrastructure
of an entity. The financial information base should be complete, accurate, and timely. Every
recordkeeping system needs quality controls built into it, which are called internal controls.
Defining accounting
The term accounting is much broader; going into the realm of designing the bookkeeping system,
establishing controls to make sure the system is working well, and analyzing and verifying the
recorded information. Accountants give orders; bookkeepers follow them.
Accounting encompasses the problems in measuring the financial effects of economic activity.
Furthermore, accounting includes the function of financial reporting of values and performance
measures to those that need the information. Business managers, investors, and many others
depend on financial reports for information about the performance and condition of the entity.
Important! Accountants design the internal controls for the bookkeeping system, which serve to
minimize errors in recording the large number of activities that an entity engages in over the period.
The internal controls that accountants design are also relied on to detect and deter theft,
embezzlement, fraud, and dishonest behavior of all kinds.
Accountants prepare reports based on the information accumulated by the bookkeeping process:
financial statements, tax returns, and various confidential reports to managers. Measuring profit is a
critical task that accountants perform a task that depends on the accuracy of the information
recorded by the bookkeeper. The accountant decides how to measure sales revenue and expenses
to determine the profit or loss for the period.
TIP! Bookkeeping can become your best system for managing your financial assets and testing
your business strategies, so dont shortchange it. Take the time to develop your bookkeeping system
with your accountant before you even open your businesss doors and make your first sale.
If you use cash accounting, you record transactions only when cash changes hands. For
example, you dont record a purchase from a vendor until you actually lay out the cash to the
vendor.
If you use accrual accounting, you record a transaction when its completed, even if cash
doesnt change hands. For example, you record a purchase from a vendor when you receive the
products, and you also record the future debt in an account called Accounts Payable.
Assets include everything the company owns, such as cash, inventory, buildings, equipment,
and vehicles.
Liabilities include everything the company owes to others, such as vendor bills, credit card
balances, and bank loans.
Equity includes the claims owners have on the assets based on their portion of ownership in
the company.
Important! The formula for keeping your books in balance involves these three elements:
Assets = Liabilities + Equity
record financial transactions from balance sheets and income statements to accounts payable
and receivable. The following sections list bookkeeping terms that you'll use on a daily basis.
Balance sheet: The financial statement that presents a snapshot of the companys financial
position as of a particular date in time. Its called a balance sheet because the things owned by
the company (assets) must equal the claims against those assets (liabilities and equity).
Assets: All the things a company owns in order to successfully run its business, such as
cash, buildings, land, tools, equipment, vehicles, and furniture.
Liabilities: All the debts the company owes, such as bonds, loans, and unpaid bills.
Equity: All the money invested in the company by its owners. In a small business owned by
one person or a group of people, the owners equity is shown in a Capital account. In a larger
business thats incorporated, owners equity is shown in shares of stock.
Another key Equity account is Retained Earnings, which tracks all company profits that have
been reinvested in the company rather than paid out to the companys owners. Small
businesses track money paid out to owners in a Drawing account, whereas incorporated
businesses dole out money to owners by paying dividends.
Income statement: The financial statement that presents a summary of the companys
financial activity over a certain period of time, such as a month, quarter, or year. The statement
starts with Revenue earned, subtracts the Costs of Goods Sold and the Expenses, and ends
with the bottom line Net Profit or Loss.
Revenue: All money collected in the process of selling the companys goods and services.
Some companies also collect revenue through other means, such as selling assets the business
no longer needs or earning interest by offering short-term loans to employees or other
businesses.
Costs of goods sold: All money spent to purchase or make the products or services a
company plans to sell to its customers.
Expenses: All money spent to operate the company thats not directly related to the sale of
individual goods or services.
Accounting period: The time period for which financial information is being tracked. Most
businesses track their financial results on a monthly basis, so each accounting period equals
one month. Some businesses choose to do financial reports on a quarterly or annual basis.
Businesses that track their financial activities monthly usually also create quarterly and annual
reports.
Accounts payable: The account used to track all outstanding bills from vendors,
contractors, consultants, and any other companies or individuals from whom the company buys
goods or services.
Accounts receivable: The account used to track all customer sales that are made by store
credit. Store credit refers not to credit card sales but rather to sales in which the customer is
given credit directly by the store and the store needs to collect payment from the customer at a
later date.
Depreciation: An accounting method used to track the aging and use of assets. For
example, if you own a car, you know that each year you use the car its value is reduced (unless
you own one of those classic cars that goes up in value). Every major asset a business owns
ages and eventually needs replacement, including buildings, factories, equipment, and other key
assets.
General Ledger: Where all the companys accounts are summarized. The General Ledger is
the granddaddy of the bookkeeping system.
Interest: The money a company needs to pay if it borrows money from a bank or other
company. For example, when you buy a car using a car loan, you must pay not only the amount
you borrowed but also interest, based on a percent of the amount you borrowed.
Inventory: The account that tracks all products that will be sold to customers.
Journals: Where bookkeepers keep records (in chronological order) of daily company
transactions. Each of the most active accounts including cash, Accounts Payable, and
Accounts Receivable has its own journal.
Payroll: The way a company pays its employees. Managing payroll is a key function of the
bookkeeper and involves reporting many aspects of payroll to the government, including taxes to
be paid on behalf of the employee, unemployment taxes, and workmans compensation.
Trial balance: How you test to be sure the books are in balance before pulling together
information for the financial reports and closing the books for the accounting period.
Payroll: The total wages and salaries earned by every employee every pay period, which
are called gross wages or gross earnings, have to be calculated. Based on detailed private
information in personnel files and earnings-to-date information, the correct amounts of income
tax, social security tax, and other deductions from gross wages have to be determined.
Stubs, which report various information to employees each pay period, have to be attached to
payroll checks. The total amounts of withheld income tax and social security taxes, plus the
employment taxes imposed on the employer, have to be paid to federal and state government
agencies on time. Retirement, vacation, sick pay, and other benefits earned by the employees
have to be updated every pay period.
In short, payroll is a complex and critical function that the accounting department performs.
Many businesses outsource payroll functions to companies that specialize in this area.
Cash collections: All cash received from sales and from all other sources has to be
carefully identified and recorded, not only in the cash account but also in the appropriate account
for the source of the cash received. The accounting department makes sure that the cash is
deposited in the appropriate checking accounts of the business and that an adequate amount of
coin and currency is kept on hand for making change for customers.
Accountants balance the checkbook of the business and control who has access to incoming
cash receipts. (In larger organizations, the treasurer may be responsible for some of these cash
flow and cash-handling functions.)
Procurement and inventory: Accounting departments usually are responsible for keeping
track of all purchase orders that have been placed for inventory (products to be sold by the
business) and all other assets and services that the business buys from postage to forklifts.
A typical business makes many purchases during the course of a year, many of them on credit,
which means that the items bought are received today but paid for later. So this area of
responsibility includes keeping files on all liabilities that arise from purchases on credit so that
cash payments can be processed on time.
The accounting department also keeps detailed records on all products held for sale by the
business and, when the products are sold, records the cost of the goods sold.
Important! The accounting department may be assigned other functions as well, but this list gives
you a pretty clear idea of the back-office functions that the accounting department performs. Quite
literally, a business could not operate if the accounting department did not do these functions
efficiently and on time. To do these back-office functions well, the accounting department must
design a good bookkeeping system and make sure that it is accurate, complete, and timely.
Counting on transactions
The immediate and future financial effects of some transactions can be difficult to determine. A
business carries on economic exchanges with six basic types of persons or entities:
Its customers, who buy the products and services that the business sells.
Its employees, who provide services to the business and are paid wages and salaries and
provided with benefits, such as a retirement plan, medical insurance, workers compensation,
and unemployment insurance.
Its suppliers and vendors, who sell a wide range of things to the business, such as legal
advice, products for resale, electricity and gas, telephone service, computers, vehicles, tools and
equipment, furniture, and even audits.
Its debt sources of capital who loan money to the business, charge interest on the amount
loaned, and are due to be repaid at definite dates in the future.
Its equity sources of capital, the individuals and financial institutions that invest money in
the business and expect the business to earn profit on the capital they invest.
The government, or the federal, state, and local agencies that collect income taxes, sales
taxes, payroll taxes, and property taxes from the business.
Here's a look at the interactions between a business and the other parties in its economic
exchanges.
A business may lose a lawsuit and be ordered to pay damages. The liability to pay the
damages is recorded.
A business may suffer a flood loss that is uninsured. The waterlogged assets may have to be
written down, meaning that the recorded values of the assets are reduced to zero if they no
longer have any value to the business. For example, products that were being held for sale to
customers (until they floated down the river) must be removed from the inventory asset account.
A business may decide to abandon a major product line and downsize its workforce,
requiring that severance compensation be paid to the laid-off employees.
At the end of the year, the accountant makes a special survey to make sure that all events and
developments during the year that should be recorded have been recorded, so that the financial
statements and tax returns for the year are complete and correct.
Assets: On one side of the balance sheet the assets of the business are listed, which are
the economic resources owned and being used in the business. The asset values reported in the
balance sheet are the amounts recorded when the assets were originally acquired.
An asset is written down below its historical cost when the asset has suffered a loss in value.
Some assets are written up to their current fair values. Some assets have been on the books
only a few weeks or a few months, so their reported historical values are current. The values for
other assets are their costs when they were acquired many years ago.
Sources of assets: On the other side of the balance sheet is a breakdown of where the
assets came from, or their sources. Assets come from two basically different
sources: creditors and owners.
Businesses borrow money in the form of interest-bearing loans that have to be paid back at a
later date, and they buy things on credit that are paid for later. So, part of total assets can be
traced to creditors, which are the liabilities of a business.
Every business needs to have owners invest capital (usually money) in the business. Also,
businesses retain part or all of the annual profits they make, and profit increases the total assets
of the business. The total of invested capital and retained profit is called owners equity.
1.
Transactions
Financial transactions start the process. Transactions can include the sale or return of a product,
the purchase of supplies for business activities, or any other financial activity that involves the
exchange of the companys assets, the establishment or payoff of a debt, or the deposit from or
payout of money to the companys owners.
2.
Journal entries
The transaction is listed in the appropriate journal, maintaining the journals chronological order
of transactions. The journal is also known as the book of original entry and is the first place a
transaction is listed.
3.
Posting
The transactions are posted to the account that it impacts. These accounts are part of the
General Ledger, where you can find a summary of all the businesss accounts.
4.
Trial balance
At the end of the accounting period (which may be a month, quarter, or year depending on a
businesss practices), you calculate a trial balance.
5.
Worksheet
Unfortunately, many times your first calculation of the trial balance shows that the books arent in
balance. If thats the case, you look for errors and make corrections called adjustments, which
are tracked on a worksheet.
Adjustments are also made to account for the depreciation of assets and to adjust for one-time
payments (such as insurance) that should be allocated on a monthly basis to more accurately
match monthly expenses with monthly revenues. After you make and record adjustments, you
take another trial balance to be sure the accounts are in balance.
6.
7.
Financial statements
You prepare the balance sheet and income statement using the corrected account balances.
8.
In general terms, conservative accounting methods are pessimistic, and liberal methods are
optimistic. The choice of accounting methods also affects the values reported for assets, liabilities,
and owners equities in the balance sheet.
Accounting methods must stay within the boundaries of Generally Accepted Accounting Principles
(GAAP). A business cant conjure up accounting methods out of thin air. GAAP isnt a straitjacket; it
leaves plenty of wiggle room, but the one fundamental constraint is that a business must stick with
its accounting method when it makes a choice.
Consistency is the rule; the same accounting methods must be used year after year. The Internal
Revenue Service (IRS) allows businesses to change their accounting methods once in a while, but
the justification has to be persuasive.
A new business with no accounting history has to make accounting decisions such as the following,
for the first time:
If the business sells products, it has to select which cost of goods sold expense method to
use.
If the business owns fixed assets, it has to select which depreciation method to use.
If the business makes sales on credit, it has to decide which bad debts expense method to
use.
Important! The choices of accounting methods for these three expenses cost of goods sold,
depreciation, and bad debts can make a sizable difference in the amount of profit or loss recorded
for the year. Choosing conservative accounting methods for these three expenses can cause profit
for the year to be lower by a relatively large percent compared with using liberal accounting methods
for the expenses.
In order to adjust the balance of accounts in the bookkeeping world, you use a combination
of debits and credits. You may think of a debit as a subtraction because youve found that debits
usually mean a decrease in your bank balance. And, youve probably found unexpected credits in
your bank or credit card account that mean more money has been added in your favor. Now forget
what youve learned about debits or credits. In bookkeeping, their meanings arent so simple.
Important! The only definite thing when it comes to debits and credits in the bookkeeping world is
that a debit is on the left side of a transaction and a credit is on the right side of a transaction.
Debit
Credit
$1,500
Cash
$1,500
In this transaction, you record the accounts impacted by the transaction. The debit increases the
value of the Furniture account, and the credit decreases the value of the Cash account. For this
transaction, both accounts impacted are asset accounts, so, looking at how the balance sheet is
affected; you can see that the only changes are to the asset side of the balance sheet equation:
Assets = Liabilities + Equity
Furniture increase = No change to this side of the equation
Cash decrease
In this case, the books stay in balance because the exact dollar amount that increases the value of
your Furniture account decreases the value of your Cash account. At the bottom of any journal entry,
you should include a brief description that explains the purpose for the entry.
Debit
Credit
$5,000
Accounts Payable
$5,000
11: Key Basic Accounts for Balance Sheets and Income Statements
A bookkeeper tracks all the financial transactions of a business and is responsible for identifying the
account in which each transaction should be recorded. Accounting provides the structure you must
use to organize these transactions, as well as the procedures you must use to record, classify, and
report information about your business.
In most cases, the accounting system will be set up with the help of an accountant to be sure the
information generated by that system will be useable and meets the requirements of solid
accounting principles.
Important! A bookkeeping system is designed based on the data needed for the two key financial
reports the balance sheet and the income statement. The balance sheet gives you a snapshot of
a business as of a particular date. The income statement gives you a summary of all transactions
during a particular period of time, usually a month, a quarter, or a year.
The key balance sheet accounts include:
Liabilities: All the money the company owes to others are considered liabilities. This
includes unpaid bills (called Accounts Payable account), loans, and bonds. Each type of liability
will have a separate account.
Equity: All the money invested in the company by the owners or stock holders is considered
equity. Each type of equity, and possibly each owner in a small business, will have a separate
account.
Revenue: All the money a business receives in selling its products or services is called
revenue or sales and tracked in these accounts.
Cost of goods sold: All money the company must spend to buy or manufacture the goods
or services it sells to customers is tracked in these accounts. An account called Purchases is
used to track goods purchased.
Expenses: All money that is spent to run the company that is not related specifically to a
product or service being sold is tracked in expense accounts. For example, Office Supplies,
Advertising, Salaries, and Wages are all types of expense accounts.
Current Assets: Includes all accounts that track things the company owns and expects to
use in the next 12 months, such as cash, accounts receivable (money collected from
customers), and inventory.
Long-term Assets: Includes all accounts that track things the company owns that have a
lifespan of more than 12 months, such as buildings, furniture, and equipment.
Current Liabilities: Includes all accounts that track debts the company must pay over the
next 12 months, such as accounts payable (bills from vendors, contractors, and consultants),
interest payable, and credit cards payable.
Long-term Liabilities: Includes all accounts that track debts the company must pay over a
period of time longer than the next 12 months, such as mortgages payable and bonds payable.
Equity: Includes all accounts that track the owners of the company and their claims against
the companys assets, which includes any money invested in the company, any money taken out
of the company, and any earnings that have been reinvested in the company.
The rest of the Chart of Accounts is filled with income statement accounts, which include:
Revenue: Includes all accounts that track sales of goods and services as well as revenue
generated for the company by other means.
Cost of Goods Sold: Includes all accounts that track the direct costs involved in selling the
companys goods or services.
Expenses: Includes all accounts that track expenses related to running the businesses that
arent directly tied to the sale of individual products or services.
When developing the Chart of Accounts, you start by listing all the Asset accounts, the Liability
accounts, the Equity accounts, the Revenue accounts, and finally, the Expense accounts. All these
accounts come from two places: the balance sheet and the income statement.
Important! You should develop an account list that makes the most sense for how youre operating
your business and the financial information you want to track. The Chart of Accounts is a money
management tool that helps you track your business transactions, so set it up in a way that provides
you with the financial information you need to make smart business decisions. Youll probably tweak
the accounts in your chart annually and, if necessary, you may add accounts if you find something
for which you want more detailed tracking. You can add accounts during the year, but its best not to
delete accounts until the end of a 12-month reporting period.
EXTRAS
Connecting the Income Statement and Balance Sheet
When an accountant records a sale or expense entry using double-entry accounting, he or she sees
the interconnections between the income statement and balance sheet. A sale increases an asset or
decreases a liability, and an expense decreases an asset or increases a liability.
Therefore, one side of every sales and expense entry is in the income statement, and the other side
is in the balance sheet. You cant record a sale or an expense without affecting the balance sheet.
The income statement and balance sheet are inseparable, but they arent reported this way!
To properly interpret financial statements, you need to understand the links between the statements,
but the links arent easy to see. Each financial statement appears on a separate page in the annual
financial report, and the threads of connection between the financial statements arent referred to.
The following figure shows the lines of connection between income statement accounts and balance
sheet accounts. When reading financial statements, in your minds eye, you should see these lines
of connection. Because financial reports dont offer a clue about these connections, it may help to
actually draw the lines of connection, like you would if you were highlighting lines in a textbook.
Making sales (and incurring expenses for making sales) requires a business to maintain a
working cash balance.
Depreciation expense is recorded for the use of fixed assets (long-term operating resources).
Some of these operating costs are prepaid before the expense is recorded, and until
the expense is recorded, the cost stays in the prepaid expenses asset account.
Some of these operating costs involve purchases on credit that generate accounts
payable.
Some of these operating costs are from recording unpaid expenses in the accrued
expenses payable liability.
A portion (usually relatively small) of income tax expense for the year is unpaid at year-end,
which is recorded in the accrued expenses payable liability.