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Accounting from the Bottom Up
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To get to the answer to the above-mentioned three questions that every business asks
• How much money came in?
• Where did the money go?
• How much money is left?
we need to understand several ideas. We’re going to start from the simplest and work our way up to the financial statements that will answer our questions. Our explanation of accounting will also follow history; accounting developed slowly over the last 500 years to the sophisticated computer systems and highlyspecialized accounting standards we use today.
Bookkeeping and Accounting
Many people confuse bookkeeping and accounting. They think that bookkeeping is accounting. Bookkeeping is the act of recording transactions in the accounting system in accordance with the accounting principles. Accounting is the way we set up the system, the principles behind it, and the ways we check the system to make sure that it is working properly. Accounting ensures that bookkeeping is honest and accurate and, through financial accounting and management accounting, it provides people outside and inside the business the picture they need of where the company’s money is.
Accountants developed bookkeeping procedures as a way to organize records, to classify the many transactions that take place. Transaction isany event that affects the financial position of the enterprise and requires recording. In some transactions, such as depositing a check, money changes hands. But in others, such as sending an invoice to a customer, no money changes hands. Bookkeeping puts related transactions together into groups so that their impact on the accounting equation can be recorded and analyzed. When we put several transactions together into one account, we’re creating complete set of accounts, i.e. a ledger. It is the “reference book” of the accounting system and is used to classify and summarize transactions and to prepare data for financial statements. It is also a valuable source of information for managerial purposes, giving, for example, the amount of sales for the period or the cash balance at the end of the period. It is desirable to establish a systematic method of identifying and locating each account in the ledger. The chart of accounts, sometimes called the code of accounts, is a listingof the accounts in the accounting system by title and numerical description. Insome companies, the chart of accounts may run to hundredsof items. Some of them may be used every day, such as Cash, and some rarely or even never.
In designing a numbering structure for the accounts, it is important to provide adequate flexibility to permit expansion without having to revise the basic system. Generally, blocks of numbers are assigned to various groups of accounts, such as assets, liabilities, and so on. There are various systems of coding, depending on the needs and desires of the company.
Henceeach account has a ledger that lists allits transactions. Every transaction is entered twice, in two ledgers, once as a credit and once as a debit. The individual lines in a ledger are called entries. In a manual system, each entry is first put on a master page called the journal, or book of first try (first entry), and then copied to the appropriate individual account pages. As a result, the books stay in balance; the total of all credits equals the total of all debits.
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Double Entry
The first principle of accounting we need to understand is called double-entry bookkeeping. Each transaction made in the accounting system is entered twice. No, this does not mean we are keeping two sets of books. We enter every transaction twice, to show where the money comes from and where it is going. An Italian monk, Luca Pacioli, gets the credit for developing double entry in 1494, although it first appeared some 50 years earlier. Next time you think you’re getting confused by double entry, remember this. It’s been around for more than 500 years.
Most of the people who used it didn’t know how to program VCRs. You are way ahead at the start.
Automagic Accounting
Even though all accounting systems are double entry, on many computerized accounting systems we enter each number only once. How does it do that? The computer maintains a chart of accounts. The bookkeeper enters the transaction in one account (say, the bank’s checkbook) and then selects another account (perhaps a particular type of expense).When the bookkeeper clicks OK, the transaction is recorded in both accounts. The computer automagically takes care of the second entry, keeping the books in balance. Program instructions also block transactions that do not fit the accounting equation.
Try paying your rent out of your insurance account. It won’t work.
There are two big advantages of computerized accounting systems. One is that they make it hard to make errors. The other is that you enter the information once, and then see it in several different ways: as data entry screens, account ledgers, and reports.
Accounting is concerned with three basic concepts:
• assets
• liabilities
• equity.
Assets are w hat a business owns or is owed. Examples are real estate, equipment, cash, inventory, accounts receivable (tangible assets), patents and copyrights (intangible assets).
Liabilities are what a business owes. Examples are debt, taxes, overheads, accounts payable, and warranty claims.
Equity is c ash that owners or stockholders have put into the business plus their accumulated claims on the assets of the business. It is also known as owner’s equity or stockholder’s equity, depending on how the business is organized.
Account is a place where we record amounts of money involved in transactions. An account shows the total amount of money in one place as a result of all transactions affecting that account.
An account may be defined as a record of the increases, decreases, and balances in an individual item of asset, liability, capital, income (revenue),or expense.
The simplest form of the account is known as the “T” account because it resembles the letter “T.” The account has three parts:
1. the name of the account and the account number
2. the debit side (left side), and
3. the credit side (right side).
The abbreviations for debit and credit are Dr. and Cr., respectively. The increases are entered on the credit side of a T account, the decreases on the debit side. The balance (the excess of the total of one side over the total of the other) is inserted near the last figure on the side with the larger amount. If the excess of the total is on the credit side of the account (the balance is positive) they say that the account stays in the black. In case of the credit side total excess the account stays in the red.
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The Journal
The journal, or day book, is the book of original entry for accounting data.
Afterward, the data is transferred or posted to the ledger, the book of subsequent or secondary entry. The various transactions are evidenced by sales tickets, purchase invoices, check stubs, and so on. On the basis of this evidence, the transactions are entered in chronological order in the journal. The process is called journalizing.
A number of different journals may be used in a business. For our purposes, they may be grouped into general journals and specialized journals.
Journalizing
The entries in the general journal have the following components:
1. Date. The year, month, and day of the first entry are written in the date column. The year and month do not have to be repeated for the additional entries until a new month occurs or a new page is needed.
2. Description. The account title to be debited is entered on the first line, next to the date column. The name of the account to be credited is entered on the line below and indented.
3. P.R. (Posting Reference). Nothing is entered in this column until the particular entry is posted, that is, until the amounts are transferred to the related ledger accounts.
4. Debit. The debit amount for each account is entered in this column.
Generally, there is only one item, but there could be two or more separate items.
5. Credit. The credit amount for each account is entered in this column.
Here again, there is generally only one account, but there could be two or more accounts involved with different amounts.
6. Explanation. A brief description of the transaction is usually made on the line below the credit. Generally, a blank line is left between the explanation and the next entry.
Posting
The process of transferring information from the journal to the ledger for
the purpose of summarizing is called posting and is ordinarily carried out in the following steps:
1. Record the amount and date. The date and the amounts of the debits
and credits are entered in the appropriate accounts.
2. Record the posting reference in the account. The number of the journal page is entered in the account.
Let’s use a series of T accounts to trace a small job all the way through a business. Let’s say you do some work for a customer and you take along a contractor as an assistant. You invoice the client; the client pays. Also, the contractor bills you.
How does this look in double-entry bookkeeping, illustrated with T accounts? Let’s walk through it one step at a time.
Your customer calls you and asks you to do the work. You plan the job, put it on the schedule, and arrange for the contractor to come with you. All of this is important business, but none of it shows up in accounting. No transaction has happened yet; if the appointment falls through, you will not get paid anything.
You go and do the work and the contractor comes with you.
The customer tells you he is happy with the work and looks forward to receiving your invoice, which he’ll pay promptly. The contractor says she’ll send you a bill and you promise to pay within one month. Still, no transaction has occurred. If no invoices are sent, and no one gets paid, then it’s as if you’d worked for free.
The next day, you write up an invoice for $1,000 and mail it to the customer. The invoice has gone out; now a transaction has occurred. In a pair of T accounts for writing a check to buy $100 of office supplies it looks like this:
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