Accounting Fundamentals for Decision Making Professionals. 6 x 2 days 12 Hrs Rs. 10,000
 a The Accounting System
Before you can set up your accounting records, dive into your day-to-day transactions, and get your books ready for end-of-month or end-of-year reporting, you must gain an understanding of basic accounting concepts.
Accounting is the method in which financial information is gathered, processed, and summarized into financial statements and reports. An accounting system can be represented by the following graphic, which is explained below.
1. Every accounting entry is based on a business transaction, which is usually evidenced by a business document, such as a check or a sales invoice.
 
2. A journal is a place to record the transactions of a business. The typical journals used to record the chronological, day-to-day transactions are sales and cash receipts journals and a cash disbursements journal. A general journal is used to record special entries at the end of an accounting period.
3. While a journal records transactions as they happen, a ledger groups transactions according to their type, based on the accounts they affect. The general ledger is a collection of all balance sheet, income, and expense accounts used to keep a business’s accounting records. At the end of an accounting period, all journal entries are summarized and transferred to the general ledger accounts. This procedure is called “posting.”
     
4. A trial balance is prepared at the end of an accounting period by adding up all the account balances in your general ledger. The sum of the debit balances should equal the sum of the credit balances. If total debits don’t equal total credits, you must track down the errors.
     
5. Finally, financial statements are prepared from the information in your trial balance.
Your accounting records are important because the resulting financial statements and reports help you plan and make decisions. They may be used by some third parties (bankers, investors, or creditors) and are needed to provide information to government agencies, such as the Internal Revenue Service.
III – b Accounting Basics
If you understand the definition and goals of an accounting system, you are ready to learn the following accounting concepts and definitions.
Assets: Things of value held by the business. Assets are balance sheet accounts. Examples of assets are cash, accounts receivable, and furniture and fixtures.
Liabilities: What your business owes creditors. Liabilities are balance sheet accounts. Examples are accounts payable, payroll taxes payable, and loans payable.
Equity: The net worth of your company. Also called owner’s equity or capital. Equity comes from investment in the business by the owners, plus accumulated net profits of the business that have not been paid out to the owners. It essentially represents amounts owed to the owners. Equity accounts are balance sheet accounts.
The accounting equation: Assets = liabilities + owner’s equity. The financial statement called the balance sheet is based on the “accounting equation.” Note that assets are on the left-hand side of the equation, and liabilities and equities are on the right-hand side of the equation. Similarly, some balance sheets are presented so that assets are on the left, liabilities and owner’s equity are on the right.
Balance sheet: Also called a statement of financial position, a balance sheet is a financial “snapshot” of your business at a given date in time. It lists your assets, your liabilities, and the difference between the two, which is your equity, or net worth. The balance sheet is a real-life example of the accounting equation because it shows that assets = liabilities + owner’s equity.
Once you master the above accounting terms and concepts, you are ready to learn about the following day-to-day accounting terms.
Debits: At least one component of every accounting transaction (journal entry) is a debit amount. Debits increase assets and decrease liabilities and equity. For this reason, you will sometimes see debits entered on the left-hand side (the asset side of the accounting equation) of a two-column journal or ledger.
Credits: At least one component of every accounting transaction (journal entry) is a credit amount. Credits increase liabilities and equity and decrease assets. For this reason, you will sometimes see credits entered on the right-hand side (the liability and equity side of the accounting equation) of a two-column journal or ledger.
Double-entry accounting: In double-entry accounting, every transaction has two journal entries: a debit and a credit. Debits must always equal credits. Because debits equal credits, double-entry accounting prevents some common bookkeeping errors. Errors that do occur are easier to find. Double-entry accounting is the basis of a true accounting system.
In double-entry accounting, every transaction in your business affects at least two accounts, since there is at least one debit and one credit for each transaction. Usually, at least one of the accounts is a balance sheet account. Entries that are not made to a balance sheet account are made to an income or expense account. Income and expenses affect the net profit of the business, which ultimately affects owner’s equity. Each transaction (journal entry) is a real-life example of the accounting equation (assets = liabilities + owner’s equity).
Some simple accounting systems do not use the double-entry system. You will have to choose between double-entry and single-entry accounting. Because of the benefits described above, we recommend double-entry accounting. Many accounting programs for the computer are based on a double-entry system, but are designed so that you enter each transaction once, and the computer makes the corresponding second entry for you. The double-entry part goes on “behind the scenes,” so to speak.
You also need to decide whether you will be using the cash or accrual accounting method. We recommend the accrual method because it provides a more accurate picture of your financial situation.
     
III – c Definitions of Accounting Terms
The following terms are often used by accountants, in accounting software, and in fact throughout our discussion. We’ve placed their definitions here so that you can print them out, if you want. Definitions are also scattered throughout the text — when you see blue or gray underlined text, click on the word to get more information.
Accounting equation: Assets = liabilities + owner’s equity. The accounting equation is the basis for the financial statement called the balance sheet.
Accounts payable: Also called A/P, accounts payable are the bills your business owes to suppliers.
Accounts receivable: Also called A/R, accounts receivable are the amounts owed to you by your customers.
Accrual method of accounting: With the accrual method, you record income when the sale occurs, not necessarily when you receive payment. You record an expense when you receive goods or services, even though you may not pay for them until later.
Adjusting entries: Special accounting entries that must be made when you close the books at the end of an accounting period. Adjusting entries are necessary to update your accounts for items that are not recorded in your daily transactions.
Aging report: An aging report is a list of customers’ accounts receivable amounts and their due dates. It alerts you to any slow-paying customers. You can also prepare an aging report for your accounts payable, which will help you manage your outstanding bills.
Allowance for bad debts: Also called reserve for bad debts, it is an estimate of uncollectable customer accounts. It is known as a “contra” account because it is listed with the assets, but it will have a credit balance instead of a debit balance. For balance sheet purposes, it is a reduction of accounts receivable.
Assets: Things of value held by the business. Assets are balance sheet accounts. Examples of assets are cash, accounts receivable, and furniture and fixtures.
Balance sheet: Also called a statement of financial position, it is a financial “snapshot” of your business at a given date in time. It lists your assets, your liabilities, and the difference between the two, which is your equity, or net worth.
Capital: Money invested in the business by the owners. Also called equity.
Cash method of accounting: If you use the cash method, you record income only when you receive cash from your customers. You record an expense only when you write the check to the vendor.
Chart of accounts: The list of account titles you use to keep your accounting records.
Closing: Closing the books refers to procedures that take place at the end of an accounting period. Adjusting entries are made, and then the income and expense accounts are “closed.” The net profit that results from the closing of the income and expense accounts is transferred to an equity account such as retained earnings.
Corporation: A legal entity, formed by the issuance of a charter from the state. A corporation is owned by one or more stockholders.
Cost of goods sold: Cost of inventory items sold to your customers. It may consist of several cost components, such as merchandise purchase costs, freight, and manufacturing costs.
Credit memo: Writing off all or part of a customer’s account balance. A credit memo would be required, for example, when a customer who bought merchandise on account returned some merchandise, or overpaid on their account.
Credits: At least one component of every accounting transaction (journal entry) is a credit. Credits increase liabilities and equity and decrease assets.
Current assets: Assets that are in the form of cash or will generally be converted to cash or used up within one year. Examples are accounts receivable and inventory.
Current liabilities: Liabilities payable within one year. Examples are accounts payable and payroll taxes payable.
Debit memo: Billing a customer again. A debit memo would be required, for example, when a customer has made a payment on their account by check, but the check bounced.
Debits: At least one component of every accounting transaction (journal entry) is a debit. Debits increase assets and decrease liabilities and equity.
Depreciation: An annual write-off of a portion of the cost of fixed assets, such as vehicles and equipment. Depreciation is listed among the expenses on the income statement.
Double-entry accounting: In double-entry accounting, every transaction has two journal entries: a debit and a credit. Debits must always equal credits. Double-entry accounting is the basis of a true accounting system.
Drawing account: A general ledger account used by some sole proprietorships and partnerships to keep track of amounts drawn out of the business by an owner.
Equity: The net worth of your company. Also called owner’s equity or capital. Equity comes from investment in the business by the owners, plus accumulated net profits of the business that have not been paid out to the owners. Equity accounts are balance sheet accounts.
Expense accounts: These are the accounts you use to keep track of the costs of doing business: where your money goes. Examples are advertising, payroll taxes, and wages. Expenses are income statement accounts.
Fixed assets: Assets that are generally not converted to cash within one year. Examples are equipment and vehicles.
Foot: To total the amounts in a column, such as a column in a journal or a ledger.
General ledger: A general ledger is the collection of all balance sheet, income, and expense accounts used to keep the accounting records of a business.
Income accounts: These are the accounts you use to keep track of your sources of income. Examples are merchandise sales, consulting revenue, and interest income.
Income statement: Also called a profit and loss statement or a “P&L.” It lists your income, expenses, and net profit (or loss). The net profit (or loss) is equal to your income minus your expenses.
Inventory: Goods you hold for sale to customers. Inventory can be merchandise you buy for resale, or it can be merchandise you manufacture or process, selling the end product to the customer.
Journal: The chronological, day-to-day transactions of a business are recorded in sales, cash receipts, and cash disbursements journals. A general journal is used to enter period end adjusting and closing entries and other special transactions not entered in the other journals. In a traditional, manual accounting system, each of these journals is a collection of multi-column spreadsheets usually contained in a hardcover binder.
Liabilities: What your business owes creditors. Liabilities are balance sheet accounts. Examples are accounts payable, payroll taxes payable, and loans payable.
Long-term liabilities: Liabilities that are not due within one year. An example would be a mortgage payable.
Merchandise inventory: Goods held for sale to customers.
Net income: Also called profit or net profit, it is equal to income minus expenses. Net income is the bottom line of the income statement (also called the profit and loss statement).
Partnership: An unincorporated business with two or more owners.
Post: To summarize all journal entries and transfer them to the general ledger accounts. This is done at the end of an accounting period.
Prepaid expenses: Amounts you have paid in advance to a vendor or creditor for goods or services. A prepaid expense is actually an asset of your business because your vendor or supplier owes you the goods or services. An example would be the unexpired portion of an annual insurance premium.
Prepaid income: Also called unearned revenue, it represents money you have received in advance of providing a service to your customer. Prepaid income is actually a liability of your business because you still owe the service to the customer. An example would be an advance payment to you for some consulting services you will be performing in the future.
Profit and loss statement: Also called an income statement or “P&L.” It lists your income, expenses, and net profit (or loss). The net profit (or loss) is equal to your income minus your expenses.
Proprietorship: An unincorporated business with only one owner.
Reserve for bad debts: Also called allowance for bad debts, it is an estimate of uncollectable customer accounts. It is known as a “contra” account because it is listed with the assets, but it will have a credit balance instead of a debit balance. For balance sheet purposes, it is a reduction of accounts receivable.
Retained earnings: Profits of the business that have not been paid to the owners; profits that have been “retained” in the business. Retained earnings is an “equity” account that is presented on the balance sheet and on the statement of changes in owners’ equity.
Sole proprietorship: An unincorporated business with only one owner.
Trial balance: A trial balance is prepared at the end of an accounting period by adding up all the account balances in your general ledger. The debit balances should equal the credit balances.
Unearned revenue: Also called prepaid income, it represents money you have received in advance of providing a service to your customer. It is actually a liability of your business because you still owe the service to the customer. An example would be an advance payment to you for some consulting services you will be performing in the future.
III – d Cash vs. Accrual Accounting
There are two basic accounting methods available to most small businesses: cash or accrual.
Cash method. If you use the cash method of accounting, you record income only when you receive cash from your customers. You record an expense only when you write the check to the vendor. Most individuals use the cash method for their personal finances because it’s simpler and less time-consuming. However, this method can distort your income and expenses, especially if you extend credit to your customers, if you buy on credit from your suppliers, or you keep an inventory of the products you sell.
Accrual method. With the accrual method, you record income when the sale occurs, whether it be the delivery of a product or the rendering of a service on your part, regardless of when you get paid. You record an expense when you receive goods or services, even though you may not pay for them until later. The accrual method gives you a more accurate picture of your financial situation than the cash method. This is because you record income on the books when it is truly earned, and you record expenses when they are incurred. Income earned in one period is accurately matched against the expenses that correspond to that period, so you get a better picture of your net profits for each period.
Pros and cons. The cash method is easier to maintain because you don’t record income until you receive the cash, and you don’t record an expense until the cash is paid. With the accrual method, you will typically record more transactions. For example, if you make a sale on account (or, on credit), you would record the transaction at the time of the sale, with an entry to the receivables account. Then, when the customer pays their bill, you will record the receipt on account as another transaction. With the cash method, the only transaction that is recorded is when the customer pays the bill. If you are using computer software to do your accounting, this is probably not a big concern, since the computer program automates much of the extra effort required by the accrual method.
Another issue to be considered is the accounting method you use for tax purposes. For convenience, you probably want to use the same method for your internal reporting that you use for tax purposes. However, the IRS permits you to use a different method for tax purposes. Some businesses can use the cash method for tax purposes. If you maintain an inventory, you will have to use the accrual method, at least for sales and purchases of inventory for resale.
We recommend the accrual method for all businesses, even if the IRS permits the cash method, because accrual gives you a clearer picture of the financial status of your business. You probably need to keep a record of accounts receivable and accounts payable anyway, so you are already keeping track of all the information needed to do your books on the accrual basis. If you are using a computer program, there really isn’t much extra effort involved in using the accrual method.
III – e Who Can Use the Cash Method?
Although the IRS allows all businesses to use the accrual method of accounting, most small businesses can instead use the cash method for tax purposes. The cash method can offer more flexibility in tax planning because you can sometimes time your receipt of revenue or payments of expenses to shift these items from one tax year to another.
However, some businesses must use the accrual method: corporations that are not S corporations and partnerships that have at least one corporation (other than an S corporation) as a shareholder. There are some exceptions to these restrictions — the cash method is available for farming businesses and entities (including corporations) with average annual gross receipts of less than five million dollars for all prior years.
Tax shelters may never use the cash method. If your business has inventories, you must use the accrual method, at least for sales and merchandise purchases.
If you are thinking about using the cash method of accounting for tax purposes, you should discuss these rules with your accountant.