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Accounting Principles |
  
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Accounting Principles |
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Double Entry Accounting
The Accounting Cycle
Period end routines
Protecting Data with Backups
How to set up accounts
Financial Statements and Other Reports
Internal Control
Things to think about
Following the Audit Trail
Depreciation
Accrual Accounting and Adjusting Journal Entries
Contra Accounts
Generally Accepted Accounting Principles
Vouchers and Invoices and why they are important
Double Entry Accounting
Long before electronic computers were invented, double entry Accounting was developed as an effective means of recording Accounting transactions.
It is not mandatory to fully understand double entry accounting to operate the Advanced Accounting system because the system was developed to accomplish both sides of an entry in most companies. However, a brief discussion of the double entry rule may enhance your ability to understand the workings of your accounting
software.
Basically, double entry accounting means that for each transaction an equal amount of debits and credits are recorded.
Double entry accounting is based on the following equation:
Assets = Liabilities + Owner's equity. The owner's equity accounts
include profit, which is income less expenses. So we can expand
our equation to include profits: Assets = Liabilities + Owner's
equity + Income - Expenses OR Assets + Expenses = Liabilities +
Owner's equity + Income.
Any account balance can increase or decrease. In arithmetic, you would indicate these changes by using the (+) and the (-).
Accountants refer to these changes as debits and credits. Debits
increase asset and expense accounts; credits decrease these accounts.
Credits increase liability, owner's equity and income accounts debits decrease these accounts.
Based on this information, we can see that asset and expense accounts have normal debit balances, while liability, owner's equity and income accounts have normal credit balances.
For each transaction made, a journal entry is recorded to affect the values in the appropriate general ledger accounts. With each journal entry, an equal number of debits and credits must be recorded. In the Advanced Accounting system, an entry will not be posted if it is out of balance, eliminating the chance of a
posting error.
The Accounting Cycle
The accounting cycle is simply a method of processing input into the desired output. The regular ten step method was developed when all processing was done by hand, and is an efficient way to manually process a large number of transactions from all sources. However, it is possible to deviate from this cycle when using a computerized accounting system like Advanced Accounting,
and take less steps.
For a computerized system, the first step is to receive data in the form of source documents and recognize transactions that need to be recorded. Source documents include customer orders, purchase requisition forms, employee timecards, and invoices and bills from vendors.
Based on these documents, entries are made into accounting journals and subsidiary ledgers. Journal entries allow us to see the detail of an entire transaction, whereas the general ledger shows us all activity for each single account.
In a manual system, you must post transactions to the correct journals yourself. In an automated system, the computer posts to the appropriate journal automatically, based on the type of transaction.
Actually, in the Advanced Accounting system, all journal entries are kept in one file. When you choose to print a certain journal, Advanced Accounting reviews all journal entries and then prints only those that belong in the selected journal.
For example, if a specific transaction involved the receipt of cash, and you printed the payroll journal, it would not be listed. But if you printed the cash Receipts journal, this transaction would be included.
Details of amounts owed (both to a company and by a company) are kept in subsidiary files, one for accounts receivable and another for accounts payable. Customer and vendor records are automatically updated with each sale and purchase. The Advanced Accounting programs make these entries based on the information you supply during invoice and purchase order entry. Information from the journal entry file is grouped by account code, summarized and posted to the general ledger so you can prepare financial statements.
Historically, this cumbersome process was done by hand, summarizing all information by general ledger account. When using a computer-based system, it is no longer mandatory that the information be summarized- a computer process can easily summarize the information for us and even allow us to see the
detail in two different ways, as a journal GL-D and as part of a ledger.
When you print a trial balance, Advanced Accounting reviews all transactions and summarizes all activity by account code. If you make adjustments, the entries are again posted to journals and transferred to the general ledger. When you are satisfied that the balances are correct, print the financial statements.
Period end routines
Period end routines (Closing the books)
Period end routines, which include the month end and year-end routines, accomplish various tasks. Some of these tasks are to clear MTD, QTD and YTD accumulations, to clear paid invoices, and to clear the purchases PO journal
GL-D, sales journal and check register.
Computerized systems mimic manual period end processes, but can save a lot of time and eliminate many of the errors that are so commonly found in manual accounting systems.
Certain housekeeping chores are required on a computerized system, which are not necessary for a manual system. Most of these have to do with the need to delete inactive records from the computer files, while others involve removing or clearing month-to-date and quarter-to-date information from the files.
When invoices become paid in full or purchase orders are fully received and invoiced, records remain in the open item file, showing a zero balance. These records must be deleted at periodic intervals or the file will keep growing forever.
The month-end routine will clear employee MTD and QTD totals as well as customer and vendor MTD and QTD totals, so that these totals may be accumulated again for the next month.
The new Advanced Accounting month end routine gives you control over what happens to your files and records during the process, and lets you customize it to suit your needs. The Advanced Accounting system is set up to accomplish all necessary closings and housekeeping chores at once.
The amount of information you clear during the month end routine depends on the type of business you have and what your needs are. If your business produces many invoices each month, you may need to delete the paid invoices from the file more often.
On the other hand, if you do not generally have a lot of activity during the month you may wish to retain this as history information. We suggest you keep the records in the trial balance file for as long as the whole year, if possible, because when this file is cleared, you lose the audit trail.
Before you clear any files with the month-end routine, make sure you have printed all necessary reports, such as inventory listings, customer and vendor aging, and payroll reports.
During the year end routine, income and expense accounts are closed and the difference (income or loss) is posted to the retained earnings account. This is the only destructive close in the system, where income and expense accounts are set to zero to start the next year.
Current asset, liability and owner's equity account balances are transferred to one year past, one year past balances are transferred to two years past, and two years past amounts are deleted from the system.
Also, year-to-date accumulations are cleared in employee, customer, vendor and inventory records. Much of the audit trail is lost with the year end routine, so be sure you have printed all necessary reports before performing this process.
Protecting Data with Backups
You should have procedures in place to protect your data and software from unauthorized individuals and system failures.
The consistent use of passwords will help to protect the system from unauthorized individuals, and frequent backups will help to protect your data from system failure and data problems.
To back up is to save a copy of data at a point in time. Requirements for backups are largely dependent on your use of the system, such as how many transactions you handle. Backups should be taken regularly, perhaps daily; it is better to err on the side of safety.
A system failure is an actual head crash or other disk drive failure that can destroy your entire database. An error in the directory or file allocation table can wipe out a file, and may even cost you more than one file because of the relations, which exist among files.
Your data can get jumbled when accounting processes are interrupted due to power failures or when data is updated to the wrong period or entered in the wrong month. In this case, there is nothing wrong with the system, but data must be recovered from a prior point in time.
Quick backups of the data files may be taken to the same hard disk. Allowing quick backups, which guard against data problems, helps encourage users to take backups before updates and changes, since they are much quicker and easier than floppy backups. If two hard drives are available, take quick backups to the one which is not the primary drive. You will then be guarding against failure of the primary drive as well as protecting data.
Archive backups are taken on removable media such as floppy CD-ROM and Zip disks or tape drives to guard against actual hardware failure. These are normally taken less frequently, and should be taken in several generations; three end-of-day backups taken on three sets of disks, for instance. Archive backups can also be carried " off site" to guard against fire and theft. Off site services are available, or someone can simply take a pack of disks home on a scheduled basis.
Programs (files) should be archived after installation and after system updates, and one copy should be stored off site. In addition to the precautions you take to protect your programs and your data, you should develop a plan to secure replacement hardware in the event of loss or destruction, so that your system can continue to be up and running.
If you do ever have to restore your data from a backup, you will be returning to a prior point in time as far as processing goes. Your organization of source documents and your system of printed report retention will determine how fast you can reenter the missing data and continue onward.
In any case we highly recommend that you have some sort of of backup procedure in place when using our software. If you have any question you can call us or email us.
In fact we have created a program to backup the accounting information in your system you can get more information by calling Computer Accounting Solutions (909)335.1205 or email us at support@cassoftware.com Web site is www.cassoftware.com
How to set up accounts
It is well worth your time to prepare and execute a thorough and Complete plan for getting your system to the point where it can be used on a day to day basis.
You will need to set up master files, which will be shared by several Advanced Accounting programs. Master files contain static information about each general ledger account, customer, vendor, payment term, company, and employee, among other things.
Even though the system allows you to enter some of this information " on the fly" during program operation, set up as much as possible before you begin processing.
Most companies already have general ledger account codes in conjunction with whatever system they are currently using. Usually, a company is already using a blocked coding scheme. This is the scheme required by the Advanced Accounting system for financial reporting.
In a blocked coding scheme, each account type is assigned to a specific block of numbers. For example, you might assign asset accounts a number between 1000 and 1999; liabilities a number between 2000 and 2999; owner's equity a number between 3000 to 3999, income a number between 4000 to 4999, and expenses a
number between 5000 to 5999.
Make sure to leave room in each block for additional accounts that you may need later. You will want your system to be able to grow with you.
When defining financial reports, you select account ranges to be included in each category. When defining a balance sheet, be sure to include all asset accounts in a single range. They may be broken down into further categories, such as current assets and fixed assets.
The codes assigned to current assets must be in a single range, such as 1000 to 1500 and the codes assigned to fixed assets in a different range, such as 1600 to 1999.
You must give thought to how you will be setting up your financial statements, including the categories you will use, when assigning codes for accounts.
When assigning vendor codes and customer codes, it is important to follow a carefully planned scheme. Your codes should be easy to remember, allow room for expansion and be descriptive (ie relate directly to what it represents).
You may choose to use the first two letters of each of the customer or vendor name, followed by the first two letters of the city and the state abbreviation. Using this scheme, Puget Power in Renton, Washington is assigned the code PUPOREWA.
Another possibility in assigning customer and vendor codes is to include a letter or number at the beginning of the code to indicate a certain class of customer or vendor in order to further identify the record.
For example, if you sell products to three types of customers (retailers, wholesalers and industrial users), you can include this distinction in the code. In our example above, Puget Power would fall into the industrial users group, so the code would be IPUPOREWA.
Financial Statements and Other Reports
Many small business owners are not interested in the basic financial statements required by creditors and stockholders of larger companies.
However, many of you are quite aware you may be required to prepare such statements anyway. If you borrow money from a bank, or deal with certain suppliers, you may have to prepare financial statements.
Even certain customers or potential customers may want to be assured that your business is sound before purchasing from your company. The financial statements will give them some of this information.
They may even require that the statements be audited, which gives them some assurance that the statements are accurate. Furthermore, the basic financial statements do provide useful information to management in most cases. Certainly, they must be supplemental to other information.
There are three basic financial statements
The Income Statement, Balance Sheet and Statement of cash Flow. These three
statements are often called external reports because they present much of a company's financial information to outsiders.
In addition, other reports may be required by different people and may be useful to management. The reports used by management are called internal reports because they are most often used within the company for analysis and decision-making.
The income statement relays information about how your company has performed over a period of time. By convention, almost all businesses prepare an income statement which covers a period of one year, whether this is the regular calendar year or some other fiscal year.
The income statement is used widely as a measure of a company's ability to make a profit. If it has always done so in the past, a potential investor or a banker may conclude that it will continue to do so.
A year is a long time to wait to find out whether or not you are making any money, so most companies prepare interim income statements, monthly or quarterly.
Unlike the income statement, the balance sheet relays information that is true at a particular point in time, the last day of the accounting period. At the end of that day, the company has a certain amount of cash, owes a certain amount to vendors, and is owed a certain amount by customers. These values appear on a balance sheet.
The balance sheet is used to identify the financial position of the company, including its financial flexibility. While the cash balance is reported by the balance sheet, many users of financial statements are interested in knowing where that cash comes from, and where it has been used.
This information is found in the Statement of Cash Flow. It shows all sources and uses of cashh for a particular time period.
Tax reports are often required by federal and state taxing authorities. This information is necessary for federal and state income tax returns, payroll reports and county property tax reports among others.
Many reports help management in the decision-making processes. These reports are called internal reports. They can give more detailed information than the three basic financial statements.
Departmental or segment reporting may be used to report the activity of a specific group in a company. These reports break down company activity in a way that is logical for the company.
That may mean preparing income statements for each product line, each sales branch, or each department. Management can use these reports to identify any departments or lines that are not profitable, and make necessary changes.
If more than one manager is involved in running a company, segments might be established which allow the owner to see how each manager is doing.
Departments may be created in Advanced Accounting through the system maintenance menu. You may choose to track only income or expenses, or only assets, or track each type of GL account for the department.
Internal Control
Internal control is the policies and procedures used to safeguard a company's assets and to ensure that accurate and reliable financial statements are the end result of an efficient accounting system.
Safeguarding assets means protecting a company's assets against loss from unintentional or intentional errors (such as fraud or theft) when processing transactions and handling the assets.
Transactions are the basis for a company's operations, and therefore the main focus of internal control. There are four general goals of good internal control. The first is to be sure that the policies of management are followed when transactions are carried out.
The second goal is to make sure that transactions are recorded when necessary so that financial statements are prepared according to generally accepted accounting principles.
Transactions should be recorded so that specific employees are held accountable for the various assets of the company. Another goal is that only authorized individuals have access to assets. Finally, good internal control will ensure that the accounting records of the company's assets agree with actual existing
assets under the company's control.
In establishing good internal control, consideration must be given to authorizing transactions, carrying out transactions, and recording transactions and also to responsibility for the resulting assets.
Each of these is discussed below, followed by several principles that have been developed that help in promoting good internal control.
The owner of a company has the final authority for business transactions, although he may delegate this authority to other people, such as managers.
Good internal control must include policies that indicate who can enter into different kinds of transactions and provide guidelines about other aspects of each transaction, such as price, quantity and timing. For example, general policies may state who is authorized to make sales to customers and who may
make purchases for inventory. Such policies assign responsibility for certain transactions to specific employees and help to prevent other employees from making unauthorized sales or purchases.
You may have more specific policies, such as the selling price of inventory items, or discounts available to certain customers. These policies ensure that similar procedures are followed for similar transactions and minimize the chance of unintentional error.
A well-established set of steps to be followed in carrying out each major type of transaction is also important to good internal control.
Although the specific steps may vary between companies, depending on the size and type of company, some general rules can help you develop your own system.
The steps involved in the sale of merchandise would include acceptance of the order, assembling, packing and shipment of the order, and billing and collection of the sales price.
These duties should be split among several different people- no one person should be responsible for an entire order. Many copies of the initial source document should be made, and initialed at each step of the order.
This ensures that all steps have been completed, and you can see who was responsible for each step. During the billing and collection cycle, these source documents ensure that a customer is billed correctly.
All of the steps involved in the execution of a transaction ensure the security of assets and those operations are run efficiently and only authorized individuals have access to assets.
In recording transactions, which includes journalizing and posting transactions and keeping up-to-date records of a company's assets, you must be sure that transactions are recorded in the correct amounts, accounts and period.
You must also be sure that no unauthorized transactions are recorded. One especially important factor in the internal control for recording transactions is the use of source documents.
Source documents, such as invoices, sales orders and credit memos, play a vital role in establishing a clear audit trail.
As a general rule, source documents prepared by an independent external party are better for internal control than those prepared internally. So, a vendor's invoice for delivered goods is better evidence of a finished transaction than a purchase order prepared by your company. It is best to assemble many source documents for each transaction.
In internal control, assets should be fully accounted for, from the time of their acquisition in one transaction to their use or disposal in another transaction. This ensures that assets are used for their intended purposes,
maintained in proper operating condition, and protected from misplacement or theft. Adequate records must be kept of who is responsible for each asset, and periodic checks must be made to ensure that the records agree with the actual assets.
Several principles have been developed to help in promoting good internal control. One is the need for competent and responsible employees.
Responsibilities must be clearly defined and employees must be technically competent for their assigned tasks and willing to accept responsibility for their performance.
Another important principle is the concept of separation of duties. One person should not be responsible both for recording transactions involving an asset and for control of that asset.
These are called incompatible duties.
One simple example of incompatible duties occurs when one individual both prepares and signs checks. He is in a position to write an unauthorized check to himself or a friend. Many businesses are lacking in this area, but the Advanced Accounting system helps reduce the ability of an individual to execute two or more of these functions by using passwords. You are allowed to assign passwords to all employees, and limit individuals' access to the system by module.
If you use passwords, however, you must have a system manager who has access to all parts of the system.
When practical, duties should be rotated among employees to uncover unintentional and intentional errors. There is less chance of fraud or theft if the employee knows someone else will be taking over his position soon and may discover his activities. Finally, each type of source document used in the
Company should be properly designed and preprinted using serial numbers with spaces for authorization signatures.
Invoices, checks, purchase orders, and any other frequently used forms should be serially numbered when they are printed. In this way, all source documents must be accounted for. If a check or invoice is misplaced or stolen, the missing number in the sequence will highlight the discrepancy.
The design of your internal control system should be based on your company's current operations. However, careful and regular review of your system may uncover some of its weaknesses, especially as your business grows and changes.
Things to think about
Your accounting processes will run a lot smoother if you develop specific written procedures about how the human operators are to interface with the system.
These procedures do not have to be anything elaborate. For many installations, a single or a few users accomplish all of the accounting entries, and a simple checklist of daily, weekly and monthly activity is all that is required.
Following are a few examples of things to consider.
When will you write computer-generated checks? It is most effective to do so in a few big batches. If you have vendors with quick terms, you may have to have payment cycles once a week or even more frequently. No matter how often you write checks, it certainly makes sense to have all vendor invoices
Entered before each check run.
How often are deposits of customer checks to be recorded? Normally your bank deposits should be entered into the computer as a daily batch.
Which documents will you keep? Where? How will you bind them? The source documents and printed reports comprise a crucial part of the audit trail.
An audit trail, simply put, means that someone reviewing your records can look at an amount on a report and trace it clearly back to its sources. While you may not have independent audits done by a public accounting firm, the state and the federal government have been known to " require" audits of records from time to time.
Also, if you ever need to restore from a backup of your data files, you will be returning to a prior point in time as far as processing goes. Your organization of source documents and your system of printed report retention will determine how fast you can reenter the missing data and continue onward.
Following the Audit Trail
An audit trail is the trail of paperwork and records for each transaction, which can be used to trace a transaction to its origin.
It is very important to maintain a clear audit trail because it can help you discover any errors in entering or posting transactions. Each journal and the detailed trial balance are large parts of the audit trail.
When transactions are posted in the Advanced Accounting system, information is entered into one of several journals; it is efficient to group the transactions as to their source (Cash Receipt, Cash Disbursements, Payroll, Purchases, Sales, General, Other).
When using a computerized system, the abilities of the computer are used to manage these entries. With Advanced Accounting, all journal entries are kept in one file. When you select to print a certain type of journal, the programs recognize which entries should be printed for that journal.
When you need to trace a transaction, identify the journal it should have posted to, depending on the type of transaction. For example, payroll entries are posted in the Payroll journal. When you print the payroll journal, all payroll journal entries are printed by date.
From this journal you should be able to see the transaction you are interested in, with a description, reference numbers and amounts.
Often the reference numbers are the numbers on the actual source document you need to see. In our payroll example, the reference number would be the number of the check printed for the employee.
Using the reference number and the date of the transaction, you can then find the source documents that serve as evidence for that transaction.
It is a good idea to prepare binders to file all the reports you print out. If binders are not available for quick filing of the necessary reports, users tend to lose them.
Depending on the volume of reports, you may choose to have a separate AP binder for the check register, purchases journal and vendor aging; an AR binder for the sales journal, Cash receipts journal and customer aging; and a GL binder for the trial balance, general ledger, YTD trial balance or general ledger.
These journals replace any manual journals which may have been used with your manual accounting system, and accordingly must be kept as part of the normal audit trail.
Depreciation
Depreciation is part of the cost of a long-term physical asset assigned as an expense to each accounting period in which the asset is used. It can be viewed as the cost of using an asset during a period; allocation of the asset's cost is spread over its useful life.
The depreciation expense for each year is accumulated in a contra account called accumulated depreciation, and is subtracted from the corresponding asset account to determine book value.
In computing depreciation, you should keep several things in mind. Compute depreciation based on the time the asset was actually yours. If you bought an asset in June you would depreciate the asset for only half of that first month. Use a depreciation method that suits your company, based on the type of assets you have and their use.
The time to record depreciation varies among companies. Many record depreciation expense each month, while others find it necessary to make an entry only once a year. The goal of financial accounting is to match the cost of the asset against the revenues it helps to produce.
Since it is usually impossible to measure precisely the benefits that a particular asset provides, the underlying principle is that costs should be matched in a " systematic and rational" manner against revenues. The calculation you use should follow a formula and not be determined in an arbitrary manner.
There are several methods for calculating depreciation, some of which are explained below.
Straightline is the most simple method of calculating depreciation expense. Using this method, depreciation expense is equal to the cost of the asset less any residual value, divided by the asset's estimated useful life. For example, suppose you bought an asset for $28,0, and can trade it in for $8,0 at the end of its useful life of ten years. The depreciation expense for one year would be $2,0. [(28,000-8000)/10]
Another method of depreciation is the double-declining balance method. The depreciation expense is computed by multiplying the book value of the asset at the beginning of the period by twice the straightline rate. Above, the depreciation rate was 10% per year.
For the double-declining balance method, you would multiply the book value at the beginning of a specific period by 20% to get the depreciation expense for the period.
Note that the book value is the cost of the asset less any depreciation taken so far. Although the residual value is not considered in the calculation, the asset should never be depreciated below the estimated residual value.
In the last year that depreciation is available, you will probably have to adjust the amount taken so that you do not depreciate the asset too much.
The sum of the years' digits method is another rapid depreciation method in which the depreciation is computed by multiplying the depreciable cost by a fraction that decreases each year. The depreciation expense for a given year is
determined by multiplying the cost of the asset less the residual value by this fraction.
The fraction is determined by adding the years' digits. For an asset with a five year useful life, the sum of the years' digits is 5+ 4+ 3+ 2+ 1= 15. In the first year, the fraction would be 5/15. In the second year, the fraction would be 4/15, and so on.
The methods of computing depreciation discussed above are used in computing depreciation for financial accounting purposes. But the depreciation you take on assets may be quite different for income tax purposes.
The difference arises because the objectives of financial accounting and income tax reporting are different. For financial accounting, depreciation is taken in order to match revenues with expenses. However, management generally aims to minimize income taxes paid by the company. They want to record as much depreciation as possible early in the life of an asset in order to reduce taxable income.
In 1981 the Accelerated Cost Recovery System (ACRS) was introduced as the method to be used for depreciating assets for income tax purposes, and minor revisions were made in 1984.
With this system, assets are placed into one of various recovery periods, and are depreciated by a specified percentage each period. Keep in mind that ACRS does not follow the GAAP principles of financial accounting.
Some companies keep two sets of books, one for financial accounting and one for income tax reporting, because the type of information that is important to each can vary significantly.
Accrual Accounting and Adjusting Journal Entries
Most companies use the accrual basis of accounting, in which revenues are recorded in the accounting period when products are sold and services are performed for customers and not necessarily when cash is collected.
All the related expenses are then matched against the revenues, regardless of the inflow or outflow of cash. In many cases, not all revenue and expense accounts are up to date at the end of the accounting period.
Certain amounts must be adjusted to report the correct net income on the income statement and the correct ending financial position on the balance sheet. These adjustments are made by adjusting entries at the end of the accounting period.
An adjusting entry usually affects both a permanent (balance sheet) and a temporary (income statement) account. Adjusting entries may be grouped into two types. One is the apportionment of depreciable, prepaid and unearned items (depreciable assets, prepaid expenses, and unearned revenue). The other group is the recording of accrued items (such as accrued interest expense and accrued interest income).
The adjusting entry for depreciation involves a debit to the expense account (such as Depreciation Expense: Building) and a credit to the accumulated depreciation account for the asset. The amount of the depreciation expense may be determined by a variety of methods.
See the discussion on depreciation for more information.
Prepaid expenses are economic resources that are expected to be used in the near future. Prepaid expenses are like depreciable assets, but they may be intangible. Examples include prepaid insurance, prepaid rent and office supplies. When goods or services involving a prepaid expense are acquired, the cost is usually recorded as an asset.
At the end of the accounting period a part of the goods or services has been used in order to earn revenues. The expired cost must be matched, as an expense, against the revenues of the period, while the remaining un-expired cost remains as an asset on the ending balance sheet.
The allocation of the cost of each prepaid expense between an expense and an asset is recorded in an adjusting entry at the end of the accounting period.
For example, the payment of three years' ($50,000 per year) rent on January 1, 1996, would be recorded as an asset (prepaid rent) of $150,000 on that day. At the end of 1996, you must recognize that part (one third) of the prepaid rent was used in this period to produce revenues.
That amount must be recorded as an expense, and the asset decreased. To do this, you must make an adjusting entry which involves a debit to rent expense of $50,000 and a credit to prepaid rent of $50,000. Now the expense is properly matched to the revenues of the period and the
asset is not overstated.
Most of a company's expenses are recorded when payment is made. However, at the end of an accounting period, a few of the company's expenses have not yet been recorded. These expense are called accrued expenses. An accrued expense is an expense that has been incurred during the accounting period but has not yet
been recorded or paid.
The most common type of accrued expense is unpaid employees' wages and salaries, because often the pay period does not end exactly on the last day of the accounting period. Payment for work performed in this accounting period will not be made until the next period. Other common accrued expenses include unpaid
interest, taxes and utility bills.
In order to match all expenses against revenues and to report all the liabilities at the end of the period, an adjusting entry must be made for each accrued expense. These adjusting entries recognize the expense for the period in which it occurred and create a liability for it to be paid.
The adjusting entry for recording an accrued expense would involve a debit to the expense account (ie Salaries Expense) and a credit to the corresponding liability account (ie Salaries Payable).
After the journal entry is posted, the salaries expense account will include the total employees' salaries for the year, whether they have been paid or not. The salaries payable will be listed on the balance sheet as a liability at the end of the period.
Contra Accounts
A contra account is an account whose balance is used to offset a related account. Contra accounts are often used to record accumulated depreciation, sales discounts, sales returns and allowances, purchase discounts and discounts on bonds payable. A contra account always has a balance opposite of the account to which it is related.
When setting up an account in your Chart of Accounts, simply define all asset accounts as debits and all liability accounts as credits, whether they are contra accounts or not. The only time a contra account will be used in the system is in a General Journal entry, in which case you will debit or credit the
account properly.
For instance, when recording depreciation expense, you would make a journal entry that debits Depreciation Expense and credits Accumulated Depreciation (an asset account).
By handling contra accounts this way, your trial balance and financial statements will accurately reflect the balance of the contra account by using brackets to show it is offsetting the related account.
Generally Accepted Accounting Principles
The users of financial information may have many needs for different kinds of information. In preparing these statements, accountants are confronted with the potential dangers of bias, misinterpretation, in exactness, and ambiguity.
In order to minimize these dangers and to prepare financial statements that can be easily compared between organizations and accounting periods, the accounting profession has attempted to develop a body of theory that is generally accepted and universally practiced.
These efforts have resulted in the adoption of a common set of standards and procedures called generally accepted accounting principles (GAAP). GAAP are the currently acceptable principles, procedures and practices that should be used for financial reporting.
The organizations that have had a significant influence in establishing generally accepted accounting principles in the US are the American Institute of Certified Public Accountants (AICPA), the Financial Accounting Standards Board (FASB), the Securities and Exchange Commission (SEC), and the Governmental
Accounting Standards Board (GASB).
Many of the generally accepted accounting principles are complex and very technical in nature. You may want to familiarize yourself with more of the basic principles if outsiders use your financial statements, in order to present an accurate and comparable picture of your financial information.
It is important to recognize, however, that these principles do change; they are modified as business practices and decisions change and as better accounting techniques are developed.
There are several underlying concepts of financial accounting that you should keep in mind when preparing information to be used in your financial statements. The general objective of these concepts is to provide information to external users as they make decisions.
To be useful, accounting information must be relevant and reliable, among other things. Relevance is the capacity to influence a user's decision. The accounting information communicated to users must be relevant to their decision-making process.
Reliable accounting information is factual and capable of being verified. Reliability does not necessarily imply certainty. Source documents and recorded transactions play an important part (as evidence) in establishing and confirming the reliability of the information in the auditing process.
Materiality is the concept that accounting information is useful when the monetary amount involved is large enough to make a difference in a user's decision. Only material accounting information should be accumulated and communicated to users.
Amounts that are material to a local auto parts store may not be material to General Motors because of the difference in size of the two companies.
The entity concept recognizes that each business is treated as a separate economic entity, considered to be separate from its owners and from any other business. Thus, each business has its own accounting system and accounting records for identifying, measuring, recording, retaining and communicating its accounting information.
The going concern concept, also called the continuity assumption, is the general assumption made by accountants that the company will continue to operate long enough to meet its current obligations and long-term commitments.
These are just a few GAAP concepts. There are many rules associated with the practice of accounting, such as when to record revenue, how to account for assets, and the presentation of financial statements.
In order to present accurate and reliable financial statements you should familiarize yourself with these principles.
Vouchers and Invoices and why they are important
A voucher system is a method of providing internal control over the function of purchasing goods or services, paying for them, and ensuring that the correct accounts are debited and credited. A voucher is a document used to summarize a transaction and approve payment and recording.
It allows an individual to prepare input information with a common format away from the computer, keeping entry time to a minimum. Vouchers are sometimes used in a manual system, but are more important to a computer-based system.
In the Advanced Accounting system, vouchers take on an additional meaning. They are used when you want to enter a transaction that will affect the AR or AP subsidiary files but will not affect inventory.
Invoices, on the other hand, are used to record the sale and purchase of inventory items, thereby affecting inventory as well as the AP and AR subsidiary file.
The invoicing program is integrated with the inventory module, so the system checks inventory quantities and prices as you enter invoice line items.
When an invoice is printed, it contains the terms of a sale, including the customer's name and address, date of sale, items sold and selling price, total amount, payment terms, and other information.
Both the voucher and the invoice are important in maintaining accurate accounting records. When vouchers or invoices are posted, all appropriate customer, vendor and inventory files are updated immediately. Hard copies of each invoice and voucher are essential in maintaining the audit trail. If there is a dispute over a customer's bill the voucher or invoice is proof of the
order.
Bookkeeping
Bookkeeping is the systematic recording of the monetary value of business transactions in a book of accounts. It is the preliminary record-keeping stage of ACCOUNTING.
The double entry system of bookkeeping enables a business to know at any time the value of each item that is owned, how much of this value is owed to creditors, and how much belongs to the business clear of DEBT. It also indicates the portion of this debt-free ownership that is the result of the original investment in the company and the portion accruing from profits.
One advantage of the double entry system is that its information is so nearly complete that it can be used as the basis for making business decisions. Another advantage is that errors are readily detected, since the system is based on two equations that must always balance. The term asset means anything of value that is owned.
Assets may be tangible, as are furniture and property, or intangible, as are stocks and good will. Assets belong to their owner, regardless of who possesses them and regardless of whether they were purchased with borrowed money. All of a company's assets are either owed to someone else or are owned clear of debt.
LIABILITY is the amount that a business owes to another firm, to an individual, or to the government. The amount that is not owed to anyone else but is owned free of debt is called the owner's equity in the firm. Since everything that is owned is either owed or is free of debt, assets equal liabilities plus EQUITY.
This is called the accounting equation: Assets (owned) equals Liabilities (owed) plus Equity (clear of debt). Each of the assets and the liabilities and the equity is shown separately on a company's books and is called an account.
An account has two sides, the left side (debit) and the right side (credit). One is the increase side; the other is the decrease side. All assets are increased on the debit side of the account, and any decrease in value is shown on the credit side. Liabilities and equity, the other half of the equation, are increased and decreased in the opposite manner.
Liabilities and equity are increased on the credit side and decreased on the debit side.
The owners' equity can be increased either by investing more money in the firm or by earning a profit.
Equity is decreased by the owners' withdrawal of funds from the business or by losses of the firm. A separate type of equity account is used for each of these.
The owners' investment is shown in an account called capital or, if there is one owner, proprietorship. The earnings of the company are put into an income account. Since both the capital and the income increase the owners' equity, capital and income accounts are increased on the credit side (the increase side of equity). Withdrawals and expenses (expenditures incurred without receiving an asset) are increased on the debit side, for each additional expense or withdrawal takes from the owners' equity.
Every transaction, or change in the firm's values, affects two or more accounts, which will result in a debit and a credit of the same total amount.
For example, if a new typewriter is purchased for cash, the asset account office equipment is increased by debiting, and the asset account cash is decreased by crediting. If the typewriter had been bought on credit, the office equipment account would have been increased by debiting, and the liability accounts payable would have been increased by crediting.
If, instead of purchasing the typewriter, it had been rented, the expense account rent expense or miscellaneous expense would have been increased by debiting, and either the asset cash decreased by crediting or the liability accounts payable increased by crediting. Thus, the same amount is always debited to one account and credited to another account.
At all times, when the balances remaining in each of the accounts are added together, total debits will equal total credits. At the end of each month, or more often if desired, the record-keeping accuracy can be checked by making a trial balance: the total of all accounts having a debit balance must equal the total of all accounts having a credit balance.
Ledgers
The book of accounts is known as a general ledger and usually has a separate page for each account. A separate book showing the name and balance owed for each account payable may be kept. This is called a subsidiary ledger; and the total of the balances owed as shown in the accounts payable ledger would, of course, be identical to the balance of the accounts-payable account in the general ledger. A subsidiary ledger can also be kept for accounts receivable if the firm extends credit to its customers.
Journals
Transactions are not entered directly in the accounts. They are first recorded in a book known as a journal, sometimes called the book of original entry. Several kinds of journals are used.
The most common type is the general journal. In this, the title of the account to be debited is placed on the top line, with its amount shown in the debit column. The title of the account that is to be credited is shown below it, with its amount placed in the credit column. Below this may be a written explanation of the transaction. If more than one account is to be debited or credited, a separate line is used for each, always showing debits first and then credits below. The total of the debits column should always equal the total of the credits column on each general journal page.
If a large portion of the firm's business concerns cash transactions, a separate cash journal can be used instead of the general journal for all those transactions affecting the cash account. All entries not affecting cash are made in the general journal.
At the end of the month, or more frequently if desired, all journal entries are recorded in the ledger accounts. This is called posting. As each journal entry is recorded on the planned side of its account, a mark is placed in the post column of the journal to show that it has been recorded in the ledger. The date used in the ledger is the date on which it was first entered in the journal. The post column in the account is designed to show which page this entry was posted to in the ledger. If a cash journal is used, the monthly cash totals, rather than each entry, can be posted to the cash account.
FINANCIAL STATEMENTS BOOKKEPING
The principal financial statements used to determine the status of a company are the income and expense statement and the balance sheet. These may be made out annually, monthly, or at any desired time. Before preparing the financial statements, a trial balance is made to be certain that the debits equal credits.
Adjusting Entries
If a particular trial balance shows that certain items—the delivery truck and office equipment, for example—are losing value as a result of age and use, then this loss of value, called depreciation, must be calculated and recorded prior to preparing the statements.
Several methods may be used to calculate depreciation. The simplest and most common method is to write off the original cost of the asset evenly over the period of its expected usefulness. If the delivery truck is expected to last eight years, it can be thought of as losing $1,000 in value each year because of depreciation. Depreciation takes from the value of the asset and increases the firm's expenses, therefore a depreciation entry must be made in the general journal and then posted.
Another expense that must be recorded before financial statements are prepared is the value of the office supplies that have been used. The used supplies are no longer owned and should be taken out of the asset account and recorded as an expense.
To determine the used portion of office supplies, the value of the supplies currently on hand is subtracted from the total amount purchased. If the firm has a current supplies inventory worth $200, an entry will be made to take the used portion out and record it as an expense. The same type of entry is made for INSURANCE, INTEREST, and any other prepaid expense.
The following are some other entries that may need to be recorded: the allowance for bad debts if the firm extends credit, any government taxes or employee salaries that are owed but have not yet been recorded, and a merchandising firm's change in the inventory of items for sale.
After these entries are posted, it is often wise to make another trial balance to be certain that the debits and credits still balance.
Income and Expense Statement
The income and expense statement indicates the change in the owners' equity as a result of the firm's operation. It shows the net income, or net profit, that the firm has earned in the interval since financial statements were last prepared. The income and expense statement lists the total amounts of all the income and expense accounts as shown on the trial balance after the adjusting entries have been recorded. If the total expenses had exceeded the total incomes during this period of time, the difference would have been a net loss.
Since the financial statements are prepared for the use of management rather than for the bookkeeping department, they contain no debit and credit columns.
Balance Sheet
The balance sheet is a statement of the total assets owned at a specified time, the value that the firm owes to others, and the value that is clear of debt. It is basically a statement of the accounting equation: assets equal liabilities plus equity.
All asset accounts are listed as shown on the trial balance, with any accumulated depreciation taking from the value of the asset. Usually, assets that can be readily converted into cash, known as current assets, are shown first.
All liability accounts are also recorded. The equity section states the owners' investment, as shown in the proprietorship or capital account, plus any net income earned. This net income is taken from the income and expense statement and is the excess of the revenue accounts over the expense accounts. If the income and expense statement had resulted in a net loss, this would be deducted from the owners' investment. Any withdrawals made by the owners are deducted, since they take from their equity remaining in the firm.
The two sides of the balance sheet, assets and liabilities plus equity, must be in balance. Sometimes a worksheet is used to plan the adjusting entries, the income and expense statement, and the balance sheet.
CLOSING ENTRIES
Closing the books simply means transferring the balances of the three other types of equity accounts (income, expense, and withdrawals) into the capital account. Thus, closing entries affect only the equity accounts. After closing entries, the owners' capital or proprietorship account will show the balance indicated at the end of the equity section of the balance sheet. All other equity accounts will be at a zero balance, since their amounts have been transferred into capital.
Often the credit balances of the income accounts and the debit balances of the expense accounts are first transferred into a temporary account known as the income and expense summary. The balance of this account would then be the same as the net income or net loss shown on the income and expense statement. This balance is then taken out of the income and expense summary and transferred into capital.
The debit balance of the withdrawals account is transferred into capital by debiting and out of withdrawals by crediting.
These general journal closing entries are posted to the ledger accounts, and all zero-balance accounts are double ruled. Thus the books are now ready to begin the new accounting period.
Bibliography for Bookkeeping:
Bibliography: Barnes, John, How to Learn Basic Bookkeeping in Ten Easy Lessons (1987); Dyer, Mary Lee, Practical Bookkeeping for the Small Business (1976); Gorham, John P., Bookkeeping Simplified and Self-Taught (1983); Kravitz, Wallace, Bookkeeping (1983); Weaver, David H., and Hanna, J. Marshall, Elements of Financial Records, 3d ed. (1977), Multimedia Encyclopedia (1992) Grolier Electronic Publishing, Inc.
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