It makes no difference whether the bookkeeping process is done manually by handwritten or a 21st-century bookkeeper working at a computer keyboard. The recordkeeping process is fundamentally the same; adopt a chart of accounts, make original entries using debits and credits to keep the books in balance, make adjusting entries to get profit for the period right, and close the books at the end of the year. IBM does it this way, and so does you at a local convenience store.
This extremely long post explains the first three elements of the bookkeeping fundamental series: the chart of accounts, original entries, and debits and credits. I hope it is worth reading, so that it doesn’t waste your time hence my time in writing it 🙂
Constructing the Chart of Accounts
Accounts are the basic building blocks of an accounting system. An account is a category of information, like a file in which a certain type of information is stored. The reason for establishing an account is that the business needs specific information pulled together in order to prepare a financial statement or some other accounting report.
The first step in setting up an accounting system is to identify the particular accounts that are needed. The financial effects of transactions are recorded as increases or decreases in accounts, and you CANNOT make an accounting entry for a transaction without having accounts to increase or decrease. So, In short…
[Info_Box]No accounts mean no accounting![/Info_Box]
Suppose you’re the chief accountant of a brand new business. It’s your very first day on the job. Where do you start (after finding the restroom)?
Your first order of business is to establish the chart of accounts that will be used to record the transactions of the business. The chart of accounts becomes the official set of accounts that you use to record the effects of transactions. Unless you authorize the creation of a new account, the accounts in the chart are the only ones you use.
The need for one account in the chart of accounts, the cash account, is pretty obvious. A business needs to know how much money it has in its checking account with its bank, so it must establish a cash account and record cash receipts and disbursements in the account.
Which other accounts are needed? This is the $82,000 question. To answer this question, the chief accountant looks to the information the business needs to report in its financial statements and income tax returns (the two major information demands on the accounting system of a business).
[Info_Box]The exact titles of accounts vary from business to business.[/Info_Box]
Real and Nominal Accounts Fundamental
Businesses keep two types of accounts:
. Real accounts, are those reported in the balance sheet, which is the summary of the assets, liabilities, and owners’ equities of a business.
The label “real” refers to the continuous, permanent nature of this type of account. Real accounts are active from the first day of business to the last day. (A real account could have a temporary zero balance, in which case it’s not reported in the balance sheet).
Real accounts contain the balances of assets, liabilities, and owners’ equities at a specific point in time, such as at the close of business on the last day of the year. A real account is a record of the amount of asset, liability, or owners’ equity at a precise moment in time. The balance in a real account is the net amount after subtracting decreases from increases in the account.
. Nominal accounts, are those reported in the income statement, which is the summary of the revenue and expenses of a business for a period of time.
Balances in nominal accounts are cumulative over a period of time. Take the balance in the sales revenue account at the end of the year, for example. This balance is the total amount of sales over the entire year. Likewise, the balance in advertising expense is the total amount of the expense over the entire year. At the end of the period, the accountant uses the balances in the nominal accounts of a business to determine its net profit or loss for the period — this is the main reason for keeping the nominal accounts.
Here’s a rough analogy to help you understand the difference between real and nominal accounts:
Consider the water held behind a dam at a particular point in time. The water is real because you can dip your toe in it. Compare this body of water with the total amount of water that flowed through the dam over the last year. This water isn’t there because it has already gone downriver. This amount is the measure of total flow for a period of time. Assets are like the water behind the dam, and sales revenue is like the flow of water over the year.
Nominal (revenue and expense) accounts are closed at the end of the year. After these accounts have done their jobs accumulating amounts of sales and expenses for the year 2009, for example, their balances are closed. Their balances are reset to zero to start the year 2010. Nominal accounts are emptied out to make way for accumulating sales revenue and expenses during the following year.
Nominal and Permanent Accounts Example
A business has just released its financial report for the year just ended, which includes its balance sheet at year-end and its income statement for the year.
You take the time to count the number of accounts in each statement and find 20 accounts in the balance sheet and 6 accounts in the income statement. These counts do not include calculated amounts, such as the total of assets in the balance sheet and gross profit in the income statement. How many accounts does the business need?
The absolute minimum number of accounts that business needs is 20 balance sheet (real) accounts and 6 income statement (nominal) accounts. Otherwise, it doesn’t have enough separation of information to prepare its two financial statements. In actual practice, businesses keep many more accounts than they report in their balance sheets and income statements.
If you were to look at the chart of accounts maintained by even a relatively small business, you’d find hundreds of accounts (maybe more). For example, a business may keep a separate account for each checking account it uses but, in its balance sheet, report only one cash account, which is the combined total of all its separate cash accounts. Similarly, the business may keep different notes payable accounts, one for each note payable obligation, but combine all notes into one total liability amount in its balance sheet.
Another example is a business that keeps different sales revenue accounts, broken down by product lines, sales territories, and so on. It reports only one total sales revenue account in its income statement.
[Info_Box]Public businesses are subject to disclosure rules regarding segment reporting of sales, which is too technical to go into here.[/Info_Box]
Understanding Debits and Credits
I have discussed the fundamental concept of the ‘debit-and-credit‘ (famously known as “double entry accounting system“) in the past, but let me do it with a more concrete examples in here.
Business transactions are economic exchanges because something of value is given and something of value is received. By its very nature, an economic exchange is a two-sided transaction.
A business sells a product for $400. It receives the money (either immediately or later) and gives the product to the customer. In another example, a business receives $10 million from a lender and gives the lender a legal instrument called a note that promises to return the money at a future date and to pay interest every period starting from the date of the loan forward.
Accountants and bookkeepers use an ingenious scheme to record transactions while keeping the accounting equation constantly in balance — it’s called double-entry accounting. This method has been in use a long time. In fact, a book published in 1494 describes the method. What do you think of that?
Double-entry accounting records both sides of a transaction, and the accounting equation remains in balance as transactions are recorded. For example, if a transaction decreases cash $25,000, then the other side of the transaction is a $25,000 increase in some other asset, or a $25,000 decrease in a liability, or a $25,000 increase in an expense (to cite three possibilities).
To keep the accounting equation in balance as they record transactions, accountants use the system of debits and credits.
The famous German philosopher Goethe is reputed to have called double-entry accounting “one of the finest inventions of the human mind.” Well, I’m not sure that this bookkeeping technique deserves such high praise, but it’s undeniable that the debits and credits method has been in use over six centuries.
By long-standing convention, debits are shown on the left and credits on the right. An increase in a liability, owners’ equity, revenue, and income account is recorded as a credit, so the increase side is on the right. The recording of all transactions follows these rules for debits and credits.
Rules for Debits and Credits
- Increases: Debits
- Decreases: Credits
Expenses and Losses
- Increases: Debits
- Decreases: Credits
Liabilities and Owner’s Equities
- Decreases: Debits
- Increases: Credits
Revenue and Income
- Decreases: Debits
- Increases: Credits
Having the above ‘debit-and-credit’ rule snippet, I can say that, practically, everyone has trouble with the rules of debits and credit. (I certainly did!) Frankly, the rules aren’t very intuitive. Learning the rules for debits and credits is a rite of passage for bookkeepers and accountants. The only way to really understand the rules is to put them into a lot of practices, make accounting entries — over and over again. After a while, using the rules becomes like turning your bike left or right, that you do it without even thinking about it.
Making Initial Journal Entries
To explain the double-entry recordkeeping in the preceding section, I enter the effects of transactions directly into accounts. By keeping the number of accounts to a minimum, you can see the “big picture” because all assets, liabilities, owner’s equity, revenue, and expenses fit on one page. Looking at accounts this way is a useful first step in understanding the rules of debits and credits.
However, with a large number of accounts, recording the effects of transactions directly in the accounts of a business isn’t practical for a start. The debit’s in one account and the credit’s in another account, and the accounts may be far removed from one another. A much more useful method is to record every transaction such that both sides of the transaction are in one place; keep the debit(s) and credit(s) in the entry for the transaction next to each other.
Therefore, the standard practice is to record transactions first in journal entries so that both sides of a transaction are contiguous. Both the debits and credits of the transaction are recorded in one place.
[Info_Box]A journal is like a diary in that it’s a chronological listing of transactions.[/Info_Box]
After journal entries have been recorded, the debits and credits of the transactions are recorded in the accounts of the business. The debits and credits are delivered to their proper addresses, which in accounting parlance is called posting to the accounts.
The journey from transactions to financial statements is as follows:
Transactions –> Journal entries –> Posting to accounts –> Financial statements
One reason for keeping journals instead of recording the effects of transactions directly in accounts is that a business needs a chronological listing of all its transactions in one place. With journals, each transaction is stored in one place and is available for inspection and review. At a later date, a question or challenge may arise regarding how a transaction was recorded, and the journals allow direct access to original recording of the transaction, which is especially important for audit purposes.
Businesses use several specialized journals, usually one for each basic type of transaction. A typical business has a sales journal, purchases journal, cash receipts journal, cash disbursements (payments) journal, payroll journal, and perhaps other journals as well. In addition, a business needs one general journal in which it records low frequency and non-routine accounting entries. Adjusting and closing entries made at the end of the year are recorded in the general journal.
Today, Businesses Use Computer-based Bookkeeping/accounting Systems
The days of manual journals and accounts are history. Using computerized systems, accountants do the same things that were done in traditional bookkeeping systems, including constructing a chart of accounts, recording journal entries for transactions, posting the debits and credits of journal entries in the accounts, making end-of-period adjusting entries, and using the accounts to prepare financial statements.[/Info_Box]
A business makes $2,350 cash sales for the day. What is the journal entry for these sales?
I can’t show you the process for entering the information for this sales transaction into a computer-based accounting system, so here’s the hand-written journal entry, instead:
[Debit]. Cash = $2,350
[Sales]. Revenue = $2,350
This journal entry follows the conventional format for journal entries in that debits appear first and on the left and credits come second and are indented to the right. In this journal entry, the cash account is debited or increased $2,350; the sales revenue account is credited, or increased $2,350.
Recording Revenue and Income
A business receives cash at the time of making the sale, after the time of sale, or before the time of sale. What about credit card sales?
As you know, individuals use credit cards for a large percent of their purchases from businesses. As far as businesses are concerned, credit card sales are virtually the same as cash sales. The business immediately transmits its credit card sales to its bank for deposit into its checking account.
A business doesn’t get one hundred cents on the dollar for its credit card sales. Banks discount the credit card amounts. For example: assume a bank discounts 1.5 percent from the credit card amount. Therefore, for a $100.00 credit card sale as an example, the bank puts only $98.50 in the business’s checking account.
[Info_Box]The credit card discount rate can be higher or lower depending on several factors, but a 1.5 percent discount rate is in the ballpark for many businesses.[/Info_Box]
In addition to sales revenue, a business may have other sources of income. A prime example is investment income. Many businesses invest their spare cash in short-term marketable securities that pay interest.
Some businesses make loans to officers and employees and charge interest on the loans, which generates interest income, of course. Legally, a business faces few restrictions on the types of investments it can make unless the business adopts formal limits on permissible investments.
For a particular business, the day’s sales are summarized as follows:
- Cash sales = $3,500
- Credit card sales = $14,800
- Credit sales = $23,400
Its bank discounts 1.75 percent from credit card sales. In journal entry form, how do you record the sales activity of the business for the day?
The separate journal entries for the three types of sales for the day are:
[Debit]. Cash = $3,500
[Credit]. Sales Revenue = $3,500
(Note: Cash sales for day).
[Debit]. Cash = $14,541
[Debit]. Credit Card Discount Expense = $259
[Credit]. Sales Revenue = $14,800
(Note: Credit card sales for day, discounted by bank).
[Debit]. Accounts Receivable = $23,400
[Credit]. Sales Revenue = $23,400
(Note: Credit sales for the day).
Here are a few things to note in these entries:
- These account titles are typical but not universal. Different businesses use slightly different account titles.
- Credit card discount expense is recorded for the credit card sales; in this case, the calculation is $14,800 face value of credit card charges × 1.75 percent discount fee charged by bank = $259. Sales revenue is recorded gross, or before the bank’s discount is deducted.
Recording Expenses and Losses
How many expense accounts should a business maintain?
There’s no easy answer to this question. The glib answer is probably “As many as it needs”. To make a profit, business managers have to control expenses, and this task requires a good deal of specific information about expenses.
To get an idea of the broad range of expenses a business may have and therefore needs to account for, imagine a business with $10 million annual sales revenue. With that much revenue, you know right off that this company isn’t a small, storefront operation.
The business probably has more than 50 employees and hundreds or thousands of customers. It may have several locations, and it pays property taxes on its real estate. The business may manufacture the products its sells, or it may be a retailer that buys products in condition for resale.
Most likely, it buys insurance coverage to protect against various risks. It also probably advertises the products its sells. For a $10 million business like this one, I would expect to find several hundred different expense accounts — even a thousand or more wouldn’t surprise me.
Most businesses with $10 million annual sales revenue have total annual expenses over $9 million, or more than 90 percent of their sales revenue. Few businesses earn 10 percent or higher bottom-line profit on their sales revenue. As you may have already figured out, it takes a lot of accounts to keep track of over $9 million expenses.
Accountants record expenses by decreasing assets or increasing liabilities. Sounds straightforward enough, doesn’t it? It ain’t!
Many different assets and liabilities are credited in making expense entries. The amounts recorded for certain expenses aren’t definite or clear-cut. To complicate matters further, the liabilities used to record certain expenses are nebulous and difficult to understand. Frankly, expense accounting is a hodgepodge, so strap on your seat belt.
Below figure presents a broad overview of expenses. This summary matches expenses with the balance sheet accounts that are credited in recording the expenses. For instance, in recording cost of goods sold expense, the inventory asset account is credited. Many different expenses are recorded when cash disbursements for the expenses are made. Below figure shows that a specific expense account is recorded when a cash payment is made. The expense could be one of many in the business’s chart of accounts.
Expense Account Debited | Balance Sheet Account Credited
Many specific expenses [Cash]
Bad debts expense Accounts [receivable]
Cost of goods sold expense [Inventory]
Several specific expenses [Prepaid expenses]
Depreciation expense [Fixed Assets]
Many specific expenses [Account payable]
Income tax expense [Accrued expense liabilities]
Income tax expense [Income tax payable]
Labor cost expense [Employee’s retirement liability]
Income tax expense [Deferred income tax liability]
Stock option expense [Invested capital & Retained earnings]
A business has three expenses that it must record:
- The business issued a $45,000 check to its advertising agency for spot commercials that appeared on local television during last month; this cost has not been recorded yet.
- The accountant calculated that depreciation for the period is $306,500.
- The accountant calculated that the cost of vacation and sick pay accumulated by employees during the period just ended is $15,400; employees have taken none of this time yet.
What journal entries should be recorded for these expenses?
The following journal entries are recorded for the three expenses:
[Debit]. Advertising Expense = $45,000
[Credit]. Cash = $45,000
[Info_Box] Note: Because no expense has been recorded before the time of making cash payment, the advertising expense account is debited (increased) at the time of making payment).[/Info_Box]
[Debit]. Depreciation Expense = $306,500
[Credit]. Accumulated Depreciation = $306,500
[Info_Box]Note: The cost of a long-term operating asset, also called a fixed asset, is allocated over the estimated useful life of the asset, so a fraction of the cost is charged to the depreciation expense account each period. The fixed asset is credited (decreased) — not by a direct credit in the asset account but by a credit in the contra account, accumulated depreciation. The balance in this contra account is deducted from the original cost of the fixed asset).[/Info_Box]
[Debit]. Employee’s Benefits Expense = $15,400
[Credit]. Accrued Expense Liability = $15,400
[Info_Box]Note: Some expenses accrue, or build up over time, even though the business doesn’t receive a bill for the expense. A good example is vacation and sick pay accumulated by employees. Rather than waiting until individual employees actually take time off to record the expense, the creeping liability for this expense is recorded each period. When the employees are paid for vacation and sick time, the liability is debited (decreased)[/Info_Box].
Recording Set-Up and Follow-Up Transactions for Revenue and Expenses
Many basic types of business transactions maybe occurred, one of which consists of those transactions that take place before or after revenue and expenses are recorded. These set-up and follow-up transactions are supporting transactions for the profit-making activities of a business.
Those transactions are necessary, as you can see in the following examples:
- Buying products for inventory (the goods are held in inventory until they’re sold and delivered to customers)
- Collecting receivables from customers
- Paying liabilities for products, supplies, and services that were bought on credit
- Paying certain expenses in advance, such as for insurance policies, shipping containers, and office supplies
Profit-making activities are reported in the income statement, and investing and financing activities are reported in the statement of cash flows. In contrast, set-up and follow-up transactions for revenue and expenses aren’t reported in a financial statement. Nevertheless, these housekeeping activities have financial consequences and must be recorded in the accounts of a business. Although no revenue or expense account is involved in recording these activities, these transactions change assets and liabilities.
Recording Investing and Financing Transactions
Suppose a business recorded 10,000 transactions during the year. The large majority would be sales and expense transactions and the set-up and follow-up transactions for sales and expenses. Perhaps fewer than 100 would be investing and financing transactions.
Though few in number, investing and financing transactions are very important and usually involve big chunks of money. In fact, these two types of transactions are reported in the statement of cash flows — that ought to tell you something.
Investing activities include the purchase and construction of long-term operating assets, such as land, buildings, machines, equipment, vehicles, and so on. In general, these investments are called capital expenditures. (The term capital refers to the large amounts of money invested in the assets as well as the long-term nature of these investments.) These economic resources are also called fixed assets.
They’re not held for sale in the normal course of business; rather, they’re held for use in the operations of the business. When grouped together in a balance sheet, fixed assets are typically labeled property, plant, and equipment. Eventually, the business disposes of these assets by trading them in for new assets, selling them off for residual value, or just having the junk collector come and haul them away.
Investing transactions include acquisitions of other long-term assets, such as intangible resources (patents, for example), rental real estate, and research projects in the development stage. For example: a business could invest in a sports franchise.
Financing activities basically fall into three categories:
- A business borrows money on the basis of interest-bearing debt and either pays these loans at their maturity dates or renews them.
- A business raises capital (usually money) from shareowners and may return some of the invested capital to them.
- A business distributes cash to its shareowners based on its profit performance.
These are the three basic kinds of financing activities. Large public corporations engage in much more complex and sophisticated financing deals and instruments than these basic types, but those activities are beyond the scope of this post.
The investing and financing activities for the year of a new, start-up business corporation are summarized as follows:
Received $10,000,000 from a venture capital (VC) firm; in exchange, the business signed a $5 million note payable (interest-bearing, of course) to the VC firm and issued shares of stock to the VC firm equal to 10 percent of the total number of shares of stock issued by the business. Purchased various long-term operating assets for total cash payments of $6,000,000
The journal entries for these investing and financing activities are as follows:
[Debit]. Cash = $10,000,000
[Credit]. Notes Payable = $5,000,000
[Credit]. Owner’s Equity = $5,000,000
[Debit]. Invested Capital Property, Plant, & Equipment = $6,000,000
[Credit]. Cash = $6,000,000
One-half of the money invested in the start-up business by the VC firm is secured by a note payable on which the business has to pay interest. This transaction is recorded in the notes payable liability account to indicate that the business has the legal obligation to pay interest and to pay the loan at its maturity date.
The other half of the money that the VC firm put in the business is attributed to the account for capital stock shares issued by the business. The account title property, plant, and equipment is a generic title for long-term operating assets. The business would maintain more-specific accounts for each major asset purchased, such as buildings, machinery, vehicles, and so on.
That is all about the bookkeeping fundamental (phew!). I hope that helps you start learning bookkeeping and accounting in broader scope.