Accounting, Financial, Taxation

Accounting extends into virtually every walk of life. You’re doing accounting when you make entries in your checkbook and when you fill out your income tax return. When you sign a mortgage on your home, you should understand the accounting method the lender uses to calculate the interest amount charged on your loan each period. Individual investors need to understand accounting basics in order to figure their return on invested capital. And it goes without saying that every organization, profit-motivated or not, needs to know how it stands financially.

Here’s a quick sweep to give you an idea of the range of accounting:

1. Accounting for organizations and accounting for individuals
2. Accounting for profit-motivated businesses and accounting for nonprofit organizations (such as hospitals, homeowners’ associations, churches, credit unions, and colleges)
3. Income tax accounting while you’re living and estate tax accounting when you die
4. Accounting for farmers who grow their products, accounting for miners who extract their products from the earth, accounting for producers who manufacture products, and accounting for retailers who sell products that others make
5. Accounting for businesses and professional firms that sell services rather than products, such as the entertainment, transportation, and healthcare industries
6. Past-historical-based accounting and future-forecast-oriented accounting (budgeting and financial planning)
7. Accounting where periodic financial statements are legally mandated (public companies are the primary example) and accounting where such formal accounting reports are not legally required
8. Accounting that adheres to historical cost mainly (businesses) and accounting that records changes in market value (mutual funds, for example)
9. Accounting in the private sector of the economy and accounting in the public (government) sector
10. Accounting for going-concern businesses that will be around for some time and accounting for businesses in bankruptcy that may not be around tomorrow.
11. What else?

Accounting is necessary in a free-market, capitalist economic system. It’s equally necessary in a centralized, government-controlled, socialist economic system. All economic activity requires information. The more developed the economic system, the more the system depends on information. Much of the information comes from the accounting systems used by the businesses, institutions, individuals, and other players in the economic system.

Some of the earliest records of history are the accounts of wealth and trading activity. The need for accounting information was a main incentive in the development of the numbering system we use today. The history of accounting is quite interesting (but beyond the scope of this book). Taking a Peek into the Back Office. Every business and not-for-profit entity needs a reliable bookkeeping system.

Keep in mind that accounting is a much broader term than bookkeeping:

Accounting encompasses the problems in measuring the financial effects of economic activity. Furthermore, accounting includes the function of financial reporting of values and performance measures to those that need the information. Business managers and investors, and many other people, depend on financial reports for information about the performance and condition of the entity.

Bookkeeping refers to the process of accumulating, organizing, storing, and accessing the financial information base of an entity, which is needed for two basic purposes:

1. Facilitating the day-to-day operations of the entity
2. Preparing financial statements, tax returns, and internal reports to managers

Bookkeeping (also called recordkeeping) can be thought of as the financial information infrastructure of an entity. Of course the financial information base should be complete, accurate, and timely. Every recordkeeping system needs quality controls built into it, which are called internal controls or internal accounting controls.

Accountants design the internal controls for the bookkeeping system, which serve to minimize errors in recording the large number of activities that an entity engages in over the period. The internal controls that accountants design are also relied on to detect and deter theft, embezzlement, fraud, and dishonest behavior of all kinds. In accounting, internal controls are the ounce of prevention that is worth a pound of cure.

I have discussed about internal control (financial and operation) a lot. Here (in this post), I want to stress the importance of the bookkeeping system in operating a business or any other entity. These back-office functions are essential for keeping operations running smoothly, efficiently, and without delays and errors. This is a tall order, to say the least.

Most people don’t realize the importance of the accounting department in keeping a business operating without hitches and delays. That’s probably because accountants oversee many of the back-office functions in a business—as opposed to sales, for example, which is front-line activity, out in the open and in the line of fire. Go into any retail store, and you’re in the thick of sales activities. But have you ever seen a company’s accounting department in action?

Folks may not think much about these back-office activities, but they would sure notice if those activities didn’t get done. On payday, a business had better not tell its employees, “Sorry, but the accounting department is running a little late this month; you’ll get your checks later.” And when a customer insists on up-to-date information about how much he or she owes to the business, the accounting department can’t very well say, “Oh, don’t worry, just wait a week or so and we’ll get the information to you then”.

Typically, the accounting department is responsible for the following 5 (five) main areas:

Payroll

The total wages and salaries earned by every employee every pay period, which are called gross wages or gross earnings, have to be calculated. Based on detailed private information in personnel files and earnings-to-date information, the correct amounts of income tax, social security tax, and several other deductions from gross wages have to be determined. Stubs, which report various information to employees each pay period, have to be attached to payroll checks. The total amounts of withheld income tax and social security taxes, plus the employment taxes imposed on the employer, have to be paid to provincial (state) and the national (federal) government agencies on time. Retirement, vacation, sick pay, and other benefits earned by the employees have to be updated every pay period. In short, payroll is a complex and critical function that the accounting department performs. Many businesses outsource payroll functions to companies that specialize in this area.

Cash Collections

All cash received from sales and from all other sources has to be carefully identified and recorded, not only in the cash account but also in the appropriate account for the source of the cash received. The accounting department makes sure that the cash is deposited in the appropriate checking accounts of the business and that an adequate amount of coin and currency is kept on hand for making change for customers. Accountants balance the checkbook of the business and control who has access to incoming cash receipts. (In larger organizations, the treasurer may be responsible for some of these cash flow and cash handling functions).

Cash Payments (disbursements)

In addition to payroll checks, a business writes many other checks during the course of a year — to pay for a wide variety of purchases, to pay property taxes, to pay on loans, and to distribute some of its profit to the owners of the business, for example. The accounting department prepares all these checks for the signatures of the business officers who are authorized to sign checks. The accounting department keeps all the supporting business documents and files to know when the checks should be paid, makes sure that the amount to be paid is correct, and forwards the checks for signature.

Procurement and Inventory

Accounting departments usually are responsible for keeping track of all purchase orders that have been placed for inventory (products to be sold by the business) and all other assets and services that the business buys — from postage stamps to forklifts. A typical business makes many purchases during the course of a year, many of them on credit, which means that the items bought are received today but paid for later. So this area of responsibility includes keeping files on all liabilities that arise from purchases on credit so that cash payments can be processed on time. The accounting department also keeps detailed records on all products held for sale by the business and, when the products are sold, records the cost of the goods sold.

Property Accounting

A typical business owns many different substantial long-term assets called property, plant, and equipment — including office furniture and equipment, retail display cabinets, computers, machinery and tools, vehicles (autos and trucks), buildings, and land. Except for relatively small-cost items, such as screwdrivers and pencil sharpeners, a business maintains detailed records of its property, both for controlling the use of the assets and for determining personal property and real estate taxes. The accounting department keeps these property records.

The accounting department may be assigned other functions as well, but this list gives you a pretty clear idea of the back-office functions that the accounting department performs. Quite literally, a business could not operate if the accounting department did not do these functions efficiently and on time. And to repeat one point: To do these back-office functions well the accounting department must design a good bookkeeping system and make sure that it is accurate, complete, and timely.

What am I going to talk about through this post? It is not about calculating (measuring), nor recording transaction (debit and credit), neither about how to construct accounting/financial report in easy way. Instead, it is about: realizing how accounting is relevant to you, grasping how all economic activity requires accounting, watching an accounting department in action, shaking hands with business financial statements, and answering a question “Mama, should you let your baby grow up to be an accountant?”

Accounting is all about financial information — capturing it, recording it, configuring it, analyzing it, and reporting it to persons who use it. I won’t say much about how accountants capture, record, and configure financial information in this post. But I am going to talk a lot about how accountants communicate information in financial statements, and I explain the valuation methods accountants use — ranging from measuring profit and loss to putting values on assets and liabilities of businesses.

As you go through life, you come face to face with accounting information more than you would ever imagine. Regretfully, much of this information is not self-explanatory or intuitive, and it does not come with a user’s manual. Accounting information is presented on the assumption that you have a basic familiarity with the vocabulary of accounting and the accounting methods used to generate the information. In short, most of the accounting information you encounter is not transparent. The main reason for studying accounting is to learn its vocabulary and valuation methods, so you can make more intelligent use of the information.

People who use accounting information should know the basic rules of play and how the financial score is kept, much like spectators at a football or baseball game.

Let me point out another reason you should know accounting basics. A lot of people out there in the cold, cruel financial world may take advantage of you, not necessarily by illegal means but by withholding key information and by diverting your attention from unfavorable aspects of certain financial decisions. These unscrupulous characters treat you as a lamb waiting to be fleeced. The best defense against such tactics is to know some accounting, which can help you ask the right questions and understand the financial points that con artists don’t want you to know.

Is Accounting Just for Accountants?

One main source of accounting information is in the form of financial statements that are packaged with other information in a financial report. Accountants keep the books and record the financial activities of an entity (such as a business). From these detailed records the accountant prepares financial statements that summarize the results of the activities.

Financial statements are sent to people who have a stake in the outcomes of the activities. If you own stock in General Electric, for example, or you have money in a mutual fund, you receive regular financial reports. If you invest your hard-earned money in a private business or a real estate venture, or you save money in a credit union, you receive regular financial reports. If you are a member of a nonprofit association or organization, you’re entitled to receive regular financial reports.

In summary, one important reason for studying accounting is to make sense of the financial statements in the financial reports you get. I guarantee that Warren Buffett knows accounting and how to read financial statements.

Accounting Affects both Insiders and Outsiders

People who need to know accounting fall into two broad groups: “insiders” and “outsiders“.

Business managers are insiders; they have the authority and responsibility to run a business. They need a good understanding of accounting terms and the methods used to measure profit and put values on assets and liabilities. Accounting information is indispensable for planning and controlling the financial performance and condition of the business. Likewise, administrators of nonprofit and governmental entities need to understand the accounting terminology and measurement methods in their financial statements.

The rest are outsiders.

The Outsiders not privy to the day-to-day details of a business or organization. They have to rely on financial reports from the entity to know what’s going on. Therefore, they need to have a good grip on the financial statements included in the financial reports. For all practical purposes, financial reports are the only source of financial information we get directly from a business or other organization.

By the way, the employees of a business — even though they obviously have a stake in the success of the business — do not necessarily receive its financial reports. Only the investors in the business and its lenders are entitled to receive the financial reports. Of course, a business could provide this information to those of its employees who are not shareowners, but generally speaking most businesses do not. The financial reports of public businesses are in the public domain, so their employees can easily secure a copy. However, financial reports are not automatically mailed to all employees of a public business.

In our personal financial lives, a little accounting knowledge is a big help for understanding investing in general, how investment performance is measured, and many other important financial topics. With some basic accounting knowledge, you’ll sound much more sophisticated when speaking with your banker or broker. I can’t promise you that learning accounting will save you big bucks on your income taxes, but it can’t hurt and will definitely help you understand what your tax preparer is talking about.

Overcoming the Stereotypes of Accountants

Maybe you’ve heard the joke that an accountant with a personality is one who looks at your shoes when he is talking to you, instead his own shoes.

Like most stereotypes, there’s an element of truth in the preconceived image of accountants. Even I am not an accounting professor, I have met and known a large number of accountants. Most accountants are not as gregarious as used-car sales people (though some are). Accountants certainly are more detail-oriented than your average person. However, you don’t have to be good at mathematics to be a good accountant. Accountants use very little math (no calculus and only simple algebra). Accountants are very good at one thing: They want to see both sides of financial transactions: the give and take. Accountants know better than anyone that, as economists are fond of saying, there’s no such thing as a free lunch.

If you walked down a busy street in metropolis city (Chicago, London, Tokyo, New York, or Los Angeles), I doubt that you could pick out the accountants. I have no idea whether accountants have higher or lower divorce rates than others, whether they go to church more frequently or if they generally sleep well at night. I do think that accountants are more honest in paying their income taxes than other people, although I have no proof of this.

Relating Accounting to Your Personal Financial Life

I’m sure you know the value of learning personal finance and investing fundamentals. Well, a great deal of the information you use in making personal finance and investing decisions is accounting information. One knock I have on oversee in these areas is that they often don’t make clear that you need a basic understanding of accounting terminology and valuation methods in order to make good use of the financial information.

You have a stake in the financial performance of the business you work for, the government entities you pay taxes to, the churches and charitable organizations you donate money to, the retirement plan you participate in, the businesses you buy from, and the healthcare providers you depend on. The financial performance and viability of these entities has a direct bearing on your personal financial life and well-being.

We’re all affected by the profit performance of businesses, even though we may not be fully aware of just how their profit performance affects our jobs, investments, and taxes. For example: as an employee your job security and your next raise depend on the business making a profit. If the business suffers a loss, you may be laid off or asked to take a reduction in pay or benefits.

Business managers get paid to make profit happen. If the business fails to meet its profit objectives or suffers a loss, its managers may be replaced (or at least not get their bonuses).

Your investments in businesses, whether direct or through retirement accounts and mutual funds, suffer if the businesses don’t turn a profit. I hope the stores I trade with make profit and continue in business. The government depend on businesses making profit to collect income taxes from them.

Accounting Focuses on Transactions

Accounting focuses on transactions. A good bookkeeping system captures and records every transaction that takes place without missing a beat. Transactions are economic exchanges between a business or other entity and the parties with which the entity interacts and makes deals. Transactions are the lifeblood of every business, the heartbeat of activity that keeps it going. Understanding accounting, to a large extent, means understanding how accountants record the financial effects of transactions. The immediate and future financial effects of some transactions can be difficult to determine.

A business carries on economic exchanges with six basic types of persons or entities:

1. Its customers, who buy the products and services that the business sells
2. Its employees, who provide services to the business and are paid wages and salaries and provided with benefits, such as: a retirement plan, medical insurance, workers’ compensation, and unemployment insurance.
3. Its suppliers and vendors, who sell a wide range of things to the business, such as legal advice, products for resale, electricity and gas, telephone service, computers, vehicles, tools and equipment, furniture, and even audits.
4. Its debt sources of capital who loan money to the business, charge interest on the amount loaned, and are due to be repaid at definite dates in the future.
5. Its equity sources of capital, the individuals and financial institutions that invest money in the business and expect the business to earn profit on the capital they invest.
6. The government, or the federal, state, and local agencies that collect income taxes, sales taxes, payroll taxes, and property taxes from the business.

Even a relatively small business generates a surprisingly large number of transactions, and all transactions have to be recorded. Certain other events that have a financial impact on the business have to be recorded as well. These are called events because they’re not based on give-and-take bargaining—unlike the something-given-for-something-received nature of economic exchanges.

Events such as the following have an economic impact on a business and are recorded:

1. A business may lose a lawsuit and be ordered to pay damages. The liability to pay the damages is recorded.
2. A business may suffer a flood loss that is uninsured. The waterlogged assets may have to be written down, meaning that the recorded values of the assets are reduced to zero if they no longer have any value to the business. For example, products that were being held for sale to customers (until they floated down the river) must be removed from the inventory asset account.
3. A business may decide to abandon a major product line and downsize its workforce, requiring that severance compensation be paid to the laid-off employees.

At the end of the year the accountant makes a special survey to make sure that all events and developments during the year that should be recorded have been recorded, so that the financial statements and tax returns for the year are complete and correct.

The talk is getting more seriously eh? But let’s take a break for some drinks. If you love this kind discussion, you may want to check out my next topic: Range Of Accounting: What Accounting Department Mainly Responsible For?

Hopefully this post helps you understand the role and function of source documents such as invoices and introduces the books of prime entry and the ledgers. We then look at the link between source documents and books of prime entry and the accounting ledgers. It is a basic topic that I believe as the fundament of the accounting knowledge.

Source Documents

Business transactions are nearly always recorded on a document. These source documents contain information that is fed into an accounting system to form the basis of the information in the accounts. Such documents include the following:

Sales Order (PO) – a customer provides a written order detailing the goods or services they wish to buy.

Purchase Order (PO) – A business sends a written order to a supplier for the purchase of goods or materials.

Invoice from suppliers – A business buys goods or services from a supplier and receives an invoice from the supplier. Note the goods or services received should correspond to the details on the purchase order.

Invoice sent to customers – A business sells goods or services to a customer and sends an invoice to the customer. The details on the invoice should correspond to the details on the sales order.

Other source documents include:

Credit notes from suppliers for purchases returned, or to customers for sales returned. Credit notes are sent out when goods or services are returned to the supplier by the customer. The credit note contains the same information as an invoice but is usually printed in red. In effect credit notes negative sales invoices.

Receive Of Goods Notes (ROGN) –These are sent with goods as they are shipped to the customer. The ROGN is used to book the goods into the warehouse. A copy of the ROGN is usually sent to the accounts department before an invoice can be paid.

Books Of Prime Entry

In the early days of accounting the information on the source documents was copied each day by a clerk into a book. This book is the source of any accounting entry, and gives it authority; it is called “a book of prime entry”.

There is no such thing as a typical accounting system as many of these books have been computerized or replaced by files of invoices which carry out the same function. However, familiarity with the purpose, use and effects of these important accounting documents will help you understand how basic accounting systems work.

Here are books commonly used in business:

(1). Sales Book

This book records all the sales invoices which a business has sent out to its customers. Every sale, both cash sales and on credit, should have an invoice raised. These invoices should be recorded in the sales book. Each page of the sales book is sequentially numbered to assist in the financial control of sales.

At the end of each day, each invoice should be entered, or ‘posted’, to the individual customer’s account in the sales ledger. This ledger contains an account for each customer and shows the business how much is owed by each of its customers i.e. its account receivable. The customers’ accounts can be found by reference to the sales ledger page.

Periodically, the total of the sales book page is analyzed between cash sales and credit sales and the totals posted or entered to the Sales account.

(2). Sales Returns Book

Goods sold to customers are often returned for some reason such as:

1. The goods may be faulty; or
2. The wrong goods may have been supplied.

This return may be for all the sold goods, in which case the entire original invoice has to be cancelled. Alternatively, only a few of the goods are returned, in which case only part of the invoice may be offset. To achieve this, credit notes are issued. The sales returns book should be completed in exactly the same way as the sales book in respect of goods returned from customers. When the individual entries are made to the sales ledger they will reduce the amount owed by the customer. The sales returns will also reduce the sales achieved by the business.

(3). Purchases Book

This book contains information about the purchases made by a business and is a list of invoices from suppliers. It is completed in exactly the same way as the sales book, with each page being sequentially numbered. The invoice is the source document and describes the goods and services provided and the price the buyer has to pay. It will also contain a cross-reference to the order number issued by the business to raise the purchase.

The individual invoices will be posted to the supplier’s accounts in the purchases ledger which contains an account for each supplier. This account will record the individual invoices received from the supplier and ultimately the payments made to the supplier by the business. At any point in time the supplier’s account shows the financial position between the business and the supplier.

(4). Cash Book

For accounting purposes ‘cash’ includes cash, checks and bank transactions, unless specified as ‘cash on hand’ or ‘petty cash’ (read the next section). The cash book records all ‘cash’ transactions including coins, banknotes, checks, direct debits, and credit transfers and banker’s drafts. The cash book is split into columns for cash and bank transactions.

The cash book has one page for receipts from customers depending on whether it is in the form of cash or check. On the opposite side of the cash book will be a page for payments to creditors and for other expenses such as wages, electricity, etc.

(5). Petty Cash Book

Sometimes an organization regardless of its size finds itself in a situation where it has to make or reimburse small-value payments. Such payments may be for stamps, taxi fares, tea or coffee for the office or emergency purchases of stationery. Most businesses keep a small amount of cash on their premises for this purpose. This cash or float is called a “petty cash account”. As the cash used to finance the petty cash float is normally transferred from the bank account it is in effect a subsidiary of the main cash book. Petty cash payments and receipts are recorded in a petty cash book. The petty cash is usually the responsibility of the petty cashier.

A common way of maintaining petty cash is by using the “imprest system”. A fixed float is given to the petty cashier. When a purchase is made, a petty cash voucher is completed and filed, together with the proof of purchase such as a receipt. At any one time the balance of the petty cash plus the total of all the petty cash vouchers should equal the amount of the original cash float. This method acts as automatic internal check on the accuracy and honesty of the cashier. When the petty cashier needs to replenish the float he/she presents the vouchers to the main cashier who then reimburses the petty cashier with cash equal to the value of the vouchers. The petty cash vouchers are then entered in the expense accounts of the main accounting system.

The Journal

The journal is used to make entries in the ledger that cannot be made through the other books of prime entry. Examples are the correction of posting errors in the ledger or the formal entry of accounting adjustments, such as depreciation and accruals, at the end of the year; correction of errors and large or unusual transactions.

The Ledger Accounts

The ledger is a book which consists of pages called accounts. There is an account in the ledger for each different type of item the business wishes to analyze. The accounts can be either:

1. Personal accounts of the customers (debtors) which are kept in the sales ledger. Personal accounts of suppliers (creditors) which are kept in the purchases ledger.
2. Impersonal accounts, which includes accounts such as sales, purchases, wages, depreciation, stocks, cash and bank, and fixed assets, capital and liabilities, etc. It will also include the total receivable and total payable of the business. These accounts are kept in the nominal ledger.

And here are ledgers commonly used in business:

(1). Sales ledger

The sales ledger contains an account or record for each customer. Invoices raised will be posted to the account to increase the customer’s indebtedness, while credit notes will be posted to reduce their indebtedness. Any cash received will be posted to the cash book and to the customer’s account to reduce their indebtedness. The balance column on the account shows at any one time how much is owing to you by that customer.

(2). Purchases Ledger

This will be completed in a similar manner to the sales ledger. This ledger contains an account or record for each supplier. Invoices received will be posted to the account to increase the amount owed to the supplier, whilst the credit notes will be posted to reduce the business’s indebtedness. Any cash paid will be posted to the cash book and to the suppliers account to reduce the business’s indebtedness. The balance column on the account shows at any one time how much is owed by the business to that supplier.

(3). General (Or Nominal) Ledger

This ledger is made up of all the non-personal accounts – in contrast to the personal ledgers which include the names of customers and suppliers.

Examples of accounts in the nominal ledger include the following:

1. Fixed assets at cost – a separate account for each type of fixed asset, e.g. motor vehicles, machinery, etc.
2. Provision for depreciation of fixed assets – a separate account for each provision, e.g. provision for depreciation of motor vehicles, provision for depreciation of motor vehicles, etc.
3. Capital account – of owner.
4. Stocks of finished goods.
5. Total debtors.
6. Total creditors.
7. Expense accounts – a separate account for each expense, e.g. salaries, heating, bank charges, petrol, etc.
8. Sales income.
9. Total cash.

These accounts form the basis for preparing the profit and loss account and balance sheet.

Putting It All Together

We have described how accounting entries are recorded from the source documents to the books of prime entry to the individual accounts in the accounting books or ledger. This can be quite daunting to non-accountants as it is full of terminology complicated by the fact that many of the terms have alternative names. Below Graph may helps to clarify the accounting records and its flow process: