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.

Though many of the other ratios in this post series are useful for determining a company’s performance level in a variety of areas, the core issue is whether there is enough cash flowing from ongoing operations to sustain the company. This post contains a variety of measurements ratio formula that involve a company’s cash flow. If a performance measure in this post yields a poor result, then action must be taken at once to ensure that corporate survival is maintained. The measures here can also be combined with the liquidity measurement.

The cash flow measures in this post are:

1. Cash Flow from Operations
2. Cash Flow Return on Sales
3. Fixed Charge Coverage
4. Expense Coverage Days
5. Cash Flow Coverage Ratio
6. Cash Receipts to Billed Sales and Progress Payments
7. Cash to Current Assets Ratio
8. Cash Flow to Fixed Asset Requirements
9. Cash Flow Return on Assets
10. Cash to Working Capital Ratio
11. Cash Reinvestment Ratio
12. Cash to Current Liabilities Ratio
13. Cash Flow to Debt Ratio
14. Stock Price to Cash Flow Ratio
15. Dividend Payout Ratio

And here is the measurement ratio formula list:

More measurement ratio formula you may want to know as well:

Asset Utilization Measurements (Ratios)

Operating Performance Measurements (Ratios)

Liquidity Measurements (Ratio)

Capital Structure and Solvency Measurements (Ratios)

Return on Investment Measurements (Ratios)

Market Performance Measurements (Ratios)

Measurements and Ratios For Financial and Accounting Department

Measurements and Ratios For Engineering Department

Measurements and Ratios For Logistics Department

Measurements and Ratios For Production Department

Measurements and Ratios For Sales Departments

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: