Accounting, Financial, Taxation

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:

This “Bank Reconciliation Procedure” may help those who is an accounts payable clerk to compare his or her internal cash records to those of the bank and reconcile any differences between the two. Have a look at the “Bank Reconciliation Form example” at the end of this post for better understanding.

Bank Reconciliation Procedure

Responsibilities: Accounts Payable Clerk

Entries Procedure:

During the month, enter each lockbox or deposit amount in its entirety, print the batch total, and store the batch total report with the lockbox or deposit record. Take the following steps to apply cash:

1. Go to the accounting computer system’s cash application module.
2. Call up the account of the customer for whom a payment has been received.
3. Log in the amount received, the date of the payment, and the identifying number of the check. Repeat the process until all cash has been applied for all the invoices paid by each customer.
4. Use a journal entry to record cash receipts for items not related to invoices.

Manual Checks Procedure:

During the month, enter manual checks into the computer system as soon as they are issued.

Journal Entries Procedure:

1. Make a journal entry to record all expenditures associated with each payroll as soon as the payroll is generated.
2. Make a separate journal entry for each wire transfer noted on the bank statement, unless these cash flows are already accounted for through the accounts payable or accounts receivable systems.

Reconcile the General Ledger Balance:

Once the month-end bank statement arrives, reconcile the general ledger to the bank balance with the following steps:

1. Go to the accounting computer system and access the bank reconciliation module.
2. Check off all issued checks listed in the bank reconciliation module that are listed as having cleared the bank on the bank statement. If any check amounts listed by the bank differ from the amounts listed in the module, make a journal entry to correct to the bank balance.
3. Check off all deposits listed in the bank reconciliation module that are listed has having been received by the bank on the bank statement. If any deposit amounts listed by the bank differ from the amounts listed in the module, make a journal entry to correct to the bank balance.
4. Make a separate journal entry for each special expense or revenue item on the bank statement, such as a monthly account processing fee.
5. Record in the accounting system any manual checks not previously recorded, but which are listed on the bank statement as having cleared the bank.
6. If all items reconcile and the bank statement still does not match, then the only remaining possible solution is that the beginning bank reconciliation was incorrect.
7. When the reconciliation is complete, print the Bank Reconciliation and store it with the bank statement in a bank statement file for the current year, sorted by month.

And here is an example of Bank Reconciliation form for better understanding

:

You should appraise the reasons and take corrective steps to rectify any delays in receiving and depositing cash. What to do: Ascertain how and where cash receipts come, how cash is transferred from outlying accounts to the main corporate account, banking policy on fund availability, and time lag between receiving a check and depositing it.

Float Time of A Check

The types of delays in processing checks are:

1. Mail float. The time it takes for a check to move from customer to the company.
2. Processing float. The time it takes for the company to record the payment in the books.
3. Deposit collection float. The time for a check to clear.

You  should evaluate the causes and take corrective measures for delays in having cash receipts deposited. One should ascertain how and where the cash receipts come, how cash is transferred to your bank account, banking policy regarding availability of funds, and time lag between receiving a check and depositing it.

What Does The Amount Of Float Depend On?

The amount of float depends on both the time lag and the dollars involved. Float may be determined in dollar-days multiplying the lag in days by the dollar amount delayed. The cost of float is the interest lost because the money was not available for investment or the interest paid because money had to be borrowed during the lag period. The cost of float is computed by multiplying the average daily float by the cost of capital (opportunity cost) for the time period involved.

Example Of Float Measurement:

How can cash be received sooner?

There are many ways to accelerate cash receipts including:

[1]. Lockbox arrangement where the collection points are situated closer to customers. Customer payments are mailed to strategic post office boxes to speed mailing and depositing time. Banks collect from these boxes several times a day and make deposits to the corporate account. Furthermore, one should arrange for weekend deposits into the lockbox. There is a computer listing of payments received by account and a daily total.

Recommendation: Undertake a cost-benefit analysis to assure that the lockbox arrangement results in net savings. Determine the average face value of checks received, cost of operations eliminated, reducible processing overhead, and reduction in ‘‘mail float’’ days. Because per-item processing cost is usually significant, it is beneficial to use a lockbox with low-volume, high-dollar collections. However, lockboxes are becoming available to companies with high-volume, low-dollar receipts as technological advances (such as machine-readable documents) lower the per-item cost.

Tip: Compare the return earned on freed cash to the cost of the lockbox. A wholesale lockbox is used for checks received from other companies. The average cash receipts is large, and the number of cash receipts is small. The bank prepares an electronic list of payments received and transmits the information to the company. A wholesale lockbox strengthens internal control because there is a separation between billing and receivables processing. Many wholesale lockboxes result in mail time reductions of no more than one business day and check-clearing time reductions of only a few tenths of one day. Wholesale lockboxes are cost-effective for companies having gross revenues of at least several million dollars. They work best when large checks are received from distant customers.

A retail lockbox is used for a company dealing with the public (retail consumers as distinguished from companies). Retail lockboxes usually have numerous transactions of a nominal amount.

The lockbox reduces float and transfers workload from the company to the bank. The bottom line should be more cash flow and less expenses.

[2]. Identify and monitor changes in collection patterns. The reasons for delays should be ascertained, and the underlying problems should be corrected.

[3]. On the return envelope for customer remission, use bar codes, nine-digit code numbers, and post office box numbers.

Note: Accelerated Reply Mail (ARM) is the assignment of a unique ‘‘truncating’’ ZIP code to payments, such as lockbox receivables. The coded remittances are removed from the postal system and processed by banks or third parties.

[4]. Send customers preaddressed, stamped envelopes. Include an ‘‘Attention’’ line on the return envelope to speed delivery within the company. Return envelopes reduce customers’ errors in addressing and accelerating mail handling.

[5]. Obtain permission from a customer to have a preauthorized debit (PAD) charged to the customer’s bank account automatically for recurring charges. An example is an insurance company that has PADs charged to its policyholders for insurance premiums. These debits take the form of paper preauthorized checks (PACs), or paperless automatic clearing house entries. PADs result in cost savings because they avoid the process of billing a customer, receiving and processing a payment, and depositing a check.

Note: Variable payments are not as efficient as fixed payments because the amount of the PAD must be changed each period, and usually the customer must be notified by mail of the amount of the debit. PADs are suggested for constant, relatively nominal periodic (e.g., monthly, semiweekly) payments.

[5]. Transfer funds between banks by wire transfers or depository transfer checks (DTCs). Wire transfers can be used for intra-company transactions. Wire transfers can be made by computer terminal and telephone. A wire transfer allows for the same-day transfer of funds. It should only be made for significant dollar amounts since per-wire transfer fees are charged by both the originating bank and the receiving bank.

Examples include making transfers to and from investments, placing funds in an account the day checks are expected to clear, and placing funds in any other account that requires immediate fund availability. Two types of wire transfers are preformatted (recurring) and free-form (non-repetitive). In the case of preformatted wire transfers, extensive authorization is not required. This type is appropriate for usual transfers such as for investments and other company accounts. The company specifies an issuing bank and a receiving bank along with the account number.

There is greater control for nonrecurring transfers. The control includes written confirmation rather than confirmation from telephone or computer terminal. Wire transfers may also be used to fund other types of checking accounts, such as payroll accounts. In order to control balances in the account, the account may be funded on a staggered basis. However, to guard against an overdraft, balances should be maintained in another account at the bank.

Paper or paperless depository transfer checks can be used to transfer funds between the company’s bank accounts. Although no signature is required on depository transfer checks, the check is still payable to the bank for credit to the company’s account. However, controls must be in place so an employee does not use depository transfer checks to transfer money from an account on which he or she does not have signature authorization to an account in which he or she does. Depository transfer checks usually clear in one day. If manual depository transfer checks are used, preprinted checks include all information except the amount and date. Manual preparation is suggested if there are only a few checks prepared daily.

If there are automated depository transfer checks, they are printed as needed.

Tip: It is typically cheaper to use the bank’s printer than for the company to buy its own. Automatic check preparation is suggested when many transfer checks are prepared daily.

[5]. Encourage customers to use a purchase order with payment voucher attached (POPVA). The payment voucher is a blank draft that the seller fills out, detaches, and then deposits. It is usually for amounts less than $1,000. Buyers will only deal with sellers they trust to make this arrangement.

[6]. Accelerate billing. Send out bills to customers immediately when the order is shipped. Also, send out individual invoices rather than only a monthly statement.
Correct invoice errors immediately.

[7]. Require deposits on large or custom orders or progress billings as the work progresses.

[8]. Promptly correct invoice errors. Customers should be encouraged to call an 800 telephone number if discrepancies exist.

[9]. Charge interest on delinquent accounts receivable.

[10]. Employ personal collection efforts.

[11]. Offer discounts for early payment.

[12]. Have postdated checks from customers.

[13]. Provide cash-on-delivery terms.

[14]. Deposit checks immediately.

[15]. Make repeated collection calls and visits.

Case Example-1:

You are considering whether to start a lockbox arrangement that will cost $150,000 annually. The daily average collections are $700,000. The system will reduce mailing and processing time by two days. The rate of return is 14 percent.

Return on freed cash (14% × 2 × $700,000) = $196,000
Annual cost = $150,000
Net advantage of lockbox system = $ 46,000

Case Example-2:

You currently have a lockbox arrangement with Bank X in which it handles $5 million a day in return for an $800,000 compensating balance. You are considering canceling this arrangement and further dividing your western region by entering into contracts with two other banks. Bank Y will handle $3 million a day in collections with a compensating balance of $700,000, and Bank Z will handle $2 million a day with a compensating balance of $600,000. Collections will be half a day faster than at present. The rate of return is 12 percent.

Accelerated cash receipts ($5 million per day × 0.5 day) = $2,500,000
Increased compensating balance = $500,000
Improved cash flow = $2,000,000
Rate of return ×0.12
Net annual savings $ 240,000

Further worth reading about cash flow management: How Can Cash Payments Be Delayed To Earn A Greater Return?