If you are a bookkeeper, you serve as the eyes and ears of the accountant. Therefore you want to understand, at least, the basics of accounting. This post provides a brief overview of accounting basics and show you how to use that information to design a bookkeeping system. You also get a chance to practice the key concepts of bookkeeping design, as well as the key functions of a bookkeeping system., and learn how to set up basic chart of account.
Understanding the Accounts
Your role as the bookkeeper requires you to track all the financial transactions of a business. Accounting provides the structure you must use to organize these transactions, as well as the procedures you must use to record, classify, and report information about your business. On a day-to-day basis, you make sure that all transactions are entered accurately in the books. To be a bookkeeper you must be very detail oriented and love to work with numbers. Since you spend most of your day hunched over a computer massaging the numbers, if you don’t like working with numbers, forget about it — bookkeeping is not for you.
You don’t have to be certified public accountant (CPA) to do the books, but for many small businesses that don’t have the money to hire a full-time CPA, you will be the person who works with the accountant hired to review the books. He prepares the financial statements using the data you collected when you entered all the financial transactions.
In most cases the accounting system will be set up with the help of an accountant to be sure the information generated by that system will be useable and meets the requirements of solid accounting principals. A bookkeeping system is designed based on the data needed for the two key financial reports — the balance sheet and the income statement. The balance sheet gives you a snapshot of a business as of a particular date. The income statement gives you a summary of all transactions during a particular period of time, usually a month, a quarter, or a year.
As the bookkeeper you will be responsible for identifying the account in which each transaction should be recorded. We will take a closer look at the types of accounts that fall under each of these categories.
Understanding The Bookkeeping Cycle
In addition to understanding all the new terminology and types of accounts, as a bookkeeper you’ll also need to understand how the accounting cycle works. There are eight steps in the accounting cycle:
- Transactions: The process starts with financial transactions. These can include the sale or return of goods, the purchase of goods or supplies, the payment of salaries — essentially any time cash changes hands or the promise of payment is made a transaction has occurred.
- Journal entries: The first thing you do after a transaction has occurred is prepare a journal entry so you can record it in the books.
- Posting: After preparing the journal entry you post it to the books.
- Trial balance: At the end of an accounting period you’ll test the books to see if they are in balance.
- Worksheet: Often on the first try you’ll find the books are not in balance. A worksheet is used to figure out the problem.
- Adjusting journal entries: After you figure out what is wrong, you make adjustments to the books using Adjusting Journal Entries.
- Financial statements: Financial statements are prepared using the corrected trial balance.
- Closing: At the end of an accounting period you close the books and get ready for the next accounting period.
When you close the books, everything starts again. The accounting cycle is more like a circle than a straight line — cycling from accounting period to the next accounting period.
Preparing Chart Of Accounts
Bookkeepers need a roadmap that helps them determine where to put the numbers. By developing a Chart of Accounts with clearly defined places for all your transactions, you can produce financial statements that will accurately reflect your businesses activities for the year. This section will introduce you to what goes into developing a chart of accounts and how to set it up.
A Chart of Accounts is organized to make it easier for you to produce two key financial statements:
- The balance sheet, which shows what your business owns and what it owes
- The income statement, which shows how much money your business took in (revenue) and how much money it spent to generate those sales (expenses).
The Chart of Accounts should always start with the accounts you need to produce a balance sheet and then follow with accounts you need to produce an income statement.
Note: For a starter [and easier understanding], It uses a very basic chart account development using trading company type.
The basic order for your Chart of Accounts should start by listing the balance sheet accounts. The rest of the chart is filled with income statement accounts, which you list in this order.
Detailing Your Balance Sheet Accounts
The balance sheet is one of the three primary financial statements that businesses report. It’s also called the financial condition statement or statement of financial position. The balance sheet summarizes the assets, liabilities, and owners’ equity accounts of a business at an instant in time.
Next, Let’s take a closer look at the types of Balance Sheet accounts you would have in each of the five Asset sections of the Chart of Accounts — Current Assets, Long-term Assets, Current Liabilities, Long-term Liabilities, and Equity. Then I will give you space to jot down your own list of Balance Sheet accounts for your business. Whatever you write down now is not carved in stone. You can add to and subtract from the Chart of Accounts. You can add an account at any time of the year, but you should only subtract accounts at the end of an accounting period to be sure you don’t lost any transactions with the deletion.
When thinking about the types of accounts you want to list as current assets, think about things your business owns that you expect will be used up in the next 12 months. Here are the most common types of current asset accounts:
- Cash in Checking: Your company’s primary account that is used to deposit revenues and pay expenses would be tracked in this account. You may have more than one cash operating account if your company has several divisions each with their own Cash in Checking account.
- Cash in Savings: Your company would use this account for surplus cash. Cash for which you have no immediate plans at the very least should be deposited in an interest-earning savings account until the company decides what to do with it.
- Cash on Hand: Your company would use this account to track any petty cash or cash kept in store cash registers.
- Accounts Receivable: If you offer your products or services to customers on store credit given by your company, then you need this account to track the customers who buy on credit, so you can collect from them at a later date.
- Inventory: You track all products you have on hand to sell to your customers. You may also want to set up asset accounts for items that you prepay, such as insurance, which is usually paid for an entire year. You would track it as a current asset and gradually reduce its value as you allocate it as an expense month to month. This would be called Prepaid Insurance.
When thinking about the types of accounts you want to list as long-term assets, think about the things your company owns that you will use for more than 12 months. Here are some common Long-term Asset accounts:
- Land: You can track any land owned by the company in this account.
- Buildings: You can track the value of any buildings owned by the company in this account.
- Leasehold Improvements: If your company leases any facilities, you track the value of any improvements that you did to this leased space in this account. For example, if you lease a retail store, any improvements that you make to customize this space for your business would be traced in this account.
- Vehicles: Any vehicles your company owns would be tracked in this account.
- Furniture and Fixtures: You track any furniture or fixtures purchased for use in the business in this account.
- Equipment: You track any equipment that was purchased for use for more than one year, such as computers, copiers, tools, and cash registers in this account.
In addition to these accounts, each long-term asset account will have an “accumulated depreciation“, a subsidiary account to reflect the portion of the asset that already has been used up.
Current liabilities are debts due in the next 12 months. Some of the most common types of Current Liabilities accounts that appear on the Chart of Accounts include:
- Accounts Payable: You should track any money the company owes to vendors, contractors, suppliers, and consultants that must be paid in the next 12 months in this account.
- Sales Tax Collected: You may not think of sales tax as a liability, but because the business collects taxes from customers and doesn’t pay them immediately to the government, the taxes collected become a liability tracked in this account.
- Accrued Payroll Taxes: You should use this account to track payroll taxes collected from employees to pay state, local, or federal income taxes as well as Social Security and Medicare taxes.
- Credit Cards Payable: You should track all your company’s credit card accounts to which the business is liable.
How you set up your current liabilities and how many individual accounts you establish depends upon how detailed you want to track each type of liability. For example, you can set up a separate Current Liability account for each of your major vendors if you find that approach provides you with a better money management tool.
Long-term liabilities include any debts that are due in more than 12 months. The number of Long-term Liabilities accounts you maintain on your Chart of Accounts depends on your debt structure. The two most common types of long-term liability accounts are:
- Loans Payable: You use this account to track any long-term loans, such as a mortgage on your business building. Most businesses have separate loans payable accounts for each of their long-term loans. For example, you could have Loans Payable – Mortgage Bank for your building and Loans Payable – Car Bank for your vehicle loan.
- Notes Payable: Some businesses borrow money from other businesses using notes, a method of borrowing that doesn’t require the company to put up an asset, such as a mortgage on a building or a car loan, as collateral. This account tracks any notes due.
In addition to any separate Long-term Debt accounts you may want to track in their own account, you may also want to set up an account called “Other Liabilities”. You would use this account to track debt that you don’t think needs its own individual account.
Every business is owned by somebody. Equity accounts track owners’ contributions to the business as well as their share of ownership. For a corporation, ownership is tracked by the sale of individual shares of stock because each stockholder owns a portion of the business. In smaller companies that are owned by one person or a group of people, equity is tracked using Capital and Drawing accounts. Here are the basic Equity accounts that appear in the Chart of Accounts:
- Common Stock: If your company is structured as a corporation, then the value of outstanding shares of stock that were sold to investors would be tracked in this account.
- Retained Earnings: Whether or not your company is incorporated, use this account to track any earnings that were kept in the business.
- Capital: You use this account if you are keeping the books for a small, unincorporated business. The Capital account reflects the amount of initial money the business owner contributed to the company as well as other owner contributions made after initial start-up.
- Drawing: This account is another that will be necessary if you are keeping the books for a small, unincorporated business. The Drawing account tracks any money that a business owner takes out of the business. If the business has several partners, each partner gets his or her own Drawing account to track what he or she takes out of the business.
Detailing Income (Profit & Loss) Statement
The Income Statement shows whether or not your business made a profit. Accounts that you set up to produce this statement can be grouped into three types of accounts:
- Revenue: These accounts track all money coming into the business, including sales, interest earned on savings, and any other methods used to generate income.
- Cost of Goods Sold: These accounts track the money spent to manufacture or buy the products you sell.
- Expenses: These accounts track all money that a business spends in order to keep itself afloat.
This section examines the various accounts that make up the Income Statement portion of the Chart of Accounts. You always start by listing the Revenue accounts, followed by the Cost of Goods Sold accounts and then the Expenses accounts.
In the revenue section, the accounts you set up will track all money taken into the business from sales. If you choose to offer discounts or accept returns, that activity also falls in this section. The most common income accounts are:
- Sales of Goods or Services: You track all the money that the company earns selling its products, services, or both in this account.
- Sales Discounts: If you offer sales discounts, you track any reductions to the full price of merchandise in this account.
- Sales Returns: Every business ends up needing to accept returns from customers. You track any returns from customers in this account.
- Other Income: If your company takes in income from a source other then its primary business activity, you should record that income in this account. For example, suppose you decide to encourage recycling and earn income from the items recycled, record that income in this account.
Cost of Goods Sold
Before you can sell a product, you must spend some money to either buy or make that product. You track these costs in accounts in the Cost of Goods Sold category. The most common Cost of Goods Sold accounts include:
- Purchases: Track all purchases of products in this account.
- Purchase Discount: If you get discounts on what you purchase, track them in this account. For example, a company may give you a 2 percent discount on your purchase if you pay the bill in 10 days rather than wait until the end of the 30-day payment allotment.
- Purchase Returns: If you’re unhappy with a product you’ve bought, record the value of any returns in this account.
- Freight Charges: Any charges related to shipping items you purchase for later sale are tracked in this account.
- Other Sales Costs: Use this account for any costs that don’t fit into one of the other Cost of Goods Sold accounts.
Your longest list of individual accounts will be the Expense accounts. Any money you spend on the business that can’t be tied directly to the sale of an individual product falls under the Expense account category. For example, advertising a storewide sale isn’t directly tied to the sale of any one product, so the costs associated with advertising fall under the Expense account category. The most common Expense accounts include:
- Advertising: Tracks all expenses involved in promoting a business or its products. In this account money spent on newspaper, television, magazine, and radio advertising is recorded as well as any money spent to print flyers and mailings to customers. Also, when a company participates in community events such as cancer walks or craft fairs, associated costs are tracked in this account as well.
- Bank Service Charges: Use this account to track any charges made by a bank to service a company’s bank accounts.
- Dues and Subscriptions: Use this account to track expenses related to business club membership or subscriptions to magazines for the business.
- Equipment Rental: Use this account to track expenses related to renting equipment for a short-term project. For example, if you need to rent a truck to pick up some new fixtures for the store, record that truck rental in this account.
- Insurance: Use this account to track expenses for buying insurance.
- Legal and Accounting: Use this account to track money paid for legal or accounting advice.
- Miscellaneous Expenses: Use this account for expenses that don’t fit in other accounts. If you start recording expenses in this account and later decide you want to track them individually in their own account, you can choose to add an account to the Chart of Accounts and move related expenses into that new account by subtracting all related transactions from the Miscellaneous Expenses account and adding them to the new account. With this movement of transactions, it’s important to carefully balance out the adjusting transaction to avoid any errors or double counting.
- Office Expense: Use this account to track any items purchased in order to run an office. For example, office supplies such as paper and pens or business cards fit in this account.
- Payroll Taxes: Use this account to track any taxes paid related to employee payroll, such as the employer’s share of Social Security and Medicare, unemployment compensation, and workman’s compensation.
- Postage: Use this account to track any money spent on stamps, express package shipping, and other shipping.
- Rent Expense: Use this account to track rental costs for a business’s office or retail space.
- Salaries and Wages: Use this account to track any money paid to employees as salary or wages.
- Supplies: Use this account to track any business supplies that don’t fit into the category of office supplies. For example, supplies needed for the operation of retail stores are tracked using this account.
- Travel and Entertainment: Use this account to track money spent for business purposes for travel or entertainment. Some businesses separate these expenses into several accounts, such as Travel and Entertainment; Meals, Travel and Entertainment; Travel, and Travel and Entertainment; Entertainment to keep a close watch.
- Telephone: Use this account to track all business expenses related to the telephone and telephone calls.
- Utilities: Use this account to track money paid for utilities, such as electricity, gas, and water.
- Vehicles: Use this account to track expenses related to the operation of company vehicles.
Use the lists you just developed to set up your Chart of Accounts. You can see there really isn’t a secret to how these Chart of Accounts are set up. You set them up based on how you believe your business will operate.
Your Chart of Accounts is not carved in stone. This is a chart that you can regularly update as your business grows and changes. But, you should be very careful about adding and subtracting accounts in the middle of an accounting period.
If you want to add an account, you can do so at any time, but be sure you carefully transfer the funds from the old account in which you were posting the transactions to the new account you decide to set up. You do this with what is called an adjusting journal entry. If you want to delete an account, indicate in your books that no new transactions should be added to that account, but wait until the end of the year to delete the account.