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The are often short courses for non-accounting people on understanding balance sheets, income statements, cashflow statements, etc. As good as these courses may be, do many people using these reports not always understand the basics of accounting.
Since the advent of computers where the numbers are punched in and the computer does the rest, correctly or incorrectly ..... Gone are the days when bookkeeping was a trade (if I may call it that, since it required a high level of training, competence and attention to detail). Gone are the days of a journal book, a cash book, and a general ledger book, and when the first thing a student of accountancy learnt was how to manually balance an account. Gone are the days when in closing the books, was everything written to a trading account and from there on to the Income Satement. Gone are the days of advertising for a Bookkeeper to Trial Balance because the computer now does most of that work.
Unfortunately will even the best accounting software not be a substitute for a good understanding of accounting concepts, and will such a basic knowledge of the fundmentals help you in your career, and save lots of time by doing things right the first time.
The purpose of this page is to explain some of the most important fundamentals of bookkeeping mainly for non-accounting people, but also those who have for so long worked with computer programs that they have forgotten the basics.
We'll cover the following main topics .....
- The basics of Accounting
- Setting up a modern (computer based) accounting system.
- Setting up a meaningful accounting system for a multi-operation organisation
- And lastly, a review of the terminology
THE BASICS OF BOOKKEEPING
THE DOUBLE ENTRY SYSTEM
The Double Entry System was developed (more like discovered) around the 13th century. This was a major improvement over anything else that existed at the time, as it not only reduced the possibilities of fraud and errors, but also provided a methodical and systematic way of drawing up reports.
With computers now doing the accounting, have people however become removed from the Double Entry System, and can we be forgiven for forgetting that in fact modern accounting systems are still very much based on the Double Entry System. This is because in most cases of data capturing is only one account number entered..... the other account number was entered when the program was set up and has long since been forgotten by the people using the system.
The Double Entry System simply means that for every transaction must in fact the amount be written to two accounts. This might not sound like such a great feature, but in simple terms would such an approach pick up if for instance a mistake was made. More significant however, did such a system prevent fraudulant activities, because for every entry did the 2nd entry serve as a kind of controlling entry, and in the case of a fraudulent entry would it be rather difficult to know where to place the second entry without making it a lot easier to be caught out!
BALANCE SHEET VS. INCOME STATEMENT ACCOUNTS
Before tackling another complicated topic, let's take a breather...... and now that we understand the Dual Entry System, deal with the concept of Balance Sheet vs. Income Statement type accounts.
A very important feature of modern accounting and largely the result of the Dual Entry System, must accounts be one of two types, either....
-Balance Sheet accounts largely consisting of either Asset or Liability accounts and making up the Balance Sheet, or
-Income Statement accounts largely consisting of either Income or Expense accounts and making up the Income Statement.
The Balance Sheet then gives an indication of the state of the entity at a particular point in time (nromally at the end of the accounting period), ie. the value of it's assets, and it's liabilities and the difference Accumulated Income (if Assets exceed Liabilities), or Accumulated Losses (if Liabilities instead exceed Assets), which technically makes the entity bankrupt (or insolvent)
The Income Statement gives an indication of the profit that was made over the accounting period (either a month, a quarter, a year) if Income exceed expences, or losses if Income was less than Expences
By separating the accounts into the above two types, do these two reports give very different yet specific information about the state of the entity.
THE ACCRUAL BASIS
This requirement quite simply means that transactions should be accounted for, not in terms of when the monetary transaction took place, but instead when the income or expense was actually incurred
A good example reflecting the accrual basis is the existance of a Creditors and a Debtors account, recording transactions made in one month of which the cash transaction only follows in a subsequent month
The theory sounds reasonable simple, but it is often more difficult to apply the principle in practise, because a system has to be introduced to separate transactions into different periods even though the monetary transaction took place in the same month, ie. payments for COD purchases should be brought into the current month, while payments for purchases on credit should be brought into the previous month (when they were incurred)
It is for this reason that drawing up accounts from your bank statement is in fact incorrect, as they reflect when the monetary transactions took place instead of the actual transactions
It is therefore required that processing be done from source documents ie. the COD purchases file, the credit purchases files, but be reconciled back to the monetary transaction documents and bank statements
It is also for this reason that Stock is taken, nl. to account not for when goods were purchased but rather when it was used.
Similarly does the taking of Work In Progress result in accounting not of when goods were sold, but rather when it was produced.
Other accounts resulting from the Accrual Basis system are ..... Accrued Expenses, Accrued Income, Deferred Expenses, Deferred Income.
SETTING UP A MODERN COMPUTER BASED ACCOUNTING SYSTEM
Having mastered the basics of accounting, what are the key elements in getting your accounting system going.....
Source documents are those documents that contain and represent the transaction. These must exist, and if not created as part of your normal business system, should they be created even if only to serve as a starting point for the recording of transactions.
Source documents have traditionally been paper based, and will for a long time continue to be so. Modern computer systems that process transactions electronically have to a large extent managed to do away with paper based documents, but the source document still exists as data in the computer system.
It is not possible for one person to do everything in medium to larger accounting systems. A fundamental issue is what to separate into sub-functions, ie. get someone else to handle and merely obtain the condensed information from them. These sub functions often include, purchasing, sales, cash book, etc.
In order to be computer based, do you need to go out and purchase a program that will allow you to process your accounts on computer. There are many very good programs out there, ranging from simple and cheap, to more elaborate and expensive, to highly sophisticated and unaffordable. The average user would limit his/her options to the first two.
Some important considerations when selecting a program are....
-is it popular and readily available
-are the various disciplines all included, or can you purchase them separetely as modules..... there are pros and cons to either options
-are transaction automatically posted as they are entered, or are they grouped into a batch that can be viewed, printed and edited before posting. Although a little bit more elaborate, is the second option better
ACCOUNTS (NAMING AND NUMBERING)
This is a very important issue, especially the numbering of the various accounts, as you will have to live with it for a long time .....
-These are what used to be called journals, nl. the document onto which the details of ALL transactions were sequentially written. Instead of using the source documents or slips of paper, is there a lot of merit in drawing up a set of standardised Entry Sheets onto which the transactions can be entered, and typed into the computer from there.
ENTERING DATA, PRINTING REPORTS
Having attended to all of the above points, is this the easiest step which quickly will become routine.
The most important requirement is that you get into a monthly cycle of working, and measuring your efficiency in terms of the number of days after month end that you close and start processing the next month
EFFECTIVE MANAGEMENT ACCOUNTING
If you want to go one step further than only keeping the books that tell you whether a profit or loss is being made, to establishing where the profits and losses are made helping to make the appropriate decisions about what actions to take to improve the profitability of the operation and ensure it's long term survival.... I call this Effective Management Accounting
This involves setting up a system that will give more meaningful information, that can be used to make quality decisions about the organisation.
It invariably involves dividing the organisation up into Departments, introducing an effective system of budgeting, which includes the important step of setting internal transfer prices in a meaningful way,
..... and also very important, placing people in charge of these departments and getting them to accept responsibility for the operating results...... but this is another topic, more of which you will find under the heading of Management
DIVIDING THE ORGANISATION INTO DEPARTMENTS
Dividing the organisation into smaller functional units is a powerful way of not just improving the effectiveness of these disciplines, but also giving you the abibility to measure the performance of each
Because it is often very difficult if not impossible to determine the cost of producing a particular product or providing a service, does departmentalisation in a much more accurate manner determine the costs (and profitability) of a department that produces/provides a particular range of products or services.
The decision about what to divide, and what to make a sub-division of what, etc. may sound easy but some serious thought should be given to these aspects as it may have a pronounced effect later, when it might not be so easy to change. Normally are divisions and departments formed along functional lines, ie. according to their function.
This process helps to "break-up" the organisation into smaller more manageable parts, and most certainly a very important step in delegating / devolving authority and responsibility away from the powers at the top.
One of the problems that comes when an organisation is divided into departments is an increased level of internal competition and conflict. This can be both good and bad, and the challenge is to retain the good and try to prevent the bad elements from affecting the success of the exercise. Ways of reducing the bad effects are......
+encourage communication of problems
+have inter department social events
+transfer people between departments (if at all possible)
-Budgeting simply involves drawing up a plan for (say) the next 12 months and expressing it in numbers. In short does this give details of expected income, expected expences, and expected profit or loss.
Obviously should such a budget be backed up with various strategy plans, giving more information as to how you intend achieving the proposed budget.
This process of budgeting is actually very important, because it not only serves as a measure of your success, but also to monitor your progress. It also indicates where you plan to be in 12 months time allowing you to decide whether in fact that's where you want to be before you start out.
One issue that comes up as a result of departmentalisation is that of internal charges, ie. what one department should pay for the products or servives provided internally by another department. This is a very important issue, and if not handled correctly can wreck the whole exercise.
-One guideline is that a department which does not provide a product or service to an external customer should not "receive" income allowing it to make a substantial profit, other than through it's own efforts to improve it's efficiency and operate at a lower cost.
-Another guideline is that such departments should not be allowed to every year simply add x% to their previous year's income/charges.
+The term zero based budgeting has been used in an attempt to pressurize people into justifying their required income, but as good as the intention is does it often just result in more elaborate schemes to justify income.
+A system that works fairly well as an improvement to determining internal charges is where it is related to the level of activity of the organistion that may in a reasonable manner be related to the extent of the internal service required. Although not necessarily the best, can turnover as a first example be used, ie. the internal income may be increased (or decreased) by the same percentage as the turnover had changed since the previous year. This approach lays down an income not necessarily based on what the department requires, but instead what the organisation can afford.
Last and most important, setting up your reports and interpreting the results
Having divided the organisation up into functional departments, instead of drawing your Income Satement report up along functional lines, can it now be drawn up according to what is lately being referred as the Marginal approach without loosing any important information, and instead getting the benefits of separating costs between variable, semi variable and fixed.
Your Income Satement report should therefore be laid out not just to show Turnover and Material Consumption, but also Raw Mat % and Value Added.
Furthermore must it in addition to Production Costs leading to Gross Profit, and Nett Profit after Fixed Costs, also show Contribution which is found by splitting the Fixed Costs associated with a particular department between avoidable (direct) and unavoidable (indirect) Fixed Costs.
Contribution is a very important sub-total, because it will tell you in the case of a department that isn't making a profit, whether it is at least making a contribution to the Overhead Costs of the organisation, in which case closing it down would simply shift some of the costs to other departments and if anything adversely affect the profits of the whole organisation.
Having read through all of the above and hopefully understanding most of it, herewith a explanation of some of the terms.....
The most difficult to understand of all accounting terms is, the Debit and the Credit......
Originally an entry that goes into the left column of an account, and indicating in the case of a Balance Sheet Account an Asset, and in the case of an Income Statement Account an Expense.
Originally an entry that goes into the right column of an account, and indicating in the case of a Balance Sheet Account a Liability, and in the case of an Income Statement Account an Income
If you are confused, well dont say that I hadn't warned you. However as you start to understand bookkeeping, will you come to realize just how meaningful and powerfull the above two concepts are after all.
Indicates the value of things that belong to, or is owed to you or the entity
Indicates the value of things that you, or the entity owes to someone else.
The extent to which your or the entity's Assets exceed the Liabilities.
If instead the Liabilities exceed the Assets are you insolvent or more commonly said to be bankrupt
Indicates the monetary value of the proceeds of your efforts or sales
Indicates the monetary value of costs incurred in order to generate Income
The extent to which your Income exceeded your Expenses
The extent to which your Income is less than your Expenses
What transactions of a similar nature is grouped into, of which normally only the total is used subsequently.
ACCOUNT NAME is the descriptive name given to an account, which largely determines it's meaning and significance.
This used to be the name of the main/final book in which the details of all the transactions were written up per account. In the computer age is this the name that is given to that (normally the files) that contain all the accounts and transactions.
-Such transactions are either entered manually or imported via another program/module in which they were initially entered.
-It is also the name of the program or module that is used to enter all these accounts and transactions, and print the various reports...... one in fact called the General Ledger report.
CASH BOOK (account)
This used to be the name of the book into which the monetary transactions that went through the bank were written into. These balances were then carried forward to the Cash Book account in the general Ledger
In the computer age is the cash book simply an account in the General Ledger, and is either maintained by manual entries or by a Cashbook program
This is not one of the accounts in the General ledger, but in fact your Bank Statement which may be similar but far from identical to your Cash Book (account).
-For one, will your Cash Book contain details of cheques written out, but will only appear on your Bank Statement once they have been cashed
-For another, will your Bank Statement contain bank charges, which your Cash Book will not, until you write them up as such
RECONCILE / RECONCILIATION
This is when two related sets of information is compared, and the differences accounted for. This is in fact a very important and required step between your Cash Book (account) and your Bank Satement
This is the process whereby transactions are added, and only the total reported or carried forward.
An account in your General Ledger of cash kept by yourself, often in a a tin referred to as Petty Cash. The amount of money in the Petty Cash tin must at all times agree with the value in the Petty Cash account, unless differences can be accounted for via a reconciliation.
A term that dates from manual bookkeeping, indicating the entry of an amount or total that is moved out of one account, and into another account.
A term that dates from manual bookkeeping, indicating the entry of an amount or total as it appears in a new account, after being Carried Forward from another account