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UNDERSTANDING THE BASICS OF ACCOUNTING

Obviously, individuals that perform bookkeeping services must have a basic knowledge of accounting. They also must be able to apply that knowledge when recording transactions. In some instances, however, the entry-level accountants and paraprofessionals that provide much of the bookkeeping work do not possess that basic knowledge.

A detailed discussion of accounting theory is beyond the scope of this article. The following paragraphs, however, discuss basic financial statement terminology and the accounting records commonly used in bookkeeping.

Balance Sheets
The balance sheet (or statement of financial position) is a financial statement that reports an entity's assets, liabilities, and equity at a specific point in time. On the balance sheet, the total of the assets presented equals the sum of total liabilities and total equity.

Balance sheets may be classified or unclassified. A classified balance sheet distinguishes current assets and current liabilities from other assets and liabilities. Because classified balance sheets disclose the components of working capital (or current assets less current liabilities), they are presumed to be more useful. Generally, classified balance sheets are presented unless an industry accounting or auditing guide specifically permits an unclassified presentation or an unclassified balance sheet is industry practice. (For example, it is accepted practice for financial institutions to present unclassified balance sheets because the working capital distinction is not relevant.)

Assets – Assets are economic resources that have the following essential characteristics: (a) they represent probable future benefits that can contribute directly or indirectly to future net cash flows, (b) an entity can obtain those benefits and control others' access to it, and (c) the event giving rise to the entity's right or control of the benefits has already occurred. Examples of assets include cash, marketable securities, accounts receivable, inventories, and equipment.

Current assets are defined as cash and other assets that are reasonably expected to be realized in cash or sold or consumed within one year (or within an entity's normal operating cycle if it is longer than a year). Current assets normally include cash, marketable securities, receivables, inventories, and prepaid expenses.

Liabilities – Liabilities are economic obligations that have the following characteristics: (a) they represent present duties to one or more entities that will be settled by the transfer or use of assets at a specified date, on occurrence of a specified event, or on demand; (b) they obligate an entity, leaving it little or no discretion to avoid the future sacrifice of assets; and (c) the transaction obligating the entity has already occurred. Examples of liabilities include accounts payable, accrued expenses, notes payable, and revenues collected in advance.

Current liabilities are obligations whose liquidation is reasonably expected to require the use of current assets or the creation of other current liabilities within one year. Generally, current liabilities include short-term obligations such as payables for materials and supplies, wages, taxes, amounts collected in advance of delivery of goods or services, the current portion of long-term obligations, and any other obligations expected to be liquidated within a year.

Equity – Equity is often referred to as net assets and is the residual interest in an entity's assets after deducting its liabilities. Equity accounts vary depending on the type of legal entity. For example, a corporation's equity accounts may include common stock, preferred stock, treasury stock, additional paid-in capital, and retained earnings. A partnership's equity accounts, however, may consist only of partners' capital.

Income Statements
An income statement is a financial statement that reports an entity's results of operations for a specific period. That is, it presents an entity's revenues, expenses, gains, and losses for a given period.

• • Revenues are actual or expected cash inflows that have occurred or will eventuate as a result of an entity's major or central operations. Revenues increase assets or decrease liabilities (or both) and, thus, increase equity. Revenue accounts vary depending on the type of business and the type of transaction that generated the revenue. Examples of revenue accounts include sales, royalty income, interest and dividend income, and rent income.
• • Expenses are outflows or other using up of assets or incurrences of liabilities (or a combination of both) from producing or delivering goods, rendering services, or carrying out other activities that constitute the entity's ongoing major or central operations. Expenses decrease assets or increase liabilities (or both) and, thus, decrease equity. Examples of expenses include cost of sales, salaries, taxes, interest expense, and supplies.
• • Gains are increases in net assets from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity except those that result from revenues or investments by owners.
• • Losses are decreases in net assets from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity except those that result from expenses or distributions to owners.

Classifying amounts as revenues, gains, expenses, or losses varies among companies and depends on the nature of a company's operations. Events or circumstances that are sources of revenues for one company may be gains for another. The primary differences between revenues and gains and between expenses and losses are that (a) revenues and expenses result from an entity's ongoing major or central operations such as producing or delivering goods or rendering services, while gains and losses result from incidental or peripheral events or circumstances; and (b) revenues and expenses usually are recorded at their gross amounts while gains and losses usually are recorded at net amounts.

Depreciation – Depreciation is the accounting process of allocating the cost of an asset to expense over the useful life of the asset. For example, if manufacturing equipment is expected to have a useful life of five years, a portion of its cost would be allocated each year for five years to the cost of production. It is important to note that depreciation is merely a method of allocating the cost of assets to expenses. It is not a method of valuing assets.

Accounting Records
General Ledgers – A general ledger is a record containing all of an entity's asset, liability, equity, revenue, expense, gain, and loss accounts. It is the record from which the information necessary to prepare financial statements is obtained. Accordingly, it contains summary totals of all transactions entered in special journals (or books of original entry).

Special Journals (Books of Original Entry) – Transactions are first recorded in special journals and then totaled periodically and recorded in the general ledger as one amount. Because entries in special journals come directly from documents that authorize the transactions, the journals are referred to as “books of original entry.” Special journals are used in many computerized (and manual) accounting systems because they:

• • Promote Efficiency. For example, a company that records all transactions in the general journal and makes several hundred sales on account in one month would have to make several hundred entries each debiting accounts receivable and crediting sales. Each entry in the general journal would then have to be posted to the accounts receivable and sales general ledger accounts. Using special journals, however, the total of all sales on account would be posted to the accounts receivable and sales general ledger accounts only once, at the end of the month.
• • Strengthen Internal Control. A company may require that each special journal be handled by a different person. Thus, for example, the person recording cash receipts need not be the same person that records the payment in the accounts receivable subsidiary ledger.
• • Reduce Errors. Special journals reduce the amount of postings to the general ledger, which reduces the possibility of errors.
• • Increase Control over Cash. Separate journals for cash receipts and disbursements provide daily and weekly information about cash balances.

Depending on the size and type of business, different special journals may be used to record different types of transactions. For example, a small company may record all of its transactions in the general journal. A larger company, however, may find that it is inefficient to use a single journal to record all transactions. As a result, it may use a sales journal to record sales on account and a cash receipt journal to record subsequent payments from customers. (Regardless of the number of special journals used, however, the company would not record a specific transaction in more than one journal. Thus, it would not record a sale on account in the sales journal and the general journal.) Companies often use the following specialized journals:

• • Sales Journal— used to record the sale of merchandise on account.
• • Sales Returns and Allowances Journal— used to record returns of merchandise by customers.
• • Purchases Journal— used to record purchases of merchandise on account.
• • Purchase Returns and Allowances Journal— used to record returns of merchandise or supplies to suppliers.
• • Cash Receipts Journal— used to record the receipt of cash from all sources.
• • Cash Disbursements Journal— used to record the disbursement or payment of cash.
• • General Journal— used to record all other transactions not recorded in specialized journals.

Accountants should be aware that, when using computerized accounting systems, the titles of the special journals may differ from those mentioned above. For instance, the sales journal in a particular software package may be called the “sales transaction register.” Although the titles may differ between computerized accounting systems, the overall content of the specialized journals generally remains the same.

Subsidiary Ledgers – A subsidiary ledger is used to keep track of various details that may relate to a specific general ledger account. When a subsidiary ledger is used, the related general ledger account functions as a control account and equals the total of all accounts maintained in the subsidiary ledger. For example, rather than set up a separate general ledger accounts receivable account for each customer, a company may record only summary information in its accounts receivable general ledger account and maintain an accounts receivable subsidiary ledger. The subsidiary ledger would keep track of information about amounts due from individual customers, and the total of all of its customer accounts would equal the general ledger accounts receivable balance. The following are some of the advantages of using subsidiary ledgers:

• • The balance due from a customer or due to a supplier may be easily located in a single account on the subsidiary ledger.
• • The balance of a general ledger account may be determined by looking at a single amount rather than by totalling several general ledger accounts.
• • Errors are easier to locate since many accounts may be eliminated from the general ledger and instead be listed separately in a subsidiary ledger.

Subsidiary ledgers are often used for cash (when there are numerous cash accounts), accounts receivable, accounts payable, operational assets, capital stock, revenues, and expenses.

Source Documents – Generally, when a business transaction is entered into, documents are prepared showing that the transaction took place. Those documents, referred to as source documents, are used to prepare the journal entries that record the transaction. Source documents vary depending on the type of transaction. In many cases, the source document that evidences a transaction will be no more than a deposit slip, check, or check stub. In other instances, a transaction's source documents will consist of invoices, receipts, or signed agreements. Exhibit 1 lists examples of common business transactions or events, the source documents that generally result, and where each transaction is recorded.

Exhibit 1

Transactions and Related Source Documents

Notes:
^a  Source documents may vary with each transaction. This exhibit lists the possible source documents that may be found in typical transactions.
^b  Each entity may use different special journals to record transactions. For example, one company may record transactions using cash receipts, cash disbursements, and general journals while another company may record similar transactions using only a general journal. This exhibit assumes that the business is using a cash receipts journal, cash disbursements journal, sales journal, purchases journal, and general journal.

Bases of Accounting
The basis of accounting determines how accounting transactions are recorded. For example, recording transactions based solely on cash receipts and disbursements (that is, cash in/cash out) is considered the cash basis of accounting. Some of the more common bases of accounting are explained in the following paragraphs.

GAAP Basis of Accounting – The method of accounting in which assets, liabilities, revenues, and expenses are recorded in the same period that the related transactions occur, regardless of whether cash was received or paid by the entity during the period, is referred to as the GAAP (or accrual) basis of accounting. The accrual basis of accounting is based on cash transactions as well as credit transactions. For example, under the accrual basis of accounting, a company that buys inventory in 20X1 but does not pay for it until 20X2 would record the purchase in 20X1 (when the transaction occurred). The accrual basis of accounting is the basis prescribed by generally accepted accounting principles.

Cash Basis of Accounting – The cash basis of accounting is a method of accounting in which transactions are recorded only when cash is collected or paid. For example, under the cash basis of accounting, a company that sells a product in 20X1 but collects the cash proceeds from the sale in 20X2 would record the sale in 20X2 (when the cash proceeds were collected).

Income Tax Basis of Accounting – The income tax basis of accounting is the method of accounting that an entity uses, or expects to use, to file its income tax return. It is based on federal income tax laws found in the Internal Revenue Code and related revenue rulings, regulations, and procedures.

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