The Basics of Accounting and Bookkeeping
Like pretty much anything else, if you don’t establish the foundation, you will not have anything to build on. If you do not know the basics of accounting, then whatever you attempt to do that relates to accounting, will be futile. Getting the numbers right, can either make or break your business, and if you are like me you want to make your business – not break it.
The first thing we need to do is define accounting and bookkeeping:
Accounting is an entire system of recording information based on specific principles, analyzing those information, and advising on the action to take based on those information. It is often broken down into two parts: the actual entering of the transactions (bookkeeping) and the analysis, interpreting, and communicating of those data (accounting). Thus, accounting is the process of making sense of information previously compiled, and producing financial models using that information. In other words, bookkeeping compiles, while accounting analyze, interprets, and communicate the information to its owner(s). Accounting entails: preparing adjusting entries – recording expenses that have occurred but are not yet recorded in the bookkeeping process, preparing financial statements, analyzing costs of living or business operations, completing income tax returns, assisting the individual or business owner in understanding the impact of financial decisions. Accounting is either accrual or cash basis; however, GAAP only accepts accrual method of accounting.
Bookkeeping is the process of recording daily transactions in a consistent, systematic way so as to output the results in reportable formats from which good business decisions can be made. It consists of: recording financial transactions – posting debits and credits, producing invoices, making purchases and paying bills, maintaining and balancing subsidiaries – general ledgers, and historical accounts, and generating payroll.
Accounting operates on a double entry basis; meaning for every debit, there is a corresponding credit and vice versa, and the entire accounting system is based on a single accounting equation: ASSETS = EQUITY + LIABILITIES. Assets, being what you own, Liabilities, being what you owe, and Equity being the difference between the two, which is what you have left.
The next thing we need to do is to lay out the principles:
Accounting principles are general rules and concepts that govern the field of accounting. These general rules, referred to as basic accounting principles and guidelines, form the groundwork on which more detailed, complicated, and legalistic accounting rules are based. For example, the Financial Accounting Standards Board (FASB) uses the basic accounting principles and guidelines GAAP as a basis for their own detailed and comprehensive set of accounting rules and standards. Generally Accepted Accounting Principles (GAAP) consists of three important sets of rules: (1) the basic accounting principles and guidelines, (2) the detailed rules and standards issued by FASB and its predecessor the Accounting Principles Board (APB), and (3) the generally accepted industry practices.
GAAP is exceedingly useful because it attempts to standardize and regulate accounting definitions, assumptions, and methods. Because of generally accepted accounting principles we are able to assume that there is consistency from year to year in the methods used to prepare a company’s financial statements. And although variations may exist, we can make reasonably confident conclusions when comparing one company to another, or comparing one company’s financial statistics to the statistics for its industry.
Again, accounting is based on principles, and since the bookkeeper usually records the information, he or she will need to know what constitutes the principles in order to accurately complete the bookkeeping task. Accountants and CPA’s rely heavily on bookkeepers for accurate information, and often work closely with bookkeepers to ensure that they do get correct information. If the bookkeeping is incorrect, then more often than not, the accounting is also incorrect and the business will suffer as a result. In addition, the Chart of Accounts, which is the backbone of the accounting system, needs to be structured correctly with each account linking to its accurate account type – expense, income, asset, liability, or equity. So what are the principles?
- Revenue Principle
- Expense Principle
- Matching Principle
- Cost Principle
- Objectivity Principle
- Full Disclosure Principle
- Continuity Assumption
- Unit-of-measure Assumption
- Separate Entity Assumption
- Time Period Assumption
The revenue principle, also known as the realization principle, states that revenue is earned when the sale is made, which is typically when goods or services are provided. A key component of the revenue principle, when it comes to the sale of goods, is that revenue is earned when legal ownership of the goods passes from seller to buyer. Note that revenue isn’t earned when you collect cash for something.
Cash Basis accounting is not accepted by GAAP standard. However, since GAAP is a standard and not the law, small businesses that earn revenue within a specified threshold, are not publicly traded, and do not carry Inventory may opt to use the cash basis method of accounting.
The expense principle states that an expense occurs when the business uses goods or receives services. In other words, the expense principle is the flip side of the revenue principle. As is the case with the revenue principle, if you receive some goods, simply receiving the goods means that you have incurred the expense of the goods. Similarly, if you have received a service, you have incurred the corresponding expense. It doesn’t matter that it takes a few days or a few weeks to get the bill. You incur an expense when goods or services are received.
The matching principle is related to the revenue and the expense principles. The matching principle states that when you recognize revenue, you should match related expenses with the revenue. The best example of the matching principle concerns the case of businesses that resell inventory. For example, if you own a natural juice stand, you should count the expense of each juice sold on the day you sell those juices. Don’t count the expense when you purchase the juices or the ingredients; count the expense when you sell them. In other words, match the expense of the item with the revenue of the item.
Accrual-based accounting, which is a term you have probably heard, is what you get when you apply the revenue principle, the expense principle, and the matching principle. In a nutshell, accrual-based accounting means that you record revenue when a sale is made and record expenses when goods are used or services are received.
The cost principle states that amounts in your accounting system should be quantified, or measured, by using historical cost. For example, if you have a business and the business owns a building, that building, according to the cost principle, shows up on your balance sheet at its historical cost. You do not adjust the values in an accounting system for changes in a fair market value.
The objectivity principle states that accounting measurements and accounting reports should use objective, factual, and verifiable data. In other words, accountants, accounting systems, and accounting reports should rely on subjectivity as little as possible. An accountant always wants to use objective data – even if it’s bad, rather than subjective data – even if the subjective data is arguably better.
Full disclosure states that if certain information is important to an investor or lender using the financial statements, that information should be disclosed within the statement or in the notes to the statement. It is because of this basic accounting principle that numerous pages of “footnotes” are often attached to financial statements. As an example, let’s say a company is named in a lawsuit that demands a significant amount of money. When the financial statements are prepared it is not clear whether the company will be able to defend itself or whether it might lose the lawsuit. As a result of these conditions, and because of the full disclosure principle, the lawsuit will be described in the notes to the financial statements. A company usually lists its significant accounting policies as the first note to its financial statements.
The continuity assumption or going concern principle assumes that a company will continue to exist long enough to carry out its objectives and commitments and will not liquidate in the foreseeable future. The importance of the continuity assumption becomes most clear if you consider the ramifications of assuming that a business won’t continue. If a business will not continue, it becomes very unclear how one should value assets if the assets have no resale value. If a business will not continue operations, no assurance exists that any of the inventory can be sold. If the inventory cannot be sold, what does that say about the owner’s equity value shown in the balance sheet? If the company’s financial situation is such that the accountant believes the company will not be able to continue on, the accountant is required to disclose this assessment.
The unit-of-measure assumption assumes that a business’s domestic currency is the appropriate unit of measure for the business to use in its accounting. In other words, the unit-of-measure assumption states that it’s okay for U.S. businesses to use U.S. dollars in their accounting. The unit-of-measure assumption also states, implicitly, that even though inflation and, occasionally, deflation change the purchasing power of the unit of measure used in the accounting system, that’s still okay.
The separate entity assumption states that a business entity, like a sole proprietorship, is a separate entity, a separate thing from its business owner. And the separate entity assumption says that a partnership is a separate thing from the partners who own part of the business. The separate entity assumption, therefore, enables one to prepare financial statements just for the sole proprietorship or just for the partnership. As a result, the separate entity assumption also relies on a business being separate and distinct and definable as compared to its business owners. For legal purposes, a sole proprietorship and its owner are considered to be one entity, but for accounting purposes they are considered to be two separate entities.
The time period assumption principle assumes that it is possible to report the complex and ongoing activities of a business in relatively short, distinct time intervals such as the three months ended March 31, 2016, or the 13 weeks ended April 1, 2016. The shorter the time interval, the more likely the need for the accountant to estimate amounts relevant to that period. For example, the property tax bill is received on December 16 of each year. On the income statement for the year ended December 31, 2015, the amount is known; but for the income statement for the three months ended March 31, 2016, the amount was not known and an estimate had to be used. It is also very important that the time interval (or period of time) be shown in the heading of each income statement, statement of stockholders’ equity, statement of cash flow, and all other reports. Labeling one of these financial statements with “December 31” is not good enough. The reader needs to know if the statement covers the one week ended December 31, 2015 the month ended December 31, 2015, the three months ended December 31, 2015, or the year ended December 31, 2015.
Of course you do not need to know all of this in order to accurately use an accounting software, but knowing the basics and having an understanding of the elements of accounting, will allow you to enter information correctly and subsequently have accurate numbers from which to run your business as well as file its taxes. Also, the way you set up your Chart of Accounts and enter data will need to be modified to reflect the type of business entity, but the basics – debits, credits, purchases, sales, income, expenses, assets, liabilities – remain the same.
Deposit the retainer/settlement check into the Trust/Escrow bank account, using a Funds Held in Trust (Escrow) liability account with the client name in the name field. I do this directly in the Make Deposit form, but you can enter a sales receipt, using an item which points to the liability account.
Write checks for any disbursements of those funds, using the Funds Held in Trust (Escrow) account on the expense tab of that check – with the client name in the name field on that line. Or, if you want the detail of how those disbursements are made, create separate items, all pointing to that account, to indicate what that “paid out” is for – taxes, insurance, fees, etc.
If applicable, invoice the client for the professional fees – time or flat fee billings, and any advanced costs – previously paid out of the operating account, as separate items.
Cut a check from the Trust/Escrow bank account to the law firm, using the Funds Held in Trust (Escrow) account on the expense tab of that check – with the client name in the name field on that line.
Receive the payment using the “Receive payment” option, with the client name, and attach that payment to the open invoice.
Deposit the funds into the operating checking account – either directly from the payment, or via Undeposited Funds.
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