Introduction to Bookkeeping
Basic Bookkeeping Terms and Phrases
Types of Bookkeeping Systems
Accounting / Bookkeeping Methods
Debits and Credits
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Introduction to Bookkeeping

BookkeepingBookkeeping (also called recordkeeping) is the recording of financial transactions. Transactions include sales, purchases, income, receipts and payments by an individual or organization. Bookkeeping is usually performed by a bookkeeper. Many individuals mistakenly consider bookkeeping and accounting to be the same thing. This confusion is understandable because the accounting process includes the bookkeeping function, but is just one part of the accounting process. The accountant creates reports from the recorded financial transactions recorded by the bookkeeper and files forms with government agencies. There are some common methods of bookkeeping such as the single-entry bookkeeping system and the double-entry bookkeeping system. But while these systems may be seen as "real" bookkeeping, any process that involves the recording of financial transactions is a bookkeeping process.

The bookkeeper brings the books to the trial balance stage. An accountant may prepare the income statement and balance sheet using the trial balance and ledgers prepared by the bookkeeper.

Keeping records is crucial for the successful management of a business. Many business finance professionals recommend that all entrepreneurs be knowledgeable about basic recordkeeping practices. The entrepreneur who decides to purchase a manual or computerized recordkeeping system, or has a bookkeeper or accountant, still needs to understand the basic premises.

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Basic Bookkeeping Terms and Phrases

The following is a simplified lexicon of basic recordkeeping that demonstrates how to set up your own accounting system.

Balance sheet terminology

  • Balance sheet: The financial statement that presents a snapshot of the company’s financial position as of a particular date in time. It’s called a balance sheet because the things owned by the company (assets) must equal the claims against those assets (liabilities and equity).

  • Assets: All the things a company owns in order to successfully run its business, such as cash, buildings, land, tools, equipment, vehicles, and furniture.

  • Liabilities: All the debts the company owes, such as bonds, loans, and unpaid bills.

  • Equity: All the money invested in the company by its owners. In a small business owned by one person or a group of people, the owner’s equity is shown in a Capital account. In a larger business that’s incorporated, owner’s equity is shown in shares of stock.

    Another key Equity account is Retained Earnings, which tracks all company profits that have been reinvested in the company rather than paid out to the company’s owners. Small businesses track money paid out to owners in a Drawing account, whereas incorporated businesses dole out money to owners by paying dividends.

Income statement terminology

  • Income statement: The financial statement that presents a summary of the company’s financial activity over a certain period of time, such as a month, quarter, or year. The statement starts with Revenue earned, subtracts the Costs of Goods Sold and the Expenses, and ends with the bottom line — Net Profit or Loss.

  • Revenue: All money collected in the process of selling the company’s goods and services. Some companies also collect revenue through other means, such as selling assets the business no longer needs or earning interest by offering short-term loans to employees or other businesses.

  • Costs of goods sold: All money spent to purchase or make the products or services a company plans to sell to its customers.

  • Expenses: All money spent to operate the company that’s not directly related to the sale of individual goods or services

Other common bookkeeping terms

  • Accounting period : The time period for which financial information is being tracked. Most businesses track their financial results on a monthly basis, so each accounting period equals one month. Some businesses choose to do financial reports on a quarterly or annual basis. Businesses that track their financial activities monthly usually also create quarterly and annual reports.

  • Accounts payable: The account used to track all outstanding bills from vendors, contractors, consultants, and any other companies or individuals from whom the company buys goods or services.

  • Accounts receivable The account used to track all customer sales that are made by store credit. Store credit refers not to credit card sales but rather to sales in which the customer is given credit directly by the store and the store needs to collect payment from the customer at a later date.

  • Depreciation: An accounting method used to track the aging and use of assets. For example, if you own a car, you know that each year you use the car its value is reduced (unless you own one of those classic cars that goes up in value). Every major asset a business owns ages and eventually needs replacement, including buildings, factories, equipment, and other key assets.

  • General Ledger: Where all the company’s accounts are summarized. The General Ledger is the granddaddy of the bookkeeping system.

  • Interest: The money a company needs to pay if it borrows money from a bank or other company. For example, when you buy a car using a car loan, you must pay not only the amount you borrowed but also interest, based on a percent of the amount you borrowed.

  • Inventory: The account that tracks all products that will be sold to customers.

  • Journals : Where bookkeepers keep records (in chronological order) of daily company transactions. Each of the most active accounts — including cash, Accounts Payable, and Accounts Receivable — has its own journal.

  • Payroll: The way a company pays its employees. Managing payroll is a key function of the bookkeeper and involves reporting many aspects of payroll to the government, including taxes to be paid on behalf of the employee, unemployment taxes, and workman’s compensation.

  • Trial balance: How you test to be sure the books are in balance before pulling together information for the financial reports and closing the books for the accounting period.

  • A transaction is entered in a journal before it is entered in ledger accounts. Transactions are entered into the journals by date, amount, description and account to which the transaction has been assigned. For example, when rent is paid, the journal entry would be made in the cash disbursement journal under the accounts of cash and rent. A journal is also called the book of original entry.

  • Different journals are used for different source documents. Cash coming into the business (cash sales, bank loans, interest income) is entered in chronological order in a cash receipts journal. Cash going out of the business (expenses: rent, insurance, payroll, purchases,) is recorded in a cash disbursement journal. The checkbook is the source for recording disbursements.

  • All disbursements should be made by check from a business account that is separate from your personal bank account. This provides an audit trail in case of an audit. Sales and Purchases on credit are entered into a sales journal and purchases journal, respectively. These journals are the original entry for the accounts receivable and accounts payable. A payroll journal is used to show employee gross wages, taxes/other deductions withheld and net wages. A general journal is used for miscellaneous entries and adjustments such as depreciation and inventory.

  • The accounting system is built around a list of account names called a chart of accounts and is organized under the categories of assets, liabilities, owner's equity, revenue or income, cost of goods sold (for a business that sells a product), operating expenses and other income/expenses. The accounts you keep are tailor made for your particular business.

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Types Of Bookkeeping Systems

A business also needs to determine the type of bookkeeping system that will be used for recording their business transactions. Many small businesses start out using the single entry system.

  • Single Entry System
    The single entry system is an "informal" accounting/bookkeeping system where a user of this system makes only one entry to enter a business financial transaction. It generally includes a daily summary of cash receipts and a monthly record of receipts and disbursements (worksheets).

    A checkbook, for example, is a single entry bookkeeping system where one entry is made for each deposit or check written. Receipts are entered as a deposit and a source of revenue. Checks and withdrawals are entered as expenses. If a manual system is used, in order to determine your revenues and expenses you have to prepare worksheets to summarize your income and categorize and summarize your different types of expenses. Bookkeeping software and spreadsheets are also available to do this for you.

    The emphasis of this system is placed on determining the profit or loss of a business. It got its name because you record each transaction only once as either revenue (deposit) or as an expense (check). Since each entry is recorded only once, debits and credits (recording method required for the double entry system) are not used to record a financial event.

    While the single entry system may be acceptable for tax purposes, it does not provide a business with all the financial information needed to adequately report the financial affairs of a business. In the near future, we'll probably see the single entry system follow the same path as the dinosaur - extinction.

  • Double Entry System
    The double entry system is the standard system used by businesses and other organizations to record financial transactions. Since all business transactions consist of an exchange of one thing for another, double entry bookkeeping using debits and credits, is used to show this two-fold effect. Debits and credits are the device that provide the ability to record the entries twice and are explained in more detail later in this tutorial.

    The double entry system also has built-in checks and balances. Due to the use of debits and credits, the double-entry system is self-balancing. The total of the debit values recorded must equal the total of the credit values recorded.

    This system, when used along with the accrual method of accounting, is a complete accounting system and focuses on the income statement and balance sheet. This system has worldwide support as the system to use by businesses for recording their financial transactions.

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Accounting / Bookkeeping Methods

Another decision faced by a new business is what accounting/bookkeeping method is going to be used to track revenues and expenses. An accounting method is just a set of rules used to determine when and how income and expenses are reported.

Some business will be required to use the accrual method of accounting while others may be granted an exception and allowed to use the cash basis along with some special rules (If inventories are a major part of a business).

You're more than likely to encounter both the term method and basis used when this topic is discussed. In some cases you'll see the term cash method used and other cases see the term cash basis used. Likewise you'll see the term accrual method used and the term accrual basis used. They both refer to the same concept and are used interchangeably.

  • Cash Method
    The cash method or basis of accounting recognizes revenues (earnings) in the period the cash is received and expenses in the period when the cash payments are made. Actually, two types of cash methods (basis) of accounting exist:

    • strict cash method (basis)
    • modified cash method (basis)

    A strict cash method follows the cash flow exactly. A modified cash method includes some elements from the accrual method of accounting and provides special methods for handling items such as inventory and cost of goods sold, payroll tax expenses and liabilities, and recording and depreciating property and equipment. Many small businesses, whether they know it or not, are actually using a modified cash method.

    By concentrating on recording revenues and expenses, the purpose of the cash or modified cash method of accounting is on determining the net income or loss for a period based on the cash received and the cash spent.

    Information, such as the amounts billed to customers for products and/or services and not paid, and the amounts billed by suppliers for their products and/or services and not paid is not normally recorded and maintained in the "books" using the cash method. Many small businesses start out using the cash basis rather than the accrual basis of accounting.

  • Accrual Method
    The accrual method or basis of accounting records income in the period earned and records expenses and capital expenditures such as buildings, land, equipment, and vehicles in the period incurred. The purpose of the accrual method of accounting is to properly match income and expenses in the correct period.

    In order to accomplish this, the accrual method of accounting records revenue as earned when the product and/or service is shipped or rendered and invoiced (billed) to customers. Likewise, expenses and capital expenditures are recorded as incurred when the product and or service is shipped or rendered and invoiced (billed) by the supplier.

    Information, such as the amounts billed to customers for products and/or services and not paid, and the amounts billed by suppliers for their products and/or services and not paid is recorded and maintained in the "books" using the accrual method. This is the accounting method that is required to be used in order to conform to generally accepted accounting principles (GAAP) in preparing financial statements for external users.

Difference Between The Two Methods
The difference between the two methods used for recording revenues and expenses results from when the business transaction is recorded in the "books" (timing). A business using the accrual method will record revenues and expenses in their "books" before a business using the cash method. In other words, unlike the cash method, they don't wait until they get paid by the customer or wait until they pay a supplier to record the transaction.

Comment: Cash Flow and Profits are two different "animals". Due to the timing difference as to when revenue and expenses are recorded and when the cash resulting from the revenue and expenses is actually received or paid out , a business using the accrual method of accounting and reporting a "hefty" profit does not necessarily mean that they have the cash to pay their bills.

Relationship Between the Type of Bookkeeping System Used and the Accounting Method Used

The Single Entry bookkeeping system is used along with the Cash Method of accounting.
Debits and Credits are not used to record financial events.

The Double Entry bookkeeping system can be used with both the Cash and Accrual methods of accounting. Debits and Credits are used to record financial events.

With the arrival of computers and accounting software, bookkeeping errors decreased and efficiency increased. For example, the accounting software will refuse a journal entry if the debit amount entered does not equal the credit amount entered. Further, because journal amounts are posted electronically and account balances are calculated electronically, the potential for human error in these tasks is eliminated.

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Debits and Credits

Whether bookkeeping tasks are performed manually by a bookkeeper or electronically by clerks, one thing remains the same: every business transaction involves at least two accounts. This is known as double entry bookkeeping (or "double entry accounting"). Double entry bookkeeping requires that for each transaction, one (or more) account must be debited, and one (or more) account must be credited.

When you are using accounting software, it may not be obvious to you that two accounts are involved with each transaction. This is because the software often updates one of the two accounts automatically. For example, whenever you enter an amount from a vendor's invoice, the computer "recognizes" it as an Accounts Payable and automatically enters the amount as a credit in that account. What you see on the computer screen is a prompt to enter only the "other" account, the one to be debited. Similarly, if you use software to generate checks, the system will automatically credit Cash and prompt you to enter only the account (or accounts) to be debited.

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