Accounting All-in-One For Dummies®, 2nd Edition
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To the general public, accounting means crunching numbers. Accountants are bean counters, whose job it is to make sure enough money is coming in to cover all the money going out. Most people also recognize that accountants help individuals and businesses complete their tax returns. Few people give much thought to the many other facets of accounting.
Accounting is much more than just keeping the books and completing tax returns. Sure, that is a large part of it, but in the business world, accounting also includes setting up an accounting system, preparing financial statements and reports, analyzing financial statements, planning and budgeting for a business, attracting and managing investment capital, securing loans, analyzing and managing costs, making purchase decisions, providing financial insight and advice to business owners and management, and preventing and detecting fraud.
Although no single book can help you master everything there is to know about all fields of accounting, this book provides the information you need to get started in the most common areas.
Accounting All-In-One For Dummies, 2nd Edition expands your understanding of what accounting is and provides you with the information and guidance to master the skills you need in various areas of accounting. This book, actually nine books in one, covers everything from setting up an accounting system to preventing and detecting fraud:
In order to narrow the scope of this book and present information and guidance that would be most useful to you, the reader, we had to make a few foolish assumptions about who you are:
Throughout this book, icons in the margins cue you in on different types of information that call out for your attention. Here are the icons you'll see and a brief description of each.
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www.dummies.com/go/accountingaiovids.You can also access a free Cheat Sheet at dummies.com (enter Accounting All-in-One For Dummies Cheat Sheet in the search box). The Cheat Sheet features key accounting terms, tips for controlling cash, essential formulas for cost accounting, and definitions of key financial accounting terms. It also explains the relationship between cash flow and profit.
Although you're certainly welcome to read Accounting All-In-One For Dummies, 2nd Edition from start to finish (probably not at a single sitting), feel free to skip and dip, focusing on whichever area of accounting and whichever topic is most relevant to your current needs and interests. If you're just getting started, Books 1 to 3 may be just what you're looking for. If you're facing the daunting challenge of preparing financial statements for a business, consult Books 4 and 5. If you own or manage a business, check out Books 6 to 8 for information and guidance on managerial accounting. And if you're in charge of preventing and detecting incidents of fraud, or you just want to know more about accounting fraud so that you can do your part to prevent it, check out the chapters in Book 9.
Wherever you go, you’ll find the information and guidance you need in an engaging and easily accessible format.
Book 1
Chapter 1
IN THIS CHAPTER
Examining the differences between bookkeeping and accounting
Getting to know the accounting cycle
Maintaining balance with the fundamental accounting equation
Most folks aren’t enthusiastic bookkeepers. You probably balance your checkbook against your bank statement every month and somehow manage to pull together all the records you need for your annual federal income tax return. But if you’re like most people, you stuff your bills in a drawer and just drag them out once a month when you pay them.
Individuals can get along quite well without much bookkeeping — but the exact opposite is true for a business. A business needs a good bookkeeping and accounting system to operate day to day, and a business needs accurate and timely data to operate effectively.
In addition to facilitating day-to-day operations, a company’s bookkeeping and accounting system serves as the source of information for preparing its periodic financial statements, tax returns, and reports to managers. The accuracy of these reports is critical to the business’s survival. That’s because managers use financial reports to make decisions, and if the reports aren’t accurate, managers can’t make intelligent decisions.
Obviously, then, a business manager must be sure that the company’s bookkeeping and accounting system is dependable and up to snuff. This chapter shows you what bookkeepers and accountants do, so you have a clear idea of what it takes to ensure that the information coming out of the accounting system is complete, accurate, and timely.
In a nutshell, accountants “keep the books” of a business (or not-for-profit or government entity) by following systematic methods to record all the financial activities and prepare summaries. This summary information is used to create financial statements.
Financial statements are sent to stakeholders. Stakeholders are people who have a stake in the company’s success or failure. Here are some examples of stakeholders:
The following sections help you embark on your journey to develop a better understanding of bookkeeping and accounting. Here you discover the differences between the two and get a bird’s-eye view of how they interact.
Distinguishing between bookkeeping and accounting is important, because they’re not completely interchangeable. Bookkeeping refers mainly to the recordkeeping aspects of accounting — the process (some would say the drudgery) of recording all the detailed information regarding the transactions and other activities of a business (or other organization, venture, or project).
The term accounting is much broader; it enters the realm of designing the bookkeeping system, establishing controls to make sure the system is working well, and analyzing and verifying the recorded information. Accountants give orders; bookkeepers follow them.
Bookkeepers spend more time with the recordkeeping process and dealing with problems that inevitably arise in recording so much information. Accountants, on the other hand, have a different focus. You can think of accounting as what goes on before and after bookkeeping. Accountants design the bookkeeping and accounting system (before) and use the information that the bookkeepers enter to create financial statements, tax returns, and various internal-use reports for managers (after).
Figure 1-1 presents a panoramic view of bookkeeping and accounting for businesses and other entities that carry on business activities. This brief overview can’t do justice to all the details of bookkeeping and accounting, of course. But it serves to clarify important differences between bookkeeping and accounting.
©John Wiley & Sons, Inc.
FIGURE 1-1: Panoramic view of bookkeeping and accounting.
Bookkeeping has two main jobs: recording the financial effects and other relevant details of the wide variety of transactions and other activities of the entity; and generating a constant stream of documents and electronic outputs to keep the business operating every day.
Accounting, on the other hand, focuses on the periodic preparation of three main types of output — reports to managers, tax returns (income tax, sales tax, payroll tax, and so on), and financial statements and reports. These outputs are completed according to certain schedules. For example, financial statements are usually prepared every month and at the end of the year (12 months).
Accounting All-In-One For Dummies, 2nd Edition is concerned predominately with financial and management accounting. Financial accounting refers to the periodic preparation of general-purpose financial statements (see Books 4 and 5). General purpose means that the financial statements are prepared according to standards established for financial reporting to stakeholders, as explained earlier in this chapter.
These financial statements are useful to managers as well, but managers need more information than is reported in the external financial statements of a business. Much of this management information is confidential and not for circulation outside the business. Management accounting refers to the preparation of internal accounting reports for business managers. Management accounting is used for planning business activity (Book 6) and to make informed business decisions (Book 7).
This chapter offers a brief survey of bookkeeping and accounting, which you may find helpful before moving on to the more hands-on financial and management topics.
Figure 1-2 presents an overview of the accounting cycle. These are the basic steps in virtually every bookkeeping and accounting system. The steps are done in the order presented, although the methods of performing the steps vary from business to business. For example, the details of a sale may be entered by scanning bar codes in a grocery store, or they may require an in-depth legal interpretation for a complex order from a customer for an expensive piece of equipment. The following is a more detailed description of each step:
Prepare source documents for all transactions, operations, and other events of the business; source documents are the starting point in the bookkeeping process.
When buying products, a business gets an invoice from the supplier. When borrowing money from the bank, a business signs a note payable, a copy of which the business keeps. When preparing payroll checks, a business depends on salary rosters and time cards. All of these key business forms serve as sources of information entered into the bookkeeping system — in other words, information the bookkeeper uses in recording the financial effects of the activities of the business.
Determine the financial effects of the transactions, operations, and other events of the business.
The activities of the business have financial effects that must be recorded — the business is better off, worse off, or affected in some way as the result of its transactions. Examples of typical business transactions include paying employees, making sales to customers, borrowing money from the bank, and buying products that will be sold to customers. The bookkeeping process begins by determining the relevant information about each transaction. The chief accountant of the business establishes the rules and methods for measuring the financial effects of transactions. Of course, the bookkeeper should comply with these rules and methods.
Make original entries of financial effects in journals, with appropriate references to source documents.
Using the source documents, the bookkeeper makes the first, or original, entry for every transaction into a journal; this information is later posted in accounts (see the next step). A journal is a chronological record of transactions in the order in which they occur — like a very detailed personal diary.
Here’s a simple example that illustrates recording a transaction in a journal. Expecting a big demand from its customers, a retail bookstore purchases, on credit, 100 copies of The Beekeeper Book from the publisher, Animal World. The books are received, a few are placed on the shelves, and the rest are stored. The bookstore now owns the books and owes Animal World $2,000, which is the cost of the 100 copies. This example focuses solely on recording the purchase of the books, not recording subsequent sales of the books and payment to Animal World.
The bookstore has established a specific inventory asset account called “Inventory–Trade Paperbacks” for books like this. And the liability to the publisher should be entered in the account “Accounts Payable–Publishers.” Therefore, the original journal entry for this purchase records an increase in the inventory asset account of $2,000 and an increase in the accounts payable account of $2,000. Notice the balance in the two sides of the transaction. An asset increases $2,000 on the one side, and a liability increases $2,000 on the other side. All is well (assuming no mistakes).
Post the financial effects of transactions to accounts, with references and tie-ins to original journal entries.
As Step 3 explains, the pair of changes for the bookstore’s purchase of 100 copies of this book is first recorded in an original journal entry. Then, sometime later, the financial effects are posted, or recorded in the separate accounts — one an asset and the other a liability. Only the official, established chart, or list of accounts, should be used in recording transactions. An account is a separate record, or page, for each asset, each liability, and so on. One transaction affects two or more accounts. The journal entry records the whole transaction in one place; then each piece is recorded in the accounts affected by the transaction. After posting all transactions, a trial balance is generated. This document lists all the accounts and their balances, as of a certain date.
The importance of entering transaction data correctly and in a timely manner cannot be stressed enough. The prevalence of data entry errors is one important reason that most retailers use cash registers that read bar-coded information on products, which more accurately captures the necessary information and speeds up data entry.
Perform end-of-period procedures — the critical steps for getting the accounting records up-to-date and ready for the preparation of management accounting reports, tax returns, and financial statements.
A period is a stretch of time — from one day (even one hour) to one month to one quarter (three months) to one year — that’s determined by the needs of the business. Most businesses need accounting reports and financial statements at the end of each quarter, and many need monthly financial statements.
Before the accounting reports can be prepared at the end of the period (see Figure 1-1), the bookkeeper needs to bring the accounts up to date and complete the bookkeeping process. One such end-of-period requirement, for example, is recording the depreciation expense for the period (see Book 3, Chapter 1 for more on depreciation).
The accountant needs to be heavily involved in end-of-period procedures and be sure to check for errors in the business’s accounts. Data entry clerks and bookkeepers may not fully understand the unusual nature of some business transactions and may have entered transactions incorrectly. One reason for establishing internal controls (see Book 2, Chapter 1) is to keep errors to an absolute minimum. Ideally, accounts should contain no errors at the end of the period, but the accountant can’t assume anything and should perform a final check for any errors.
Compile the adjusted trial balance for the accountant, which is the basis for preparing management reports, tax returns, and financial statements.
In Step 4, you see that a trial balance is generated after you post the accounting activity. After all the end-of-period procedures have been completed, the bookkeeper compiles a comprehensive listing of all accounts, which is called the adjusted trial balance. Modest-sized businesses maintain hundreds of accounts for their various assets, liabilities, owners’ equity, revenues, and expenses. Larger businesses keep thousands of accounts.
The accountant takes the adjusted trial balance and combines similar accounts into one summary amount that is reported in a financial report or tax return. For example, a business may keep hundreds of separate inventory accounts, every one of which is listed in the adjusted trial balance. The accountant collapses all these accounts into one summary inventory account presented in the balance sheet of the business. In grouping the accounts, the accountant should comply with established financial reporting standards and income tax requirements.
Close the books — bring the bookkeeping for the fiscal year just ended to a close and get things ready to begin the bookkeeping process for the coming fiscal year.
Books is the common term for a business’s complete set of accounts along with journal entries. A business’s transactions are a constant stream of activities that don’t end tidily on the last day of the year, which can make preparing financial statements and tax returns challenging. The business has to draw a clear line of demarcation between activities for the year ended and the year to come by closing the books for one year and starting with fresh books for the next year.
©John Wiley & Sons, Inc.
FIGURE 1-2: Basic steps of the accounting cycle.
Most medium-sized and larger businesses have an accounting manual that spells out in great detail the specific accounts and procedures for recording transactions. A business should regularly review its chart of accounts and accounting rules and policies and make revisions. Companies don’t take this task lightly; discontinuities in the accounting system can be major shocks and have to be carefully thought out. The remaining chapters in Book 1 lead you through the process of developing an accounting system. See Book 3 for details on adjusting and closing entries.
The fundamental accounting equation (also known as the accounting equation or the balance sheet equation) helps explain the concept that all transactions must balance.
Assets = Liabilities + Owners’ equity
Net assets equals assets minus liabilities. If you do some algebra and subtract liabilities from both sides of the previous equation, you get this formula:
Assets – Liabilities = Owners’ equity
Or:
Net assets = Owners’ equity
Before going any further, acquaint yourself with the cast of characters in the equation:
Owners’ equity (or simply equity) is what’s left over in the business at the end of the day. If you sold all your assets for cash, then paid off all your liabilities, any cash remaining would be equity. Many accounting textbooks define equity as the owners’ claim to the company’s net assets. Book 4, Chapter 5 discusses the different components of equity.
Don’t confuse capital and equity. Capital is cash and other assets used to run the business, whereas equity is assets minus liabilities. A firm can raise capital in two ways: by issuing stock or by taking on debt (borrowing money). It can increase equity in a number of ways, including generating net income (profit), reducing employee costs, lowering manufacturing costs, closing an office, or issuing stock to shareholders to raise capital. Check out Book 6, Chapter 1 for more about capital.
You may read the explanation of owners’ equity and think, “That’s just another way to say ‘net worth’” But you can’t use the term net worth interchangeably with owners’ equity in an accounting setting. Generally accepted accounting principles (GAAP), explained in Book 4, Chapter 1, don’t allow accountants to restate all assets to their fair market value, which would be required to calculate a company’s net worth.
Here’s a simple example of the fundamental accounting equation at work:
Or, after subtracting liabilities from each side of the equation:
Finally, you can restate assets less liabilities and net assets:
Chapter 2
IN THIS CHAPTER
Introducing the chart of accounts
Warming up with balance sheet accounts
Creating your own chart of accounts
Grasping the basics of debits and credits
Getting schooled in double-entry accounting
Can you imagine the mess your checkbook would be if you didn’t record each debit card transaction? If you’re like most people, you’ve probably forgotten to record a debit card purchase or two on occasion, but you certainly learn your lesson when you realize that an important payment bounces as a result. Yikes!
Keeping the books of a business can be a lot more difficult than maintaining a personal checkbook. You have to carefully record each business transaction to make sure that it goes into the right account. This careful bookkeeping gives you an effective tool for figuring out how well the business is doing financially.
You need a road map to help you determine where to record all those transactions. This road map is called the chart of accounts. This chapter introduces you to the chart of accounts and explains how to set up your chart of accounts. This chapter also spells out the differences between debits and credits and orients you to the fine art of double-entry accounting.
The chart of accounts is the road map that a business creates to organize its financial transactions. After all, you can’t record a transaction until you know where to put it! Essentially, this chart is a list of all the accounts a business has, organized in a specific order; each account has a description that includes the type of account and the types of transactions that should be entered into that account. Every business creates its own chart of accounts based on the nature of the business and its operations, so you’re unlikely to find two businesses with the exact same chart.
Some basic organizational and structural characteristics are common to all Charts of Accounts. The organization and structure are designed around two key financial reports:
You can find out more about income statements and balance sheets in Books 4 and 5. The following lists present a common order for these accounts within each of their groups, based on how they appear on the financial statements.
The chart of accounts starts with the balance sheet accounts, which include
The rest of the chart is filled with income statement accounts, which include
When developing the chart of accounts, you start by listing all asset, liability, equity, revenue, and expense accounts. All these accounts come from two places: the balance sheet and the income statement.
This chapter introduces the key account types found in most businesses, but this list isn’t cast in stone. You should develop an account list that makes the most sense for how you’re operating your business and the financial information you want to track.
The chart of accounts is a management tool that helps you make smart business decisions. You’ll probably tweak the accounts in your chart annually and, if necessary, add accounts during the year if you find something that requires more detailed tracking. You can add accounts during the year, but it’s best not to delete accounts until the end of a 12-month reporting period.
A chart of accounts helps you keep your balance sheet accounts in balance in accordance with the balance sheet equation that we discuss in Chapter 1:
Assets = Liabilities + Equity
As you see in the prior section, the chart of accounts groups accounts based on the three categories in the balance sheet equation. All the asset accounts, for example, have account numbers that are close together, as explained in the next section. You can easily separate the chart of accounts into assets, liabilities, and equity — and see whether the balance sheet equation balances (in total dollars).