bookkeeping 101, bookkeeping overview, basics, and best practices


suppose you were asked how much to the nearest dollar you spent on food last year to answer this question would require that you gather information like receipts credit card statements and canceled checks for all your expenditures analyze that information determine which outflows relate to food and summarize those outflows into one number the cost of your food expenditures for the year once you’ve answered that question answer this one how much did you spend on clothes last year again you would have to go through the same process of collecting data analyzing the information to identify those expenditures related to clothing and then summarizing those expenditures into one number without a method for gathering and organizing day-to-day financial data answers to seemingly routine questions like these can get quite complex now you may be thinking doesn’t my detail the electronic bank statement allow me to easily answer these questions your bank statement would certainly help but it is limited in that it tracks only the transactions that go through your bank account like checks you write or debit card payments it does not track the cash in your pocket savings account or other investment accounts these payments are also not categorized by purpose and the totals are not summarized now consider the dilemma for businesses they typically have far more transactions than you and the kinds of transactions are more varied businesses buy and sell goods or services borrow and invest money pay wages to employees purchase land buildings equipment distribute earnings to owners and pay taxes to the government these activities are referred to as exchange transactions because the entity is actually trading or exchanging one thing for another a bookstore for example exchanges books for cash business documents such as a sales invoice a purchase order or a check stub are often used to confirm that a transaction has occurred to establish the amounts to be recorded and to facilitate the analysis of the business event to determine how well an entity is man it’s resources the results of transactions must be analyzed the accounting cycle makes the analysis possible by recording and summarizing and entities transactions and preparing reports that present the summary results a transaction kicks off the accounting cycle a transaction is when a business exchanges something and gets something in return the value exchanged needs to be quantified and recorded once all the transactions for a period have been recorded those transactions must then be summarized once the day-to-day transactions are summarized then financial reports can be created sound complicated well it would be without a system to capture that information but there’s no need for us to invent the accounting wheel that wheel was codified over 500 years ago and is still used by virtually all businesses around the world to capture and compile financial information large multinational corporations have millions of business transactions each day and the more complex and detailed the accounting system the more likely it is to be automated even small companies generally use some type of inexpensive accounting software to reduce the number of routine clerical functions and improve the accuracy and timeliness of the accounting records regardless of whether an automated or manual system is used the steps in the process are basically the same a transaction occurs the transaction is then analyzed journalized and recorded to the accounts and then summarized and reported and used for evaluation purposes the difference lies in who or what does the work with a computer-based system the software transforms the recorded data summarizes the data into categories and prepares the financial statements and other reports nevertheless human judgment is still essential in analyzing recording transactions especially those of an on routine nature because a manual accounting system is easier to understand we will use a manual system for the examples in this course but before we get into the details of the accounting system let’s first get an overview of the output of the accounting system the financial statements one of the major results of bookkeeping is to provide information with which individuals can make decisions financial statements are a means whereby the effects of lots of transactions are summarized and reported in a manner that is useful to users of financial statements the three most common financial statements are the balance sheet the income statement and the statement of cash flows let’s take a look at each of these in turn now we’ll start with the mother of all financial statements the balance sheet the balance sheet is called the fundamental financial statement it contains a listing of a company’s assets its resources its valuable things its cash its land its inventory those things that it holds to sell those are its assets the other part of the balance sheet is a listing of where the company got the money to buy those assets the liabilities and the equities the balance sheet embodies the accounting equation a list of things we own assets is easy anybody can list assets but the insight from the accounting equation is to then also list where do we get the money to buy those assets the liabilities and the equities now assets there are valuable resources there are items that will provide us benefit in the future cash for example is the asset that we can all quickly identify now the first thing to note is that they call this financial statement a balance sheet for a reason it balances the accounting equation requires assets to equal the liabilities plus owner’s equity it has to balance by definition this is important so let me say it one more time the accounting equation always balances the second primary financial statement is the income statement that’s revenues minus expenses equals net income we use the term revenues and expenses all the time so let’s make sure we know what those words mean in an accounting context revenue means the amount of assets generated in doing business and different companies generate assets in different ways Walmart for example generates assets by putting things on shelves that you and I buy that’s how Walmart creates assets Microsoft creates assets by creating software and hardware that you and I then buy and we pay Microsoft for those things Disney has consumer products they have cruises they have theme parks we pay to use those things or to buy those products and that’s how Disney generates assets revenue is the amount of assets generated in doing business hopefully the assets generated are less than the assets consumed expenses are the amount of assets consumed in doing business for example Microsoft consumes assets by paying programmers and by paying for equipment Walmart consumes assets by buying the inventory that they then sell to you and me and by paying rent by depreciating buildings and by paying its employees McDonald’s consumes resources by buying food buying paper and by renting facilities in each case the revenues are hopefully more than the expenses that are consumed all of this is put together in the income statement a listing of a company’s revenues less a listing of the company’s expenses equals net income now net income is a very sophisticated economic measure it’s the net amount of assets generated by business through its business operations this is the income statement now let’s look at some income statement examples for some companies of which you’ve heard Facebook Google Microsoft and Apple all of these companies have income statements that they have to release to the public on a regular basis now take a look at these first of all you will see a difference in scale Apple is so much larger than Facebook in fact Facebook is the smallest company on this list in terms revenues yet we talk about Facebook so much this illustrates an important point the financial statements are only one measure of a company’s performance a very important measure but only one measure why do we talk about Facebook so often because for Facebook its operations now are only a small fraction of what we think they are going to be in the future Facebook is expected to grow substantially in the future so we talk about them a lot now each of these companies Facebook Google Microsoft and Apple report a net income for their most recent fiscal year that is their revenues exceed their expenses by quite a large amount these four companies are quite successful at using their assets to generate revenues the point with the income statement is this a company increases its net assets through profitable operations you can see that each of these four companies have been very profitable as a result their net assets increase year after year the third Prime financial statement is the statement of cash flows conceptually the statement of cash flows is quite simple cash in cash out the insight of accountants is to separate those cash flows into three categories operating activities investing activities and financing activities those three categories of cash flows are what are reported in the statement of cash flows and the statement of cash flows summarizes cash inflows and outflows for a period of time now operating activities are what companies do every single day they collect cash from customers they pay cash for inventory they pay cash to employees for rent they pay for advertising they pay for research and development all those things are operating activities think of operating activities as the things that a business does every single day and hopefully a company would generate cash from its operating activities you would hope that a business would be collecting more on a daily basis than its spending now the second category in the statement of cash flows is investing activities investing means investing in the productive capacity of the business buying machines buying land buying buildings those are investing activities in contrast to operating activities which happen every single day investing activities happen occasionally you don’t buy land and buildings every single day you do that on occasion operating activities again are things that our business does every day investing activities investing in the productive capacity of the business happen occasionally now the third category in the statement of cash flows is financing activities and this is exactly what it sounds like financing borrowing money repaying those loans getting cash from investors paying dividends to investors getting the capital or financing to buy those assets that a business needs now a way to think of the statement of cash flows is this with financing activities I’m getting the financing the capital to buy the assets those are investing activities to then conduct the operations the operating activities these are the things that are business does the statement of cash flows is build around operating investing and financing activities let’s look at examples of the year-end statements of cash flows for three companies about what you’ve heard coca-cola exxon mobil and wal-mart now the first thing i want you to look at is look at the statement of cash flows for exxon mobil particularly look at their investing activities billions upon billions of dollars of investing activities they’re investing in the productive capacity of their business this business needs large machines and buildings and equipment and lots of land and you see that reflected in the investing cash outflows for exxon mobil these are often called capital expenditures now I want you to look at the statement of cash flows for coca-cola and Walmart we call these companies cash cows turns out Exxon is also a cash cow the reason we call them cash cows is that their operations generate more than enough cash to pay for all their investing activities with cash left over they’re just generating lots of cash wouldn’t you like to be a personal cash cow where your daily cash flows were enough to pay for all your cars and houses and land and everything else you needed to buy in cash that’s coca-cola that’s Walmart and that’s Exxon Mobil you often the most difficult aspect of accounting is determining which events are to be reflected in the accounting records and which are not suppose for example that Burger King introduced a new Big Mac clone at half the Big Mac price the proliferation of these Big Mac clones could have a serious impact on the future of McDonald’s however events that cannot be reliably measured in monetary terms will not be reflected in the financial statements since it would be virtually impossible to quantify the impact of the Big Mac clones on the future profitability of McDonald’s that information will be excluded from the financial statements while there is an obligation to inform financial statement users about this attack on the Big Mac the financial statements are not the place to do it the financial statements are only one part of the information provided to users information relating to the competitive environment product development and marketing and sales efforts is included in the company’s annual report to stockholders but not as part of the accounting information now once we’ve determined that we have a transaction that needs to be included in the accounting records the event must be analyzed to determine if an arm’s-length transaction has occurred accounting is concerned primarily with reflecting the effects of transactions between two independent entities so Delta Airlines signing a contract with Boeing to purchase airplanes in the future would not be reflected in the financial statements until the airplanes are manufactured and delivered and Delta has agreed to pay for them while many transactions between independent parties are routine some business events are quite complex and require a comprehensive analysis to determine how the event should be reflected in the financial statements consider the following example a company buys a building in addition to paying twenty thousand dollars in cash the company agrees to pay ten thousand dollars per year for the next ten years the company will also pay a two thousand dollar property tax bill associated with the building from last year as part of the purchase the company gave the former owners of the building five hundred shares of stock finally the building will require twenty three thousand dollars worth of repairs and renovations before can even be used now how much should be recorded as the cost of the building transactions like this can become quite complex but the framework introduced in this topic will allow you to break complex transactions into manageable pieces and provide you with a self-checking mechanism to ensure that you haven’t forgotten anything let’s begin our analysis of transactions by reviewing some of the basics first remember the fundamental accounting equation assets must equal liabilities plus owner’s equity that is a company’s resources can be financed using two sources creditors or owners as we said previously the accounting equation must always remain in balance to see how this balance is maintained when accounting for business transactions consider the following activities in the first transaction $50,000 is invested by owners this would cause our assets specifically cash to increase in our equity specifically capital stock to increase both by $50,000 in the second transaction we borrow $25,000 from a bank again our assets cash increased by 25,000 and our liabilities since we will have to repay this notes payable increase by $25,000 as well note that so far our accounting equation balances after each transaction and in fact we can always count on that the accounting equation will always balance the only instance in which it will not balance is when we’ve done something wrong to the third transaction inventory that is an item that we will resell later is purchased on credit we will pay for our inventory at a later date our assets specifically inventory increased by 14,000 and our liabilities specifically accounts payable increased by $14,000 as well as we now owe money to a creditor at some point in the future in the fourth transaction we purchase equipment by paying cash in this instance we are trading one asset cash for another asset equipment cash is going down by $15,000 and equipment is going up by a corresponding amount for each transaction the accounting equation remains in balance because an identical amount is added to both sides subtracted from both sides or added to and subtracted from the same side of the equation following each transaction we can ensure that the accounting equation balances note in this how after each transaction we can track the balance for our assets our liabilities and our owner’s equity to ensure that the accounting equation balances after transaction one assets equal $50,000 and owner’s equity equals fifty thousand dollars after transaction number two assets now equals 75 thousand dollars while liabilities equals 25 thousand and owner’s equity equals 50 thousand dollars after transaction 3 where we bought inventory on account assets equal eighty nine thousand dollars liabilities equal thirty nine thousand dollars and owner’s equity still equals fifty thousand dollars finally after the fourth transaction where we purchased equipment paying cash in other words we traded one asset for another our accounting equation still balances assets equal eighty nine thousand dollars liabilities equal thirty nine thousand dollars and owner’s equity equals fifty thousand dollars the accounting equation balances hold on to that concept when things get complicated and they can knowing that the accounting equation must always balance helps us determine if we have considered all the effects of a transaction recall that the three primary financial statements are the balance sheet the income statement and the statement of cash flows the yellow eights of the balance sheet are assets liabilities and owner’s equity the elements of the income statement are revenues and expenses each of these elements is comprised of many different accounts an account is a specific accounting record that provides an efficient way to categorize similar transactions thus we may designate asset accounts liability accounts and owner’s equity accounts examples of asset accounts are cash inventory and equipment liability accounts include accounts payable and notes payable for example the equity accounts for a corporation or capital stock or paid in capital and retained earnings you can think of an individual account as a summary of every transaction affecting a certain item like cash the summary may be recorded on one page of a book or in one column of a spreadsheet as illustrated here using our previous four transactions we can easily see how the accounting equation can be expanded to include specific accounts under the heading of assets liabilities and owner’s equity we can also see that after each transaction the Equality of the accounting equation can be determined by adding up the balances of all the asset accounts and comparing the total to the sum of all the liability and owner’s equity accounts now when double entry accounting was formalized over 500 years ago all the adding and subtracting was done by hand you can imagine the difficulties of tracking multiple accounts involving hundreds of transactions using the spreadsheet method above while doing all the computations by hand mixing pluses and minuses in one column would provide ample opportunity to make mistakes this problem was solved by separating the pluses and the minuses for each account into separate columns totaling each column and then computing the difference between the columns to arrive in an ending balance the simplest most fundamental format is the configuration of the letter T this is called the T account note that a t-account is an abbreviated representation of an actual account which we will illustrate later and is used as a teaching and learning tool the following segment includes examples of T accounts representing the transactions described previously the account title cash for example appears at the top of the T account transaction amounts may be recorded on both the left and the right side of the t account instead of using the terms left and right to indicate which side of a t account is affected terms unique to accounting were developed debit abbreviated er is used to indicate the left side of a T account and credit abbreviated CR is used to indicate the right side of a T account debit means left credit means right nothing more nothing less let me say that again debit means left and credit means right in addition to representing the left and right sides of an account the terms debit and credit take on an additional meeting when coupled with a specific account by convention for asset accounts debits refer to increases and credits refer to decreases for example to increase the cash account we definite to decrease the cash account we credit it since we expect the total increases in the cash account to be greater than the decreases the cash account will usually have a debit balance after accounting for all transactions thus we can make this generalization asset accounts will usually have debit balances that is their balance will typically be on the left side of the t account the opposite relationship is true of liability and owner’s equity accounts they are decreased by debits and increase by credits as a result liability and owner’s equity accounts will typically have credit balances the effect of this system is shown here with an increase indicated by a plus sign and a decrease indicated by a minus sign now remember that asset accounts will typically have debit balances whereas liability and owner’s equity accounts will typically have credit balances in addition to assets equalling liabilities and owner’s equity debits should always equal credits if you fully grasp the meaning of these two equalities you are well on your way to mastering the mechanics of accounting or learning the language of accounting debits and credits allow us to take a shortcut to ensure that the accounting equation always balances if for every transaction debits equal credits then the accounting equation will always balance to understand why this happens keep in mind three basic facts regarding double-entry accounting first debits are always entered on the left side of an account and credits on the right side second for every transaction there must be at least one debit and one credit third debits must always equal credits for every transaction if you can grasp these three points you are well on your way to understanding the mechanics of accounting assets equal liabilities plus owner’s equity debits equal credits if you hang on to these two equalities all will be well let us now see how these two equations work together with some examples now notice what these equalities mean for the investment by owners transaction we discussed previously an asset account cash is debited it’s increased an owner’s equity account capital stock is credited it’s also increased there is both a debit and a credit for the transaction and we have increased accounts on both sides of the accounting equation by an equal amount thus keeping the accounting equation in balance to make sure you understand the relationship between debits and credits the various accounts and the accounting equation we need to examine further the remaining transactions we have discussed previously when a cash is borrowed from a bank cash is increased with a debit and notes payable a liability is increased with a credit when inventory is purchased on account we have inventory increasing since inventory is an asset the inventory account will increase with a debit the amount we owe in the future the liabilities account is also increasing we know that liabilities increase with credits in the fourth transaction we purchase equipment paying cash we are exchanging one asset for another assets go up with debits and they go down with credits since we now have more equipment the equipment account will be debited and since we have less cash that is cash is decreased we know that the cash account will be credited note that every time an account is debited other accounts have to be credited for the same amount this is the major characteristic of the double-entry accounting system the debits must always equal the credits this important characteristic creates a practical advantage the opportunity for self checking if debits do not equal credits an error has been made in analyzing and recording the entity’s activities it is very important to understand the relationship between the various types of accounts and debits and credits the relationship is d 2 in this illustration asset accounts increase with debits and they decrease with credits liability and owner’s equity accounts increase with credits and they decrease with debits at the end of the day assets typically have debit balances that is the amounts being debited are larger than the amounts being credited also liabilities and owner’s equity accounts have credit balances that is the amounts being credited are larger than the amounts being debited now if this is making your head hurt don’t worry you’re not the first one whose head is hurt studying this material think about it if it were easy you would have digested this material long ago this is hard but you are right on the edge of a major breakthrough once we combine debits and credits with journal entries which are right around the corner this will begin to clear up please don’t feel bad when this seems hard it is hard that after all is why you’re watching this course if it were easy you wouldn’t need this course please make sure you understand the information contained in this exhibit once you understand the relationship of debits and credits to the different types of balance sheet accounts things start to make a lot more sense and you begin to understand the power behind this very old but very useful bookkeeping system now at this point we must bring revenues and expenses into the picture obviously they are going to be a part of every ongoing business recall from our discussion of the income statement that revenues provide resource inflows they are increases in resources from the sale of good or services expenses represent resource outflows they are costs incurred in generating revenues note that revenues are not synonymous with cash or other assets but are a way of describing where the assets came from for example cash received from the sale of a product is recorded as the asset cash but the source of that asset would be considered revenue in contrast cash received by borrowing from the bank would not be revenue but an increase in a liability by the same token expenses are a way of describing how an asset has been used thus cash paid for interest on a loan is an expense but cash paid to buy a building represents the exchange of one asset for another so how do revenues and expenses fit into the accounting equation remember that revenues minus expenses equals net income and net income is a major source of change in owner’s equity from one accounting period to the next revenues and expenses then may be thought of as temporary subdivisions of owner’s equity revenues increase owner’s equity and so like all owner’s equity accounts are increased with credits expenses reduce owner’s equity and owner’s equity is reduced with debits let me say that again revenues increase owner’s equity and owner’s equity increases with credits expenses decrease owner’s equity and owner’s equity decreases with debits this is sometimes confusing so let me be clear as expenses go up owner’s equity goes down the more debits to my expenses the more my owner’s equity decreases why because remember owner’s equity goes down with debits now one other temporary account affects owner’s equity the dividends account shows distributions of earnings to owners because dividends reflect to payments to the owners thereby reducing owner’s equity the dividends account is increased by a debit and decreased by a credit using the corporate form of business the accounting equation may be expanded to include revenues expenses and dividends as shown here all we are doing with this expansion of the accounting equation is recognizing that when expenses go up they are in effect decreasing the retained earnings account and retained earnings is decreased with a Devon dividends have a similar effect on retained earnings another way to think about dividends is that they are earnings that are not retained they are instead returned to the owners of a business earnings that are not retained would involve decreasing my retained earnings and that would require a debit to the retained earnings account revenues on the other hand effectively increase our retained earnings account and retained earnings as increased with credits now some words of caution first be careful not to let the general non accounting meeting of the words credit and debit confuse you in general conversation credit has an association with Plus and debit with – but on the asset side of the accounting equation we’re debit means increase and credit means decrease this association can lead you astray in accounting debit simply means left and credit simply means right second individuals who have trouble grasping debits and credits usually get hung up on the revenue and expense accounts remember that revenues and expenses are sub categories of retained earnings when you credit a revenue account you’re essentially increasing retained earnings when you debit an expense account you are increasing the amount of the expense which in turns reduces retained earnings finally we stated previously that owners equity accounts will have credit balances however expenses a component of retained earnings will almost always have a debit balance since revenues will usually exceed expenses the net effect on retained earnings will result in a credit balance who now that we understand that the accounting equation must always balance and that debits must always equal credits we are now ready to try our hand at actually recording transactions like real accountants do in the very next video we will introduce journal entries the mechanism for recording these debits and credits in a systematic fashion now I want to remind you once again that this is hard stuff most people pull back at about this point in time right on the edge of the big breakthrough and they don’t see it through well that is not going to be you in the very near future the dots are going to connect and you will soon know what many individuals don’t have the discipline to learn debits and credits are a new language and learning a new language requires patience and effort hang in there your effort now will be worth it later you with our knowledge of the different types of accounts assets liabilities and owner’s equity and the use of the terms debits and credits debit means left and credit means right we are now ready to actually record the effective transactions the second step in the accounting cycle is to record the results of transactions in a journal journals provide a chronological record of all transactions of a business they show the dates of the transactions the amounts involved and the particular accounts affected by the transactions sometimes a detailed description of the transaction is also included this chronological recording of transactions in a journal provides a company with a complete record of its activities if amounts were recorded directly in the accounts it would be difficult if not impossible for a company to trace a transaction that occurred say six months previously small companies such as a locally owned pizza restaurant may use only one journal called the general journal to record all transactions larger companies having thousands of transactions each year may use special journals an example of a special journal is a cash receipts journal in addition to using a general journal a specific format is used in recording transactions in a journal entry the debit entry is listed first the credit entry is listed second and is indented to the right normally the date and a brief explanation of the transaction are considered essential parts of the journal entry dollar signs are usually omitted unless otherwise noted this format but will be used whenever a journal entry is presented now to illustrate the recording of transactions using a journal entries let’s start a business you’re 18 again and you want to work outdoors and set your own schedule so let’s start our own landscaping business this business will involve mowing lawns pulling weeds trimming and planting shrubs and so forth we will use this simple business to illustrate the journal entries used to record some common transactions of a business enterprise okay your first task and starting this business is to acquire cash either through owners investment or by borrowing now remember you’re 18 again you got a full head of hair and a million ideas you’re ready to make some money you have a thousand dollars in savings and your parents have offered to match your funds you decide to issue 200 shares of stock you make this journal entry this transaction increases cash as a result of capital stock being issued to investors or stockholders the cash account is debited because an asset cash increased and the capital stock account is credited remember that owner’s equity accounts are increased with credits the economic impact of this situation may be summarized as follows in the accounting equation note from the journal entry that our debits equal our credits and note from the spreadsheet that our assets equal our liabilities plus our owner’s equity that will always happen if we’ve done things correctly okay next suppose that on top of the money from yourself and your parents you went to a bank and somehow convinced the loan officer to lend you some additional money what were they thinking you’re 18 but hey they did it the journal entry for such a transaction would be as follows here the cash account is debited and the notes payable account is credited cash is debited because cash is an asset an assets increase with debits notes payable a liability is credited because we now owe more money and increases and liabilities are recorded with credits a note is a contract specifying an amount that one party will repay to another usually with interest along the way this particular account could also be called loans payable the accounting equation captures the economic impact of borrowing the money as follows we now have assets totaling $4,000 funded with liabilities in the amount of 2000 and investments by owners also to the tune of $2,000 again our accounting equation balances because our debits equal our credits in our journal entry now that you have the funds necessary to start your business you can use that money to acquire other assets needed to operate the business you need assets like supplies inventory and equipment like a lawn mower for hauling these assets may be purchased with cash or on credit credit purchases require payment after a period of time for example 30 days normally interest expense is incurred when assets are bought on a time payment plan that extends beyond two or three months we will show how to account for interest in an upcoming section where we discuss the payment of obligations now we will demonstrate transactions involving the acquisition of non-cash assets the first thing you need is a lawn mower and some form of transportation you can’t afford a new car but you find a 1998 lime-green pickup truck for sale for $100 and you buy it paying cash with this transaction you are trading one asset for another the account truck an asset will increase and we know that assets increase with debits we also know that our cash an asset has decreased and assets decreased with credits the impact of this journal entry on our accounting equation looks like this note at all times that our assets equal our liabilities plus our owner’s equity the accounting equation always balances because the debits always equal the credits next you drive to the local Loddon garden store and purchase a lawn mower and gas can for $250 instead of paying for the mower with cash you open a charge account which will allow you to pay for the mower in 30 days with no interest charge beyond this 30 day grace period an interest charge will apply the journal entry record this purchase is shown here we increase our asset equipment and assets increase with debits we also increase our liability accounts payable and we know that liabilities increase with credits thus the debits equal the credits and as a result we know that the accounting equation will balance the accounting equation is shown here when you eventually pay for the mower cash will be reduced and the liability accounts payable will also be reduced thus keeping the equation in balance now back you go to the lawn and garden store to purchase fertilizers gloves a rake a shovel and other assorted supplies the total cost is $180 which you pay in cash an increase in one asset supplies results in a decrease in another asset cash again the debits equal the credits the accounting equation now shows that we have assets totaling four thousand two hundred fifty dollars if we add up all the asset accounts liabilities of two thousand two hundred fifty dollars if we had a father liability accounts and owners equity of two thousand dollars the amount of our assets exactly equals the amount of our liabilities and owner’s equity perfect now on the way home from the store you drive past a greenhouse and notice a big sign advertising 50% off sale on shrubs since you anticipate that planting shrubs will be part of your business you stop and your purchase for cash $150 worth of shrubs is inventory you plan to make money in two ways with the shrubs first revenue from the labor associated with planting them and second a profit on the selling of shrubs for more than you paid after all that is fair you’re saving your client the time and trouble of having to go to the greenhouse the journal entry for recording these transaction is as follows this journal entry recognizes that you are again trading one asset for another you have less cash that requires a credit to the cash account and you have more inventory which being an asset increases with a debit now the various account balances that are part of the accounting equation will look like this our assets total four thousand two hundred fifty dollars if we add up all the asset accounts our liabilities total two thousand two hundred fifty dollars and our owner’s equity account capital stock is two thousand dollars our balance sheet still balances I have been involved with accounting for almost forty years and I’m still amazed that the system always works we just need to remember the following debits go on the left side of the t-account credits go on the right assets increase with debits and liabilities and owner’s equity accounts increase with credits there’s always one debit and one credit for each transaction for each journal entry and debits always equal credits we need a little more practice to solidify these concepts let’s start generating some assets in our business let’s start making some money now that you have your lawnmower transportation supplies and inventory it’s time for you to get to work the next category of common transactions involves the sale of services or merchandise you generate revenues and incur expenses during this process sometimes you might sell services and merchandise for cash at other times you may sell them on credit and a receivable is established for collection at a later date therefore revenues indicate the source not only of cash but of other assets as well all of which are received in exchange for the merchandise or services provided similarly expenses may be incurred and paid immediately with cash or they may be incurred on credit that is they may be charged with a cash payment to be made at a later date we will illustrate these possibilities in the transactions that follow and note that the effect of revenues and expenses on owner’s equity is indicated in brackets for each transaction so let’s get started as soon as your neighbors find out that you’re in the lawn care and landscaping business your phone begins ringing although most of your clients pay you immediately when you perform the service some prefer to pay you just once a month as a result a portion of your revenues is received immediately in cash while the balance becomes a receivable the journal entry to record your first week’s revenue for lawn care services as follows a debit to cash because cash is an asset and assets go up with debits for $270 a debit to accounts receivable again because accounts receivable is an asset and assets increase with debits for 80 and a credit to lawn care revenue for $350 lawn care revenue is a revenue account which based on the expanded accounting equation is part of owner’s equity and owner’s equity accounts go up with a credit as this journal entry illustrates more than two accounts can be involved in recording a transaction this type of entry is called a compound journal entry because revenues increase with owner’s equity the accounting equation shows an increase in assets and an increase in owner’s equity both increasing by three hundred fifty dollars now please note that revenue is not an asset the asset in this transaction are the cash and the accounts receivable revenue is the label given to the source of these assets they were generated in the normal course of business when assets are received from investment by owners the source of the asset is capital stock part of owner’s equity as we showed previously when assets are borrowed the source of the asset is a liability and when assets are generated by providing a good or a service the source of that asset is labeled revenue okay now one of your customers asked if you’ll plant some shrubs in her backyard she is thrilled that you have just the shrubs that she wants thereby saving her a trip to the greenhouse you use one half of your inventory of shrubs in this customers yard and it takes you three hours to complete the job she pays you in cash in this instance we are dealing with two different types of revenues profit from the sale of the shrubs and revenue from your labors let’s deal with each type of revenue separately first the sale of the shrubs sales whether made on account or for cash require entries that reflect not only the sale but also the cost of the inventory that’s sold the cost of goods sold is an expense and as such is offset with the sales revenue to determine the profitability of sales transactions while accounting for inventory can get quite complicated for our purposes we’re just trying to illustrate the effects of these transactions on the accounting equation now in this example you charge your customer 90 dollars for one half of the shrubs you purchased earlier the journal entries to record this transaction are as follows now in this example inventory costing you $75 is being sold for $90 in cash note that the cash goes up again cash an asset goes up with a debit sales revenue increases with a credit both the debit and the credit on the amount of $90 now to the second entry associated with this transaction the cost of the goods that were sold what should we call the cost of goods that are sold well accountants tend to call things what they are the cost of the goods sold is recorded in an account called exactly that cost of goods sold is an expense and we know that expenses decrease owner’s equity and they do that through retained earnings cost of goods sold is debited for $75 in addition inventory went down and inventory being an asset goes down with a credit debit cost of goods sold credit inventory for $75 the effect on the accounting equation for each transaction is as follows with the first journal entry assets cash increase as a result of running revenue in the second journal entry assets inventory decrease as a result of using the asset to generate revenues this is called an expense the label expenses is used to explain how assets have been used sometimes assets are consumed as part of doing business in this transaction the shrubs now belong to your customer and they are gone from your business expenses is the label we give to the amount of assets consumed in doing business hopefully the revenues the amount of assets generated will be more than the expenses the amount of assets consumed now in addition to making a profit on the sale of the shrubs you also generate a revenue planting them the journal entry to record this revenue is as follows we work someone pays us cash cash increases and cash increases with a debit and the source of the increase in cash is landscaping revenue and as we know revenues increase with credits the effect of the transaction on the accounting equation is that our assets increased by 45 dollars and our owner’s equity through revenues increases by 45 dollars as well thank heavens the accounting equation still balances but we knew it would because our debits always equals our credits in addition to expenses relating to the sale of inventory other expenses are also incurred in operating a business examples include gas for your lawnmower in your truck and the wages you agreed to pay your little brother for working for you after all mom said you had to hire him the following journal entries illustrate how these expenses would be accounted for gasoline expense is a debit for $50 recognizing that owner’s equity is decreased and cash is credited to show that cash went down the cash paid for wages are treated the same way and debit to the expense account and a credit to cash the effect on the accounting equation of the gasoline expense is that it decreases assets by $50 and decreases owner’s equity by $50 as well now the entry for wage expense affects the equation in the same manner the only difference being the amount $60 obviously once merchandise or services are sold on the account the receivable must be collecting the cash received is generally used to meet daily operating expenses and to pay other obligations excess cash can be reinvested in the business or distributed to the owners as a return on their investment so now it’s the end of the month let’s go collect some cash the collection of accounts receivable is an important aspect of most businesses receivables are created when you allow certain customers to pay for your services at a later date when receivables are collected the asset is reduced and cash is increased as shown in this journal entry the asset cash increased and increased with a debit of course and the asset accounts receivable decreases and that is shown with a credit now the effect of collecting receivables on the accounting equation is this note that no revenue is involved here revenue is recorded when the original sales transaction creates the accounts receivable the cash collection on account merely involves exchanging one asset for another now remember that lawnmower and gas that you purchased on account well now you have to pay for them what would the journal entry to pay off that previously recorded accounts payable look like well let me think cash is being paid that means cash is going down and cash being an asset goes down with a credit so what’s the corresponding debit well our liability is being paid it is no longer liabilities go down with debits there you go the journal entry looks like this after payment of accounts payable the accounting equation shows a decrease in our assets and a decrease in our liabilities now recall in a previous transaction that we showed the entry required when cash was borrowed from the bank in that entry you borrowed $2,000 to be paid over 12 months suppose you’re required to make a monthly loan payment of 178 dollars with a portion of each payment being attributed to interest and a portion to reducing the liability just like a mortgage on a house as the following compound journal entry shows a note payable or similar obligation requires an entry for payment of the principal as well as the interest to note that interest is the amount charged for borrowing money analysis of this transaction reveals that the asset cash in this case has decreased for two reasons first a portion of a liability has been paid with cash and liabilities decreased with debits second interest expense of 12% for one month on the note payable has been paid and expenses are recorded as debits remember expenses reduce owner’s equity and that happens with a debit since the interest charges in expanse and decreases owner’s equity the impact of the entry on the accounting equation looks like this now recall that you obtain financing in two ways to start your business investors you mom and dad and the bank in the previous journal entry we illustrated how the bank receives a return on its investment well mom and dad would like a return as well corporations that are profitable generally paid dividends to their stockholders dividends represent a distribution to the stockholders a part of the earnings of the company this is reasonable because the earnings belong to the owners of the company the stockholders the following entry illustrates the payment of a cash dividend with a debit to the dividend account and a credit to cash now as noted earlier dividends like revenues and expenses affect owner’s equity unlike revenues and expenses dividends are a distribution of profits and therefore are not considered in determining net income because dividends reduce the retained earnings accumulated by a corporation they decrease owner’s equity the payment of a $50 dividend affects the accounting equation as follows now a summary of the transaction since we started recognizing revenue are shown here with their corresponding effect on the accounting equation the grand takeaway from this exercise as there because debits equal credits with each and every journal entry the accounting equation balanced with every transaction this spreadsheet also shows us the balance in each and every account with this information we can prepare financial statements but not yet we’re going to get to that now that you’ve seen some examples of journal entries perhaps you’re starting to see a pattern I want to share with you three simple questions you can ask for every transaction if you get in the habit of asking these three questions the whole debits and credits thing gets a lot easier 1 what accounts are involved – did the accounts increase or decrease and 3 by how much did each account change the answer to question 1 tells you if the accounts involved are assets liabilities or owner equity accounts the answer to question 2 considered in conjunction with the answer to question 1 tells you if those accounts are to be debited or credited consider the instance where $25,000 is borrowed from a bank the two encounted volved are cash and notes payable cash increased and since cash is an asset and assets increase with debits than cash must be debited notes payable increased we owe more money and since notes payable is a liability and liabilities increased with credits then notes payable must be credited the answer to question 3 completes the journal entry cash is debited for $25,000 and notes payable is credited for $25,000 now this three-step process will always work even for complex transactions consider the case where inventory costing $60,000 is sold on account for $75,000 using the three-step process results in the following question 1 what accounts are involved well accounts receivable that’s an asset inventory that’s also an asset cost of goods sold that’s an expense part of owner’s equity and sales revenue a revenue account also part of owner’s equity so we’ve got our four accounts question 2 they be accounts increase or decrease well a couch receivable went up customers owe us more money since accounts receivable is an asset it’s increased with a debit now inventory that decreased we don’t have it anymore since inventory is an asset it’s decreased with a credit now our third account cost a good sold increased that’s an expense causing owner’s equity to go down since owner’s equity decreases with a debit cost of goods sold must be debited our fourth account sales revenue sales revenue increased remember a revenue causes owner’s equity to go up since owner’s equity increases with the credit sales revenue must be credited alright question three by how much did each account change the answer to question three combined with one and two results in the following journal entry now this three question process works every time you just have to be systematic the same three questions asked consistently for every transaction will ensure that debits always equal credits and as a result the accounting equation will always balance once transactions have been analyzed and recorded in a journal it’s necessary to classify and group all similar items this is accomplished by the bookkeeping procedure of posting all the journal entries to appropriate accounts that simply means that the numbers from the journal entries must be transferred to the individual accounts I should note at this point that computers are very very good at this part of bookkeeping Computers transfer the right numbers to the right accounts and make sure those numbers get put on the proper side of the account the debit side or the credit side as indicated earlier accounts are records of like items they show transaction dates increases and decreases and balances for example all increases and decreases in cash arising from transactions recorded in the journal are accumulated in one account called cash similarly all sales transactions are grouped together in the sales account posting is no more than sorting all journal entry amounts by account and copying those amount to the appropriate account no analysis is needed all the necessary analysis is performed when the transaction is first recorded in the journal all accounts are maintained in an accounting record called the ledger here’s an example of how the first three transactions involving cash in the general journal would be posted to the cash account in the general ledger with arrows depicting the posting procedures observed that a number has been inserted in the posting reference column in both books this number serves as a cross-reference between the general journal and the accounts in the general ledger in the journal it identifies the account to which the journal entry has been posted in the ledger it identifies the page on which the entry appears in the general journal for example the gj1 notation in the cash account for the July 1st entry means that the $2,000 has been posted from page 1 of the general journal as you might imagine these posting references are useful in tracking down mistakes with a computer system the software automatically generates these posting references now you can see that the cash account is constantly updated journal entries are posted the cash account you see here serves the same purpose as the cash column in the spreadsheet that we’ve been reviewing all the transactions related to a specific account are accumulated together now you can see why a spreadsheet would quickly get unwieldy if we had several hundred accounts that would be a very big spreadsheet a particular company will have as many or as few accounts as it needs to provide a reasonable classification for its transactions the list of accounts used by company is known as its chart of accounts the normal order of a chart of accounts begins with assets then liabilities followed by owner’s equity sales and expenses here is one example of some accounts that might appear in a typical company’s chart of accounts for big multinational corporations the chart of accounts could involve thousands of accounts imagine dealing with all those accounts by hand that would be impossible now at the end of the accounting period you review the accounts in the general ledger to determine each accounts balance asset expense and dividend accounts normally have debit balances liability owner’s equity and revenue accounts normally have credit balances in other words the balance is normally on the side that increases the account to illustrate how to determine an account balance consider the following t-account depicting all the cash transaction from our landscaping business we’ve added dates the beginning cash account balance plus all cash debit entries less total credit entries equals the ending balance in the cash account in this instance the cash balance at the end of the period is two thousand seven hundred and sixty seven dollars cash was increased during the period by four thousand four hundred eighty five dollars and decreased during the period with credits totaling $718 our cash inflows exceeded our cash outflows that certainly is good news you

12 thoughts on “bookkeeping 101, bookkeeping overview, basics, and best practices

Leave a Reply

Your email address will not be published. Required fields are marked *