Bookkeeping: Past and Present

Bookkeeping in the Old Days

Prior to computers and software, the bookkeeping for small businesses usually began by writing entries into journals. Journals were defined as the books of original entry. In order to reduce the amount of writing in a general journal, special journals or daybooks were introduced. The special or specialized journals consisted of a sales journal, purchases journal, cash receipts journal, and cash payments journal.

The company's transactions were written in the journals in date order. Later, the amounts in the journals would be posted to the designated accounts located in the general ledger. Examples of accounts include Sales, Rent Expense, Wages Expense, Cash, Loans Payable, etc. Each account's balance had to be calculated and the account balances were used in the company's financial statements. In addition to the general ledger, a company may have had subsidiary ledgers for accounts such as Accounts Receivable.

Handwriting the many transactions into journals, rewriting the amounts in the accounts, and manually calculating the account balances would likely result in some incorrect amounts. To determine whether errors had occurred, the bookkeeper prepared a trial balance. A trial balance is an internal report that lists 1) each account name, and 2) each account's balance in the appropriate debit column or credit column. If the total of the debit column did not equal the total of the credit column, there was at least one error occurring somewhere between the journal entry and the trial balance. Finding the one or more errors often meant spending hours retracing the entries and postings.

After locating and correcting the errors the bookkeeping phase was completed and the accounting phase began. It began with an accountant preparing adjusting entries so that the accounts reflected the accrual basis of accounting. Adjusting entries were necessary for the following reasons:

• additional revenues and assets may have been earned but were not recorded
• additional expenses and liabilities may have been incurred but were not recorded
• some of the amounts that had been recorded by the bookkeeper may have been prepayments which are no longer prepaid
• depreciation and other non-routine adjustments needed to be computed and recorded

After all of the adjustments were made, the accountant presented the adjusted account balances in the form of financial statements.

After each year's financial statements were completed, closing entries were needed. The purpose of closing entries is to get the balances in all of the income statement accounts (revenues, expenses) to be zero before the start of the new accounting year. The net amount of the income statement account balances would ultimately be transferred to the proprietor's capital account or to the stockholders' retained earnings account.

Bookkeeping Today

The electronic speed of computers and accounting software gives the appearance that many of the bookkeeping and accounting tasks have been eliminated or are occurring simultaneously. For example, the preparation of a sales invoice will automatically update the relevant general ledger accounts (Sales, Accounts Receivable, Inventory, Cost of Goods Sold), update the customer's detailed information, and store the information for the financial statements as well as other reports.

The accounting software has been written so that every transaction must have the debit amounts equal to the credit amounts. The electronic accuracy also eliminates the errors that had occurred when amounts were manually written, rewritten and calculated. As a result, the debits will always equal the credits and the trial balance will always be in balance. No longer will hours be spent looking for errors that occurred in a manual system.

CAUTION:
While the accounting software is amazingly fast and accurate in processing the information that is entered, the software is unable to detect whether some transactions have been omitted, have been entered twice, or if incorrect accounts were used. Fraudulent transactions and amounts could also be entered if a company fails to have internal controls.

After the sales invoices, vendor invoices, payroll and other transactions have been processed for each accounting period, some adjusting entries are still required. The adjusting entries will involve:

• revenues and assets that were earned, but not yet entered into the software
• expenses and liabilities that were incurred, but not yet entered into the software
• prepayments that are no longer prepaid
• recording depreciation expense, bad debts expense, etc.

The adjusting entries will require a person to determine the amounts and the accounts. Without adjusting entries the accounting software will be producing incomplete, inaccurate, and perhaps misleading financial statements.

After the financial statements for the year are released, the software will transfer the balances from the income statement accounts to the sole proprietor's capital account or to the stockholders' retained earnings account. This allows for the following year's income statement accounts to begin with zero balances. (The balance sheet accounts are not closed as their balances are carried forward to the next accounting year.)

Recording Transactions

Bookkeeping (and accounting) involves the recording of a company's financial transactions. The transactions will have to be identified, approved, sorted and stored in a manner so they can be retrieved and presented in the company's financial statements and other reports.

Here are a few examples of some of a company's financial transactions:

• The purchase of supplies with cash.
• The purchase of merchandise on credit.
• The sale of merchandise on credit.
• Rent for the business office.
• Salaries and wages earned by employees.
• Buying equipment for the office.
• Borrowing money from a bank.

The transactions will be sorted into perhaps hundreds of accounts including Cash, Accounts Receivable, Loans Payable, Accounts Payable, Sales, Rent Expense, Salaries Expense, Wages Expense Dept 1, Wages Expense Dept 2, etc. The amounts in each of the accounts will be reported on the company's financial statements in detail or in summary form.

With hundreds of accounts and perhaps thousands of transactions, it is clear that once a person learns the accounting software there will be efficiencies and better information available for managing a business.

Accrual Method

There are two main methods of accounting (or bookkeeping):

• Accrual method
• Cash method

The accrual method of accounting is the preferred method because it provides:

1. a more complete reporting of the company's assets, liabilities, and stockholders' equity at the end of an accounting period, and
2. a more realistic reporting of a company's revenues, expenses, and net income for a specific time interval such as a month, quarter or year.

As a result, US GAAP requires most corporations to use the accrual method of accounting.

The following table compares the accrual and cash methods of accounting:

Accrual method	Cash method
Receivables are reported as assets when they are earned.	Receivables are not reported as assets.
Revenues are reported when they are earned.	Revenues are reported when cash is received.
Payables are reported as liabilities when they are incurred.	Payables are not reported as liabilities.
Expenses are reported when they best match revenues or when they are used up.	Expenses are reported when cash is paid.
Net income is based on revenues earned and expenses incurred during an accounting period.	Net income is based more on cash receipts and cash disbursements rather than the revenues earned and expenses incurred during the accounting period.
The balance sheet is more complete as far as the reporting of assets, liabilities and the amount of stockholders' equity.	The balance sheet omits certain assets, liabilities. The amount of stockholders' equity will also be affected.
The accrual method is required by generally accepted accounting principles.	The cash method is likely to violate the matching principle in accounting.

NOTE: Some small companies may be allowed to use the cash method of accounting and in turn may experience an income tax benefit. Since our website does not provide income tax information, you should seek tax advice from a tax professional or from IRS.gov.

Revenues and Receivables

Under the accrual method, revenues are to be reported in the accounting period in which they are earned (which may be different from the period in which the money is received).

To illustrate the reporting of revenues under the accrual method, let's assume that the hypothetical business Servco provides a service to a customer on December 27. Servco prepares a sales invoice for the agreed upon amount of $1,000. The invoice is dated December 27 and states that the amount is due in 30 days.

Under the accrual method, on December 27 Servco:

• has earned revenue of $1,000, and
• has earned a receivable of $1,000.

If Servco uses accounting software to prepare the invoice, the following will be recorded automatically as of December 27:

• the income statement account Service Revenues will be increased by $1,000, and
• the asset Accounts Receivable will be increased by $1,000

In addition to updating the general ledger accounts (which are used in preparing the financial statements), the software will update and store the customer's information for generating an aging of accounts receivable and a statement of each customer's activity.

Expenses and Payables

Under the accrual method, expenses should be reported on the income statement in the period in which they best match with the revenues. If a cause and effect relationship is not obvious, the expense should be reported on the income statement when the cost is used up or expires. In any event, the payment of cash is not the primary factor for determining the accounting period in which an expense is reported on the income statement.

To illustrate, let's assume that Servco uses a temporary help agency at a cost of $200 in order to assist in earning revenues on December 27. The invoice from the temp agency is received on December 27, but it will not be paid until January 4.

Under the accrual method, on December 27 Servco:

• has incurred an expense of $200, and
• has incurred a liability of $200.

If accounting software is used to record the temp agency invoice, the following will occur automatically as of December 27:

• the income statement account Temporary Help Expense will be increased by $200, and
• the liability Accounts Payable will be increased by $200.

When Servco issues its check on January 4:

• the asset Cash will be decreased by $200, and
• the liability Accounts Payable will be decreased by $200.

Net Income

If Servco had only the two transactions described above, its net income under the accrual method for the day of December 27 will consist of the following:

• Earned revenue of $1,000
• Incurred an expense of $200
• Earned a net income of $800 ($1,000 of revenues minus $200 of expenses).
  
  [The cash method of accounting would have reported a much different picture:
  
  • No revenue, expense or net income would have been reported on the December income statement.
  • The revenues of $1,000 might be reported in February if the customer paid in 35 days.
  • The expense of $200 will be reported in January when Servco pays the temp agency.]

Obviously, the accrual method does a better job of reporting what occurred on December 27, the date that Servco actually provided the services and incurred the expense.

General Ledger Accounts

The accounts that are used to sort and store transactions are found in the company's general ledger. The general ledger is often arranged according to the following seven classifications. (A few examples of the related account titles are shown in parentheses.)

• Assets (Cash, Accounts Receivable, Land, Equipment)
• Liabilities (Loans Payable, Accounts Payable, Bonds Payable)
• Stockholders' equity (Common Stock, Retained Earnings)
• Operating revenues (Sales, Service Fees)
• Operating expenses  (Salaries Expense, Rent Expense, Depreciation Expense)
• Non-operating revenues and gains (Investment Income, Gain on Disposal of Truck)
• Non-operating expenses and losses  (Interest Expense, Loss on Disposal of Equipment)

Balance Sheet Accounts

The first three classifications are referred to as balance sheet accounts since the balances in these accounts are reported on the financial statement known as the balance sheet.

• Balance sheet accounts
  • Assets
  • Liabilities
  • Stockholders' (or Owner's) equity

The balance sheet accounts are also known as permanent accounts (or real accounts) since the balances in these accounts will not be closed at the end of an accounting year. Instead, these account balances are carried forward to the next accounting year.

Income Statement Accounts

The four remaining classifications of accounts are referred to as income statement accountssince the amounts in these accounts will be reported on the financial statement known as the income statement.

• Income statement accounts
  • Operating revenues
  • Operating expenses
  • Non-operating revenues and gains
  • Non-operating expenses and losses

The income statement accounts are also known as temporary accounts since the balances in these accounts will be closed at the end of the accounting year. Each income statement account is closed in order to begin the next accounting year with a zero balance.

The year-end balances from all of the income statement accounts will be combined and entered as a single net amount in Retained Earnings (a balance sheet account within stockholders' equity) or in a proprietor's capital account.

NOTE: If an account has not had any activity in the current or recent periods, it is often omitted from the current general ledger.

Chart of Accounts

The chart of accounts is simply a list of all of the accounts that are available for recording transactions. This means that the number of accounts in the chart of accounts will be greater than the number of accounts in the general ledger. (The reason is that accounts with zero balances and no recent entries are often omitted from the general ledger until there is a transaction for the account.)

The chart of accounts is organized similar to the general ledger: balance sheet accounts followed by the income statement accounts. However, the chart of accounts does not contain any entries or account balances.

The chart of accounts allows you to find the name of an account, its account number, and perhaps a brief description. It is important to expand and/or alter the chart of accounts to accommodate the changes to an organization and when there is a need for improved reporting of information.

In some accounting software, the chart of accounts is also used to designate where an account will be reported in the financial statements.

Asset Accounts

Asset accounts are one of the three major classifications of balance sheet accounts: 

• Assets
• Liabilities
• Stockholders' equity (or owner's equity)

The ending balances in the balance sheet accounts will be carried forward to the next accounting year. Hence the balance sheet accounts are called permanent accounts or real accounts.

The asset accounts are usually listed first in the company's chart of accounts and in the general ledger. In the general ledger the asset accounts will normally have debit balances.

The balances in some of the asset accounts will be combined and presented as a single amount when the balance sheet is prepared. For example, if a company has ten checking accounts, the balances will be combined and the total amount will be reported on the balance sheet as the asset Cash.

Assets include the things or resources that a company owns, that were acquired in a transaction, and have a future value that can be measured. Assets also include some costs that are prepaid or deferred and will become expenses as the costs are used up over time.

Here are some examples of asset accounts:

• Cash
• Short-term Investments
• Accounts Receivable
• Allowance for Doubtful Accounts (a contra-asset account)
• Accrued Revenues/Receivables
• Prepaid Expenses
• Inventory
• Supplies
• Long-term Investments
• Land
• Buildings
• Equipment
• Vehicles
• Furniture and Fixtures
• Accumulated Depreciation (a contra-asset account)

Descriptions of asset accounts

The following are brief descriptions of some common asset accounts.

Cash
Cash includes currency, coins, checking account balances, petty cash funds, and customers' checks that have not yet been deposited. A company is likely to have a separate general ledger account for each checking account, petty cash fund, etc. but will combine the amounts and will report the total as Cash (or Cash and Cash Equivalents) on the balance sheet.

Short-term Investments
Short-term or temporary investments may include certificates of deposit, bonds, notes, etc. that will mature in less than one year. It may also include investments in the common or preferred stock of another corporation if the stock can be easily sold on a stock exchange.

Accounts Receivable
Accounts receivable is a right to receive an amount as the result of delivering goods or services on credit. Under the accrual method of accounting, Accounts Receivable is debited at the time of a credit sale. Later, when the customer pays the amount owed, the company will credit Accounts Receivable (and will debit Cash).

Allowance for Doubtful Accounts
The Allowance for Doubtful Accounts is a contra-asset account since its balance is intended to be a credit balance (or a zero balance). When the balance in this account is combined with the balance in Accounts Receivable, the resulting amount is known as the net realizable value of the receivables. The Allowance for Doubtful Accounts is used under the allowance method of reporting bad debts expense.

Accrued Revenues/Receivables
Under the accrual method of accounting, revenues are to be reported when goods or services have been delivered even if a sales invoice has not been generated. This account will report the amounts that a company has a right to receive but the sales invoices have yet to be prepared or entered in Accounts Receivable.

Prepaid Expenses
These are future expenses that have already been paid. The amounts appear as assets until the costs have been used up or expire. A common example of a prepaid expense is the payment for vehicle insurance. To illustrate this, let's assume that on December 29, a new company pays $6,000 for the insurance covering its vehicles for the six-month period that will begin on January 1. As of December 31, the entire $6,000 will be a prepaid expense because none of the cost has expired. Since none of the cost expired in December, there is no insurance expense in December. The insurance expense will begin in January at a rate of $1,000 per month. This is depicted in the following chart:

	Dec	Jan	Feb	Mar	Apr	May	June
Payment	$6,000	$   -	$   -	$   -	$   -	$   -	$   -
Expense*	-	1,000	1,000	1,000	1,000	1,000	1,000
Prepaid/asset**	6,000	5,000	4,000	3,000	2,000	1,000	-

*The expense is the amount that is expiring during the month.
**The prepaid amounts are the unexpired amounts and should be the balance in the asset account Prepaid Expenses or Prepaid Insurance at the end of each of the months.

Inventory
Inventory is the cost of goods that have been purchased or manufactured and have not yet been sold.


Supplies
Supplies could be office supplies, manufacturing supplies, packaging supplies or other supplies that are on hand. The cost of the supplies that remain on hand is reported as an asset.

Long-term Investments
This account or asset category will be reported on the balance sheet immediately following current assets. It may include investments in the common stock, preferred stock, and bonds of another corporation. It also includes real estate being held for sale and also the money that is restricted for a long-term purpose such as a building project or the repurchase of bonds payable. The cash surrender value of a life insurance policy owned by a company is also reported under this asset heading.

Land
This account represents the property portion of the balance sheet heading “Property, plant and equipment.” It reports the cost of land used in a business. Since land is assumed to last indefinitely, the cost of land is not depreciated.

Buildings
This account will report the cost of the building used in the business. The cost of buildings will be depreciated over their useful lives.

Equipment
This account reports the cost of the machinery and equipment used in the business. The cost of equipment will be depreciated over the equipment's useful life.

Vehicles
This account reports the cost of trucks, trailers, and automobiles used in the business. The cost of vehicles is to be depreciated over the vehicles' useful lives.

Furniture and Fixtures
This account reports the cost of desks, chairs, shelving, etc. that are used in the business. The cost of furniture and fixtures is to be depreciated over the useful lives.

Accumulated Depreciation
Accumulated Depreciation is known as a contra asset account because it has a credit balance instead of a debit balance that is typical for asset accounts. Whenever Depreciation Expense is debited for the periodic depreciation of the buildings, equipment, vehicles, etc. the account Accumulated Depreciation is credited. The credit balance in Accumulated Depreciation will continue to grow until an asset is sold or scrapped. However, the maximum amount of the credit balance is the cost of the asset(s).

Adjusting Entries

Why adjusting entries are needed

In order for a company’s financial statements to be complete and to reflect the accrual method of accounting, adjusting entries must be processed before the financial statements are issued. Here are three situations that describe why adjusting entries are needed:

Situation 1
Not all of a company’s financial transactions that pertain to an accounting period will have been processed by the accounting software as of the end of the accounting period. For example, the bill for the electricity used during December might not arrive until January 10. (The reason for the 10-day lag is that the electric utility reads the meters on January 1 in order to compute the electricity actually used in December.  Next the utility has to prepare the bill and mail it to the company.)

Situation 2
Sometimes a bill is processed during the accounting period, but the amount represents the expense for one or more future accounting periods. For example, the bill for the insurance on the company’s vehicles might be $6,000 and covers the six-month period of January 1 through June 30. If the company is required to pay the $6,000 in advance at the end of December, the expense needs to be deferred so that $1,000 will appear on each of the monthly income statements for January through June.

Situation 3
Something similar to Situation 2 occurs when a company purchases equipment to be used in the business. Let’s assume that the equipment is acquired, paid for, and put into service on May 1. However, the equipment is expected to be used for ten years. If the cost of the equipment is $120,000 and will have no salvage value, then each month’s income statement needs to report $1,000 for 120 months in order to report depreciation expense under the straight-line method.

These three situations illustrate why adjusting entries need to be entered in the accounting software in order to have accurate financial statements. Unfortunately the accounting software cannot compute the amounts needed for the adjusting entries. A bookkeeper or accountant must review the situations and then determine the amounts needed in each adjusting entry.

Steps for Recording Adjusting Entries

Some of the necessary steps for recording adjusting entries are

• You must identify the two or more accounts involved
  • One of the accounts will be a balance sheet account
  • The other account will be an income statement account
• You must calculate the amounts for the adjusting entries
• You will enter both of the accounts and the adjustment in the general journal
• You must designate which account will be debited and which will be credited.

Types of Adjusting Entries

We will sort the adjusting entries into five categories.

1.	Accrued revenues	Revenues (and the related receivables) have been earned, but the sales invoices have not yet been processed.
2.	Accrued expenses	Expenses (and the related payables) have been incurred, but the vendors’ invoices have not been completely processed.
3.	Deferred revenues	Money was received in advance of having been earned.
4.	Deferred expenses	Money was paid for a future expense.
5.	Depreciation expense	An asset was purchased in one period, but its cost must be allocated to expense in each of the accounting periods of the asset’s useful life.

1. Accrued revenues
Under the accrual method of accounting, a business is to report all of the revenues (and related receivables) that it has earned during an accounting period. A business may have earned fees from having provided services to clients, but the accounting records do not yet contain the revenues or the receivables. If that is the case, an accrual-type adjusting entry must be made in order for the financial statements to report the revenues and the related receivables.

If a business has earned $5,000 of revenues, but they are not recorded as of the end of the accounting period, the accrual-type adjusting entry will be as follows:

Accrued Receivables		5,000
	Service Revenues		5,000

2. Accrued expenses
Under the accrual method of accounting, the financial statements of a business must report all of the expenses (and related payables) that it has incurred during an accounting period. For example, a business needs to report an expense that has occurred even if a supplier’s invoice has not yet been received.

To illustrate, let’s assume that a company utilized a worker from a temporary personnel agency on December 27. The company expects to receive an invoice on January 2 and remit payment on January 9. Since the expense and the payable occurred in December, the company needs to accrue the expense and liability as of December 31 with the following adjusting entry:

Temporary Help Expense		200
	Accrued Liabilities		200

3. Deferred revenues
Under the accrual method of accounting, the amounts received in advance of being earned must be deferred to a liability account until they are earned.

Let’s assume that Servco Company receives $4,000 on December 10 for services it will provide at a later date. Prior to issuing its December financial statements, Servco must determine how much of the $4,000 has been earned as of December 31. The reason is that only the amount that has been earned can be included in December’s revenues. The amount that is not earned as of December 31 must be reported as a liability on the December 31 balance sheet.

If $3,000 has been earned, the Service Revenues account must include $3,000. The remaining $1,000 that has not been earned will be deferred to the following accounting period. The deferral will be evidenced by a credit of $1,000 in a liability account such as Deferred Revenues or Unearned Revenues.

The adjusting entry for this deferral depends on how the receipt of $4,000 was recorded on December 10. If the receipt of $4,000 was recorded with a credit to Service Revenues (and a debit to Cash), the December 31 adjusting entry will be:

Service Revenues		1,000
	Deferred Revenues		1,000

If the entire receipt of $4,000 had been credited to Deferred Revenues on December 10 (along with a debit to Cash), the adjusting entry on December 31 would be:

Deferred Revenues		3,000
	Service Revenues		3,000

4. Deferred expenses
Under the accrual method of accounting, any payments for future expenses must be deferred to an asset account until the expenses are used up or have expired.

To illustrate, let’s assume that a new company pays $6,000 on December 27 for the insurance on its vehicles for the six-month period beginning January 1. For December 27 through 31, the company should have an asset Prepaid Insurance or Prepaid Expenses of $6,000.

In each of the months January through June, the company must reduce the asset account by recording the following adjusting entry:

Insurance Expense		1,000
	Prepaid Insurance		1,000

5. Depreciation expense
Depreciation is associated with fixed assets (or plant assets) that are used in the business. Examples of fixed assets are buildings, machinery, equipment, vehicles, furniture, and other constructed assets used in a business and having a useful life of more than one year. (However, land is not depreciated.)

Depreciation allocates the asset’s cost (minus any expected salvage value) to expense in the accounting periods in which the asset is used. Hence, office equipment with a useful life of 5 years and no salvage value will mean monthly depreciation expense of 1/60 of the equipment’s cost. A building with a useful life of 25 years and no salvage value will result in a monthly depreciation expense of 1/300 of the building’s cost.

Closing Cut-Off

At a minimum of once per year, companies must prepare financial statements. In addition companies often prepare quarterly and monthly financial statements which are referred to as interim financial statements.

For any of the financial statements to be accurate it is necessary to have a proper cut-off. This means including all of a company’s business transactions in the proper accounting period. For example, the electricity bill arriving on January 10 might be the cost of the electricity that was actually used in December. (The time lag resulted from the utility company reading the electric meters and preparing and mailing the bill.) Hence under the accrual method of accounting, the bill received on January 10 needs to be included in December’s expenses and must also be reported by the company as a liability as of December 31. Similarly, the hourly payroll processed during the first few days in January and paid on January 6 is likely to include the cost of employees working during the last few days in December. The cost of the hours worked through December 31 must be included in the company’s December expenses and in the liabilities as of December 31.

As you read the previous paragraph, you may have been reminded of our discussion of adjusting entries. That’s because the adjusting entries are part of each period’s closing process. The adjusting entries are prepared in order to report a company’s revenues and expenses in the proper accounting period.

The closing process
To achieve a proper cut-off and to distribute the financial statements in a timely manner, it is helpful to have a timeline (or PERT chart) that indicates the necessary steps in the closing process. The timeline will indicate what needs to be done and the sequence in which things need to occur. It will also reveal what is preventing the financial statements from being distributed sooner.

In addition, a checklist of the closing tasks should be prepared and distributed to the appropriate employees as to what is required, who is responsible, and the day it is due.

If some journal entries must be written every month, it is helpful to assign journal entry numbers to these standard journal entries or recurring journal entries. For example, a company may designate JE33 (Journal Entry #33) to be the recurring accrual of expenses that have occurred but have not yet been recorded in Accounts Payable as of the end of a month. Perhaps the timeline/checklist will indicate that JE33 must be submitted by the accounts payable clerk six days after each month ends. The company may also have its computer automatically prepare JE34 which is the entry that automatically reverses the previous month’s accrual entry JE33.

Some recurring journal entries will have the same amount each month. For example, a company’s JE10 might be $10,800 every month of the year for the company’s depreciation expense. (Some companies will refer to the entries that have the same amounts and accounts every month as standard entries.)

Another recurring entry may involve the same accounts each month, but the amounts will vary from month to month. For example, a company’s JE03 might be the recurring monthly entry for bad debts expense. The company has determined in advance that the amount of JE03 will be 0.002 of the company’s monthly credit sales. Since the amount of sales is different every month, the amounts on JE03 will be different each month.

Having entry numbers and standard entries should help to make the monthly closings more routine and efficient.