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Accounting System Setup

1.1 Accounting Basics

1.2 Determining a Form of Entity

1.3 Creating a Filing System

1.4 Establishing the Chart of Accounts

1.5 Opening the General Ledger

1.1 Accounting Basics

In this subchapter, we explain the function of accounting and who benefits from the information it provides. We also introduce the building blocks of an accounting system—assets, liabilities, and owner’s equity—and show how transactions affecting these accounts are summarized into key financial statements.

The Functions of Accounting

Accounting has been called the language of business, and rightly so. Every day, companies complete numerous transactions: selling products or services, paying employees, buying supplies, collecting outstanding bills, and so on. Accountants take all this information—the numbers, the documents, the headaches, really—and translate it into a format that provides a pretty good picture of how the business is doing.

The financial reports generated through accounting provide decision-making data for a host of users, including …

Perhaps the most important user, however, is you, the business owner or employee. Accounting provides answers to some of the most basic questions you have about your company.

You can see why it’s in your interest to set up an accounting system that accurately reflects how your business is doing. After all, the better information you have, the better decisions you’ll be able to make and the better your company is likely to do financially.

Accounts

To make sense of all the random financial data a business processes daily, accountants classify like items or transactions into accounts. There are five types of accounts:

Assets, liabilities, and equity are permanent accounts that carry a running balance. Revenues and expenses are activity accounts that are closed out into equity at the end of the period. In this section, we focus on permanent accounts. We cover revenue and expenses in the next subchapter.

SEE ALSO 11.5, “Opening New Books”

The Accounting Equation

Your company’s assets are the things it owns—the equipment, the cash in the bank, the products it’s selling. Liabilities, on the other hand, are monies owed—to the employees who assemble your product or the bank that helped finance your manufacturing plant. Owner’s equity is what’s left over of your investment after debt is taken into account.

Accounting gets a bad rap for being difficult to understand, but its basic premise is really quite simple:

What you own (minus What you owe) = Your investment in the company

Or in accounting terms:

Assets (minus Liabilities) = Equity

To put it in more concrete terms: if Sam Smith deposits $5,000 in a business bank account to open Sam’s Car Repair:

Sam’s assets ($5,000) = Sam’s equity ($5,000)

This formula is known as the accounting equation and is at the root of the double entry system. One of the basic tenets of accounting is that every transaction has two sides, and that a change in one account affects another. Investing in a business increases its cash on the one hand and the owner’s investment on the other.

The accounting equation is often shown this way:

Assets = Liabilities + Equity

To continue with our previous example, if Sam Smith purchased $5,000 worth of equipment on account for his repair shop:

Sam’s assets = Sam’s liabilities + Sam’s equity

$10,000 ($5,000 cash + $5,000 equipment) = $5,000 + $5,000

The balance sheet is derived from the accounting equation. No matter how many accounts are added or how many transactions take place, the asset side must always “balance” the liabilities and equity.

Financial Statements

The primary method of communicating business results is through financial statements. Indeed, a chance encounter with a complex-looking page of num-
bers might have been what initially drove you to pick up this book. Here we offer a quick review of the basic reports—the balance sheet and the income statement—and what each can tell you.

SEE ALSO 13.1, “Analysis Methods”

SEE ALSO 13.2, “Assessing Profitability”

SEE ALSO 13.3, “Determining Ability to Pay Debt”

SEE ALSO 13.4, “Measuring Liquidity”

The Balance Sheet

The balance sheet is a report that shows the financial position of a company at a given point in time. One quick glance reveals quite a bit about what the company has (assets) and what it owes (liabilities) with the difference representing net worth or owner’s equity. A deeper analysis of a balance sheet’s numbers can tell a seasoned investor or manager much more.

SEE ALSO Chapter 13, “Analyzing Financial Results”

The following example shows a balance sheet for Every Day Adventure Company. The firm markets survival training courses and equipment to corporations. Every Day’s accountant has prepared this balance sheet as part of the company’s year-end financial statements. Note that assets, liabilities, and owner’s equity are put in separate sections, with current (or short-term) assets and liabilities listed first.

SEE ALSO 1.4, “Establishing the Chart of Accounts”

The Income Statement

The income statement, also called a profit and loss statement, or P&L statement, reports revenues and expenses of a business for a certain period of time, usually a month or year. If revenues exceed expenses, it shows a profit; if expenses exceed revenues, it is said to post a loss. Expenses on the income statement of a company that sells a product will include cost of goods sold.

Take a look at the following income statement for Every Day Adventure Company. Note that net income is derived by subtracting the cost of goods sold from sales less operating expenses, interest, and taxes.

SEE ALSO 5.1, “Accounting for Inventory”

SEE ALSO 5.5, “Cost of Goods Sold”

SEE ALSO 9.1, “Time Value Basics”

SEE ALSO 12.4, “Income Taxes”

SEE ALSO 14.4, “The Operating Expenses Budget”

The Statement of Cash Flow

The third key financial statement is the statement of cash flow, or the cash flow statement. This tells you about a company’s cash position; about cash received and payments made in the course of doing business for loans and investments; and about its ability to meet future financial obligations.

SEE ALSO 11.4, “Generating Financial Statements”

The cash flow statement is prepared after the balance sheet and income statement, because some figures on these reports are necessary to determine cash flow. Following is the year-end cash flow statement for Every Day Adventure Company.

The Rules of Accounting

When setting up accounts and preparing financial statements, accountants must follow certain rules. These Generally Accepted Accounting Principles (GAAP) are updated from time to time, but some basic assumptions about how accounting is done never change:

Internal Controls

GAAP requires that financial statements be stated fairly. One means to help achieve this is by having adequate internal controls.

Internal controls are important no matter how big or small the organization. Internal controls basically fall into these categories:

Physical, mechanical, or technological internal controls keep assets protected from theft or misappropriation. This category contains things like storing money in a safe, using timecards, or requiring computer passwords to access certain systems.

Establishing responsibility. Assigning certain duties to certain individuals creates accountability over processing transactions. An example would be making sure only the petty cash custodian makes disbursements from the fund.

Segregating duties means no one individual has too much access to or control over any one asset. For example, the individuals responsible for keeping track of inventory shouldn’t also handle purchases and shipments, the rationale being it would be easier for this person to cover up any errors or irregularities.

Independent verification establishes that each employee’s computations and work are checked by another employee. For example, a manager verifies cash collected with the cash register tape.

Good documentation procedures ensure that all transactions can be accounted for. These include controls like prenumbered invoices and forwarding documents to the accounting department.

We cover specific internal control procedures for various assets in later chapters.

SEE ALSO 3.1, “Classifying Cash”

SEE ALSO 4.3, “Accounts Receivable”

SEE ALSO 5.1, “Accounting for Inventory”

SEE ALSO 7.1, “Property, Plant, and Equipment”

1.2 Determining a Form of Entity

Before you set up any accounting system, you need to decide what kind of business you are or are going to be. That classification will determine the way your chart of accounts, books, and files should be organized. You can choose among a number of legally recognized structures, or forms of entity, to operate your business depending on your risk tolerance and desired tax situation. The most common forms include these:

To determine the right one for you, you need to weigh your desire for simplicity and ease of operation against the importance of being protected from liability.

Sole Proprietorships

Going into business as a sole proprietor is the simplest way to operate a business. It eliminates the need to pay yourself a fixed salary, but you can still withdraw cash as needed as a capital withdrawal, which is tax-free. As owner, you’ll report profit or loss from the business on your own federal income tax return (on Schedule C) without regard to cash withdrawals during the year.

The drawbacks? The assets of the business, as well as everything else you own, are not protected in the event of a successful judgment against the business. It’s as if you and the business are one in the court’s eyes. Even your personal property is fair game if your company runs into trouble.

Partnerships

A partnership requires two or more owners. It operates much like a proprietorship, except that decisions such as opening a bank account, for example, must be approved by all the partners. As a partner, you’re also entitled to draw on the capital account as needed. You also report profit or loss on your federal income tax return Schedule E (cash withdrawals not included).

A con: as is the case with a sole proprietor, personal assets as well as business assets are unprotected in the event of any lawsuits or judgments against the business.

Limited Liability Companies

Limited liability companies (LLCs) are entities created by state law that may operate as a partnership, but without the personal liability issues. So that means successful judgments against the business are limited to the assets of the business. You’re not included.

LLCs have drawing accounts—distributions may be made to owners, and there’s no requirement that they be based on your share of the business. Profits or losses pass through to shareholders and are treated the same way as with partnerships.

C Corporations

A C corporation is a separate taxable entity that limits liability to the business’s assets. (C refers to the tax code section that pertains to this particular entity.) Owners are required to be on the payroll just like any other employee, so there are no drawing accounts. C corporations pay taxes on their own net income. Owners pay taxes on their salaries.

S Corporations

An S Corporation is also a pass-through entity that limits the liability to the assets of the business. (S refers to part of the applicable tax code.) The net income or losses are passed through to the shareholders’ individual income tax returns. Owners are salaried employees, as with C corporations. S corporations are limited to 100 shareholders and follow strict election rules.

Because of the many legal and tax ramifications involved with forming an entity, it’s worth consulting an expert on this one. If you have any questions, an attorney or CPA can thoroughly explain the particular business attributes of each form of entity.

1.3 Creating a Filing System

When you know what your business is going to be and you’ve found your location, you’re ready to organize your office. That means ordering appropriate accounting documents and setting up your files. For the purposes of this book, our initial explanations will assume you’re using a manual bookkeeping system. Although current accounting software is inexpensive, easy to use, and saves time, it never hurts to understand the basics, and your knowledge of a manual system will come in handy in selecting the right software and using it properly. Because more and more business people are choosing to automate, however, we have included descriptions in this edition of how a computerized system would handle certain transactions and processes. We also address computer software and online accounting programs in more detail later in the book.

SEE ALSO Chapter 15, “Computerized Accounting”

Accounting Documents

Here are the basic documents you should have in your accounting kit:

You can order accounting documents through a supply store, or in the case of checks and deposit slips, from your bank. You won’t need to order shipping or receiving documents. The bill of lading that comes with a shipment, or the invoice you fill out with your shipper, serves as your documentation.

In computerized systems, many of these documents will be automatically generated when a transaction occurs. Sequentially numbered sales invoices, for example, will be produced when a sale is recorded. Similarly, checks can be generated when a payment is due.

Setting Up Your Filing System

Let’s deal with paper files first. You can set up computer files as well for convenience, but you’ll still want to keep the hardcopy documentation. The IRS requires documentation going back at least 3 years for most business transactions. If you do your accounting via computer, a record of all of your transactions will be kept in the system and will be readily accessible in the event you get audited or want to review something. Obviously, you’ll need to be sure to back up your system regularly.

Customer Files

For starters, you’ll need a file folder for each customer, in which you’ll store paid invoices for that customer, as well as any pertinent customer data. This could include credit reports, terms, purchasing history, shipping specifications, etc.

You’ll also want to create an unpaid invoices file which will contain all customers’ invoices that have not been paid. Here is where you’ll put bills that have not yet come due as you receive them. Check these files periodically to determine whether customers are up-to-date on their payments and to ensure nothing falls through the cracks. At any given time, the total of all the unpaid invoices in the file will add up to your company’s accounts receivable.

Vendor Files

Set up a file folder for each vendor, in which you store paid invoices for that vendor, as well as details, terms, etc. In addition to individual files for each vendor, you’ll also want to set up your unpaid file by due date. This means creating separate file folders for each day of the month, containing invoices due to be paid that day. That way, you’ll have all the bills due on a particular date at your fingertips. To be sure you capture any discounts, file bills by the earlier date.

1.4 Establishing the Chart of Accounts

The chart of accounts is your road map. Here’s where you take stock of what you have and the kind of business you expect to do and decide for which accounts you’ll need to classify your transactions. In this subchapter, you learn more about revenue and expense accounts, as well as how to develop your own chart of accounts.

Balance Sheet Accounts

Balance sheet accounts include all asset, liability, and equity accounts. This means everything from the cash you have in the bank and inventory on hand to amounts you owe creditors and employees. In addition, this section includes accounts to record any investments you made in the company or monies withdrawn for personal use.

Determining Assets

Assets are the things you own. Typically, assets are divided into two categories:

Current assets are those you expect to either use, sell, or convert to cash within a year at the most. Accounts receivable that you’re owed from customers is an example of a current asset. A prepayment for something such as rent or insurance is also a current asset. Noncurrent assets are those you expect to have for more than a year. Land, building, and any property you need to do your business would qualify, as would intangible assets, like a brand name.

Determining Liabilities

Like assets, liabilities can also be qualified as current and long-term. Current liabilities are those debts you expect to pay within the year, such as accounts payable, which is money you owe to creditors for purchases on account. Employee salaries are another common current liability.

SEE ALSO 6.1, “Accounts Payable”

SEE ALSO 8.5, “Recording Payroll”

Long-term notes payable and mortgage debt are examples of long-term liability. You will be making payments on these loans for a number of years.

Calculating Equity

Equity can include everything from a sole proprietor’s investment and withdrawals from the business to different classes of stock sold on a public exchange. For sole proprietorships and partnerships, equity is typically divided into three accounts:

For corporations, the equity includes different classes of stock and profit and loss (or retained earnings accounts). But corporations do not have drawing accounts.

Revenue and Expense Accounts

Revenue and expense accounts are temporary accounts set up to track business activity on a yearly basis. At the end of the year, they are closed into retained earnings (also called profit and loss account) on the balance sheet, so they have a zero balance at the start of the next period. Like asset and liabilities, revenue and expense accounts are denoted by a separate series of numbers in the chart of accounts. Sales accounts are 300 series. Expenses are 400s.

Sales Accounts

Sales and income accounts represent proceeds from sales of goods or services. They can also be called revenue accounts. Accounts holding interest income, such as from a short-term loan to an employee or a payment extension to a customer, also fall into this category.

Expense Accounts

These accounts record your costs of doing business. They include fixed charges you must regularly pay out, like employee salaries and utilities, and other more variable charges like fees for advertising or supplies. The purchases account would go here as well. Also included in this category are noncash expenses such as depreciation.

SEE ALSO 7.2, “Depreciation”

A Sample Chart of Accounts

The following sample chart of accounts would be suitable for most small businesses. Some companies have fewer accounts than this; others have more. It depends on the business, the size, and the type of industry. A service company, for example, might have very little inventory (manuals to sell to customers, perhaps) or none at all. You could add other account categories as needed.

Numbering can vary. In this case, we’ve broken down the accounts as follows:

Assets	100s
Liabilities	200 to 289
Equity	290 to 299
Sales	300s
Expenses	400s and 500s

Computerized systems, however, typically use four- to seven-digit account numbers, so if you used QuickBooks, for example, cash in bank might be A/C #1010. We’ve included a sample Chart of Accounts for an automated system in Chapter 15, as it may be beneficial to see the difference. In the end, how you choose to number your accounts matters little as long as you’re consistent and know your own system. No matter how it’s set up, any organization benefits from having a chart of accounts customized to their business. In our example, we’ve also included a brief definition and chapter references where you can find more detail on particular accounts.

SEE ALSO 15.5, “Customizing and Using Your Software”

*Write-off of asset over useful life.

1.5 Opening the General Ledger

When you’ve developed your chart of accounts, you’re ready to set up your general ledger. This is where you keep a record of all activity and changes in your accounts. It’s also the book you’ll use as the basis for generating your financial statements. In this subchapter, we show you how to set up your general ledger and post the opening amounts for individual accounts.

General Ledger Setup

The general ledger is set up in the same order as the chart of accounts. Each account is given its own number and page, where you can record transactions and summaries of transactions from the various journals. In this way, the general ledger enables you to keep a running total of each account’s balance.

SEE ALSO 2.4, “Recording in Journals”

The ledger’s pages list the account name on a line across the top and show the account’s increases and decreases on separate sides of a chart. For this reason, they’re called T accounts—the horizontal and vertical line form a T. A simple version looks like this:

Any amounts posted on the left side of the T-line are considered debits to the account. Amounts on the right side are credits. Each line item represents a separate journal entry and should be dated and referenced to the source journal. In some cases, when setting up the ledger or carrying forward an opening balance, only a date is necessary. Debit and credits are discussed in more detail when we discuss recording transactions.

SEE ALSO 2.3, “Analyzing Transactions”

The following example shows how you would open a general ledger. If we were starting with an actual company, the opening amounts would be drawn from supporting documentation and journals. Here we’re using the 12/31 balances for Every Day Adventure Company as opening balances for the next period beginning 1/1. Some accounts on Every Day’s books currently carry zero balances, but that will change as monthly transactions are recorded, so we still need to create the ledger page. Most companies use a modified version of the T-account. Here is a common format, which includes labeled columns for the date, reference, debits, credits, and balance. The posting reference refers to the journal where the posting originated.

SEE ALSO 2.4, “Recording in Journals”

EVERY DAY ADVENTURE COMPANY
GENERAL LEDGER

Assets

Liabilities

Owner’s Equity

The complete general ledger for Every Day Adventure Company would continue with accounts for revenue and expenses, but because these have zero balances at the beginning of the period, we have not included them here.

SEE ALSO 2.5, “Posting to the General Ledger”

SEE ALSO 10.2, “Closing Cash Journals”

SEE ALSO 10.3, “Closing Employee Accounts”

A Sample General Ledger Page

As transactions occur, accountants enter them first to a journal and then post the monthly totals to the general ledger. By the end of the period, a general ledger page for a cash account might appear as follows:

Note that each posting is given a reference to the journal where it originated. The balance need not be computed after each entry. The end of the period is fine.

In this instance we have computed the balance after each entry to illustrate the effect of each addition or subtraction from the account. A computerized system would include updated balances as well. However, if you are familiar with the mathematics of debits and credits, running a balance at the end of the period is fine.

SEE ALSO 2.4, “Recording in Journals”