Getting to the end of the period

Although the means and specific procedures regarding how the bookkeeping process is carried out vary from business to business, all businesses walk through the following steps during the accounting period. These basic four steps take up most of the time spent on recordkeeping.

1. Prepare original source documents or electronic references for all transactions, operations, and other events of the business.

   When buying products, a business gets a purchase invoice (or its electronic equivalent) from the supplier. When borrowing money from the bank, a business signs a note payable, a copy of which the business keeps. When a customer uses a credit card to buy a retailer’s product, the business gets the credit card slip (or an electronic alternative) as evidence of the transaction. When preparing payroll checks, a business depends on salary rosters and time cards. All these key business forms serve as sources of information for the bookkeeping system — in other words, information the bookkeeper uses in recording the financial effects of the activities of the business.

2. Determine the financial effects of the transactions, operations, and other events of the business.

   The activities of the business have financial effects that must be recorded: The business is better off, worse off, or at least “different off” as the result of its transactions. Examples of typical business transactions include paying employees, making sales to customers, borrowing money from the bank, and buying products that will be sold to customers. The bookkeeping process begins by determining the relevant information about each transaction. The chief accountant (controller) of the business establishes the rules and methods for measuring the financial effects of transactions. Of course, the bookkeeper should comply with these rules and methods.

3. Make original entries of financial effects in journals, with appropriate references to source documents.

   Using source documents or electronic files, the bookkeeper makes the first, or original, entry for every transaction into a journal; this information is later recorded in accounts (see the next step). A journal is a chronological record of transactions in the order in which they occur — like a very detailed personal diary.

   Here’s a simple example that illustrates recording a transaction in a journal: A retail bookstore, expecting a big demand from its customers, purchases, on credit, 100 copies of Accounting For Dummies, 6th Edition, from the publisher, Wiley. The books are received and placed on the shelves. (One hundred copies is a lot to put on the shelves, but my relatives promised to rush down and buy several copies each.) The bookstore now owns the books and also owes Wiley $1,500, which is the cost of the 100 copies. Here we look only at recording the purchase of the books, not recording subsequent sales of the books and paying the bill to Wiley.

   The bookstore has established a specific inventory asset account called “Inventory–Trade Paperbacks” for books like this one. And the purchase liability to the publisher should be entered in the account “Accounts Payable–Publishers.” Therefore, the original journal entry for this purchase records an increase in the inventory asset account of $1,500 and an increase in the liability accounts payable of $1,500. Notice the balance in the two sides of the transaction: An asset increases $1,500 on the one side, and a liability increases $1,500 on the other side. All is well (assuming there are no mistakes).

   In ancient days, bookkeepers had to record journal entries by hand, and even today there’s nothing wrong with a good hand-entry (manual) bookkeeping system. But bookkeepers now can use computer programs that take over many of the tedious chores of bookkeeping (see the last section in this chapter, “Using Accounting Software in the Cloud and on the Ground”). Unfortunately, so much keyboard typing has replaced hand cramps with carpal tunnel syndrome for some bookkeepers, but at least the work gets done more quickly and with fewer errors!

   Summing up, a journal entry records the whole transaction in one place at one time. All changes caused by the transaction are chronicled in one entry. However, making journal entries does not provide a running balance for the individual assets, liabilities, and other financial components of a business (or other entity) — which leads to the next step in the bookkeeping process.

4. Post the financial effects of transactions in the accounts changed by the transactions.

   Journal entries are the sources for recording changes caused by transactions in the accounts of the entity. An account is a separate record or file for each asset, each liability, and so on. The pluses and minuses of the transaction are recorded in the accounts changed by the transaction. In this way a running balance is kept for each. Recording the effects of transactions from journal entries to accounts is called posting.

   Think of each account as an address. The changes recorded in the original journal entries are “delivered,” or posted to the accounts. A business (or other entity) establishes an official chart, or list of accounts, that is used for posting transactions. The original journal entry records the whole transaction in one place; then, in the second step called posting, each change is recorded in the separate accounts affected by the transaction.

   I can’t exaggerate the importance of entering transaction data correctly and in a timely manner — both in original journal entries and in the posting step. The prevalence of data-entry errors is one important reason that most retailers use cash registers that read bar-coded information on products; this approach more accurately captures the necessary information and speeds up the entry of the information. One way of stressing this point is the well-known data processing expression “garbage in, garbage out.”

Finishing up for the period

After doing the four bookkeeping procedures I explain in the preceding section, the business is ready to finish the process. At the end of the period, certain steps are necessary to make the business’s accounts ready for the preparation of its financial statements (and other accounting reports such as tax returns). I continue the numbering from the preceding section, so I start with Step 5:

5. Perform end-of-period procedures — the critical steps for getting the accounting records up-to-date and ready for the preparation of management accounting reports, tax returns, and financial statements.

   A period is a stretch of time — from one day (even one hour) to one month to one quarter (three months) to one year — that is determined by the needs of the business. A year is the longest period of time that a business would wait to prepare its financial statements. Most businesses need accounting reports and financial statements at the end of each quarter, and many need monthly financial statements.

   Before accounting reports can be prepared at the end of the period, the bookkeeper needs to bring the accounts of the business up-to-date and to complete the bookkeeping process. Generally these end-of-period procedures consist mainly of making adjusting entries in the accounts of the business. One such end-of-period adjusting entry, for example, is recording depreciation expense for the period (see Chapters 5 and 6 for more on depreciation). Another is taking an actual count and making a critical inspection of the business’s inventory so that the inventory records can be adjusted to recognize any shoplifting, employee theft, and other inventory shrinkage.

   The accountant needs to be heavily involved in end-of-period procedures and be sure to check for errors in the business’s accounts. Data-entry clerks and bookkeepers may not fully understand the unusual nature of some business transactions and may have entered transactions incorrectly. One reason for establishing internal controls (discussed in “Enforce strong internal controls,” later in this chapter) is to keep errors to a minimum. Ideally, accounts should contain very few errors at the end of the period, but the accountant can’t make any assumptions and should make a final check for any errors that may have fallen through the cracks.

6. Compile the adjusted trial balance, which is the accountant’s basis for preparing management reports, tax returns, and financial statements.

   After all the end-of-period procedures have been completed, the bookkeeper compiles a comprehensive listing of all accounts, which is called the adjusted trial balance. Modest-sized businesses maintain hundreds of accounts for their various assets, liabilities, owners’ equity, revenue, and expenses. Larger businesses keep thousands of accounts, and very large businesses may keep more than 10,000 accounts.

   In contrast, external financial statements and tax returns contain a relatively small number of accounts. For example, a typical external balance sheet reports only 25 to 30 accounts (maybe even fewer). Apple’s condensed September 26, 2015 end-of-fiscal year balance sheet contains just 24 accounts. (Apple’s 2015 10-K annual report to the Securities and Exchange Commission includes more accounts.) The annual income tax return (Form 1120) for business corporations contains a relatively small number of accounts.

   The accountant takes the adjusted trial balance and telescopes similar accounts into one summary amount that is reported in a financial report or tax return. For example, a business may keep hundreds of separate inventory accounts, every one of which is listed in the adjusted trial balance. The accountant collapses all these accounts into one summary inventory account that’s presented in the balance sheet of the business. In grouping the accounts, the accountant should comply with established financial reporting standards and income tax requirements.

7. Close the books — bring the bookkeeping for the fiscal year just ended to a close and get things ready to begin the bookkeeping process all over again for the coming fiscal year.

   Books is the common term for a business’s complete set of accounts. (Well, okay, we should include journal entries in the definition of books, but you get the point.) A business’s transactions are a constant stream of activities that doesn’t end tidily on the last day of the year, which can make preparing financial statements and tax returns challenging. The business has to draw a clear line of demarcation between activities for the year (the 12-month accounting period) ended and the year yet to come by closing the books for one year and starting with fresh books for the next year.

Most medium-size and larger businesses prepare an internal accounting manual that spells out in great detail the specific accounts and procedures for recording transactions. A business should regularly review its chart of accounts and accounting rules and policies and make revisions. Companies do not take this task lightly; discontinuities in the accounting system can be major shocks and have to be carefully thought out. Nevertheless, bookkeeping and accounting systems can’t remain static for very long. If these systems were never changed, bookkeepers would still be sitting on high stools making entries with quill pens and bottled ink in leather-bound ledgers.

Categorizing financial information: The chart of accounts

Suppose that you’re the accountant for a corporation and you’re faced with the daunting task of preparing the annual federal income tax return for the business. The Internal Revenue Service (IRS) requires that you report the following expenses (and this list contains just the minimum!):

• Advertising
• Bad debts
• Charitable contributions
• Compensation of officers
• Cost of goods sold
• Depreciation
• Employee benefit programs
• Interest
• Pensions and profit-sharing plans
• Rents
• Repairs and maintenance
• Salaries and wages
• Taxes and licenses

You must provide additional information for some of these expenses. For example, the cost of goods sold expense is determined in a schedule that also requires inventory cost at the beginning of the year, purchases during the year, cost of labor during the year (for manufacturers), other costs, and inventory cost at year-end.

Where do you start? Well, if it’s March 1 and the corporate tax return deadline is March 15, you start by panicking — unless you were smart enough to think ahead about the kinds of information your business would need to report. In fact, when your accountant first designs your business’s accounting system, he or she should dissect every report to managers, the external financial statements, and the tax returns, breaking down all the information into basic account categories such as those I just listed.

For each category of information that you need to include in an accounting report, you need an account (or a group of accounts), which is a record of the activities in that category. An account is basically a focused history of a particular dimension of a business. Individuals can have accounts, too — for example, your checkbook is an account of the cash inflows and outflows and the balance of your checking account (assuming that you remember to record all activities and reconcile your checkbook against your bank statement). I doubt that you keep a written account of the coin and currency in your wallet, pockets, glove compartment, and sofa cushions, but a business needs to keep track of all its cash, no matter where it is. An account serves as the source of information for preparing financial statements, tax returns, and reports to managers.

The term general ledger refers to the complete set of accounts established and maintained by a business. The chart of accounts is the formal index of these accounts — the complete listing and classification of the accounts used by the business to record its transactions. General ledger usually refers to the actual accounts and often to the balances in those accounts at some particular time. The chart of accounts, even for a relatively small business, contains more than 100 accounts. Larger business organizations need thousands of accounts. The larger the number, the more likely that the accounts are given number codes according to some scheme — for example, all assets may be in the 100 to 300 range; all liabilities, in the 400 to 500 range; and so on.

As a business manager, you should make sure that the controller (chief accountant) or perhaps an outside CPA consultant reviews the chart of accounts periodically to determine whether the accounts are up-to-date and adequate for the business’s needs. Over time, income tax rules change, the company goes into new lines of business, the company adopts new employee benefit plans, and so on. Most businesses are in constant flux, and the chart of accounts has to keep up with these changes.

Standardize source documents and data entry procedures for recording activities

Just like you need a constant circulation of blood to live, businesses need a constant flow of paperwork and electronic activity. Even in this age of the Internet, electronic communication, and computers, a business generates and depends on a lot of paperwork. And much of this paperwork is used in the accounting process. Placing an order to buy products, selling a product to a customer, determining the earnings of an employee for the month — virtually every business transaction needs some paperwork, generally called source documents. When you pay a bill, for example, don’t you want a “hard copy” to examine before you write the check?

Source documents serve as legal evidence of the terms and conditions agreed upon by the business and the other person or organization that it’s dealing with. Both parties receive some kind of source document. For example, for a sale at a cash register, the customer gets a sales receipt, and the business keeps a running record of all the transactions in the register, which can be printed out later if need be.

Clearly, an accounting system needs to standardize the forms and procedures for processing and recording all normal, repetitive transactions and should control the generation and handling of these source documents. From the bookkeeping point of view, these business forms and documents are important because they provide the input information needed for recording transactions in the business’s accounts. Sloppy paperwork leads to sloppy accounting records, and sloppy accounting records just won’t do when the time comes to prepare tax returns and financial statements.

If you’re the owner of a small business, you may want to check out an office supply store to see the kinds of forms that you can buy right off the shelf. You can find many of the basic forms and documents that you need for executing and recording business transactions. Also, computer accounting software packages today include templates for most business forms and source documents needed by a business.

Hire competent personnel

A business shouldn’t be penny-wise and pound-foolish. What good is meticulously collecting source documents if the information on those documents isn’t entered into your system correctly? You shouldn’t try to save a few bucks by hiring the lowest-paid people you can find. Bookkeepers and accountants, like all other employees in a business, should have the skills and knowledge needed to perform their functions. Here are some guidelines for choosing the right people to enter and control the flow of your business’s data and for making sure that those people remain the right people:

• College degree: Many accountants in business organizations have a college degree with a major in accounting. However, as you move down the accounting department, you find that more and more employees do not have a college degree and perhaps don’t even have any courses in accounting — they learned bookkeeping methods and skills through on-the-job training. Although these employees may have good skills and instincts, my experience has been that they tend to do things by the book, so you want to at least think twice about a potential employee who has no college-based accounting background.

• Professional credentials: When hiring higher-level accountants in a business organization, you want to determine whether they should be certified public accountants (CPAs). Larger businesses insist on this credential, along with a specific number of years’ experience in public accounting.

  Until recently, the only other main professional accounting credential was the CMA, or certified management accountant, sponsored by the Institute of Management Accountants (IMA). The CMA credential is American born and bred. In contrast, the Chartered Global Management Accountant (CGMA) designation is co-sponsored by the American Institute of CPAs and the British Chartered Institute of Management Accountants. Unlike the CPA license, the CMA and CGMA designations recognize professional achievement and experience, but the government doesn’t regulate these credentials. (I discuss the CPA and CGMA in Chapter 1.)

  Note: For bookkeepers, the American Institute of Professional Bookkeepers sponsors the Certified Bookkeeper designation. For more information, go to www.AIPB.org.

  In my opinion, a business is prudent to require the CPA, CGMA, or CMA credential for its chief accountant (who usually holds the title of controller). Alternatively, a business could regularly consult with a CPA in public practice for advice on its accounting system and on accounting problems that come up.

  More and more, businesses are turning to experts in recognizing fraud, embezzlement, and cybercrime for advice and to investigate suspicious situations. Even relatively small businesses are vulnerable to these threats. One mark of expertise that you could look for is the Certified in Financial Forensics (CFF) credential sponsored by the American Institute of Certified Public Accountants (AICPA).

• Continuing education: Bookkeepers and accountants need continuing education to keep up with changes in the income tax law and financial reporting requirements as well as changes in how the business operates. Ideally, bookkeepers and accountants should be able to spot needed improvements and implement these changes in order to make accounting reports to managers more useful. Fortunately, many short-term courses, online programs, and the like are available at very reasonable costs for keeping up on the latest accounting developments. Many continuing education courses are available on the Internet, but you should be cautious and check out the standards of an Internet course. States require that CPAs in public practice take 30 to 40 hours per year of continuing education to keep their licenses.
• Integrity: Possibly the most important quality to look for is also the hardest to judge. Bookkeepers and accountants need to be honest people because of the control they have over your business’s financial records. Conduct a careful background check when hiring new accounting personnel. After you hire them, periodically (and discreetly) check whether their lifestyles match their salaries, but be careful not to invade their privacy. Small-business owners and managers have closer day-in and day-out contact with their accountants and bookkeepers, which can be a real advantage — they get to know their accountants and bookkeepers on a personal level. Even so, I could tell you many true stories about long-time, “trusted” bookkeepers who made off with some of the family fortune.

Get involved in end-of-period procedures

Suppose that all transactions during the year have been recorded correctly. Therefore, the business is ready to prepare its financial statements from those accounts, isn’t it? Not so fast! As I explain earlier in “Finishing up for the period” (see Step 5), certain additional procedures are necessary at the end of the period to make sure that the accounts are correct and complete for preparing financial statements and income tax returns for the year. Two main things have to be done at the end of the period:

• Record normal, routine adjusting entries. For example, depreciation expense isn’t a transaction as such and therefore isn’t included in the flow of transactions recorded in the day-to-day bookkeeping process. (Chapter 5 explains depreciation expense.) Similarly, certain other expenses and income may not have been associated with a specific transaction and therefore haven’t been recorded. In many businesses, there’s a normal lag in recording certain transactions, such as billing customers for services already provided. These “catch up” entries should be recorded. Year-end adjusting entries are necessary to have correct balances for determining profit for the period. The purpose is to make the revenue, income, expense, and loss accounts up-to-date and correct for the year.
• Make a careful sweep of all matters to check for other developments that may affect the accuracy of the accounts. For example, the company may have discontinued a product line. The remaining inventory of these products may need to be removed from the inventory asset account, with a corresponding loss recorded in the period. Or the company may have settled a long-standing lawsuit, and the amount of damages needs to be recorded. Layoffs and severance packages are another example of what the chief accountant needs to look for before preparing reports.

Lest you think of accounting as dry and dull, let me tell you that end-of-period accounting procedures can stir up controversy of the heated-debate variety. These procedures require that the accountant make decisions and judgment calls that upper management may not agree with. For example, the accountant may suggest recording major losses that would put a big dent in profit for the year and cause the business to report a loss. The outside CPA auditor (assuming that the business has an independent audit of its financial statements) often gets in the middle of the argument. These kinds of debates are precisely why business managers need to know some accounting: to hold up their end of the argument and participate in the great sport of yelling and name-calling — strictly on a professional basis, of course.

Leave good audit trails

Good accounting systems leave good audit trails. An audit trail is a clear-cut, well-marked path of the sequence of events leading up to an entry in the accounts, starting with the source documents and following through to the final posting in the accounts; an auditor can “re-walk” the path. Even if a business doesn’t have an outside CPA do an annual audit, the accountant has frequent occasion to go back to the source documents and either verify certain information in the accounts or reconstruct the information in a different manner. Suppose that a salesperson is claiming some suspicious-looking travel expenses; the accountant would probably want to go through all this person’s travel and entertainment reimbursements for the past year.

If the IRS comes in for a field audit of your income tax return, you’d better have good audit trails to substantiate all your expense deductions and sales revenue for the year. The IRS has rules about saving source documents for a reasonable period of time and having a well-defined process for making bookkeeping entries and keeping accounts. Think twice before throwing away source documents too soon. Also, ask your accountant to demonstrate and lay out for your inspection the audit trails for key transactions, such as cash collections, sales, cash disbursements, and inventory purchases. Even computer-based accounting systems recognize the importance of audit trails. Well-designed computer programs provide the ability to backtrack through the sequence of steps in the recording of specific transactions.

Keep alert for unusual events and developments

Business managers should encourage their accountants to stay alert to anything out of the ordinary that may require attention. Suppose that the accounts receivable balance for a customer is rapidly increasing — that is, the customer is buying more and more from your company on credit but isn’t paying for these purchases quickly. Maybe the customer has switched more of his company’s purchases to your business and is buying more from you only because he’s buying less from other businesses. But maybe the customer is planning to stiff your business and take off without paying his debts. Or maybe the customer is planning to go into bankruptcy soon and is stockpiling products before the company’s credit rating heads south.

Don’t forget internal time bombs: A bookkeeper’s reluctance to take a vacation could mean that she doesn’t want anyone else looking at the books.

To some extent, accountants have to act as the eyes and ears of the business. Of course, that’s one of the main functions of a business manager as well, but the accounting staff can play an important role.

Design truly useful reports for managers

I’ve seen too many off-the-mark accounting reports to managers — reports that are difficult to decipher and not very useful or relevant to the manager’s decision-making needs and control functions. These bad reports waste the manager’s time, one of the most serious offenses in management accounting.

Part of the problem lies with the managers themselves. As a business manager, have you told your accounting staff what you need to know, when you need it, and how to present it in the most efficient manner? When you stepped into your position, you probably didn’t hesitate to rearrange your office, and maybe you even insisted on hiring your own support staff. Yet you most likely lay down like a lapdog regarding your accounting reports. Maybe you assume that the reports have been done a certain way and that arguing for change is no use.

On the other hand, accountants bear a good share of the blame for poor management reports. Accountants should proactively study the manager’s decision-making responsibilities and provide the information that is most useful, presented in the most easily digestible manner.

In designing the chart of accounts, the accountant should keep in mind the type of information needed for management reports. To exercise control, managers need much more detail than what’s reported on tax returns and external financial statements. And as I explain in Chapter 12, expenses should be regrouped into different categories for management decision-making analysis. A good chart of accounts looks to both the external and the internal (management) needs for information.

So what’s the answer for a manager who receives poorly formatted reports? Demand a report format that suits your needs! See Chapter 12 for a useful profit report model, and show it to your accountant as well.