part0005

Accounting is a broad subject that you cannot master in a few days. However, you can master the basics of accounting and be able to start taking care of your business accounts in just a week. The aim of this book is not to make you a professional accountant but rather, to help you manage your accounts without necessarily depending on anyone. To be able to become an accountant in such a short period of time, you will have to focus on the key principles of the subject. In this chapter, I am going to introduce you to the key principles of accounting and bookkeeping. I will help you understand what accounting really is, how different it is from bookkeeping, and how to manage your books, among other factors. However, before we even start looking at what accounting is, we should define some of the terms that are commonly used by accountants. You will encounter most of these terms throughout the book. It is in your best interest to keep them at the back of your mind so as to make your understanding of the book much easier.

Accounts Receivable (AR): The accounts receivable is an entry in the books of accounts that represents the money or assets owned by customers or clients. Think of accounts receivable as money that belongs to the business but is currently in the hands of another party.

Accounting (ACCG): The abbreviation ACCG is used to refer to accounting, which stands for a systematic way of recording and reporting financial transactions of a business entity. The term accounting is only used for established businesses that can sue or be sued.

Accounts Payable (AP): Accounts payable is the opposite of accounts receivable. The accounts payable is an entry in the books of accounts that represents the money your business owes creditors such as suppliers. If you purchase goods and services on credit, you should record the amount to be paid within the accounts payable.

Assets (fixed and current) (FA, CA): The term assets is used to refer to all the items of value that are owned by the company. If you are running a business, anything that adds value to your business can be referred to as an asset. Assets are divided into Current Assets CA and Fixed Assets FA. Current assets refer to the valuable items that will be converted to cash within one year. They include things such as cash, inventory, accounts, receivable, etc. Fixed assets, on the other hand, refers to assets that cannot be converted into cash within a year. Examples of fixed assets include machinery, real estate, land, etc.

Asset Classes: The term asset classes is used to refer to a group of securities that behave in a similar way in the marketplace. The main asset classes are equities, fixed income bonds, and cash equivalents.

Balance Sheet (BS): A balance sheet is one of the major financial statements prepared by accountants. It is a report that summarizes the company's assets, liabilities, and owner's equity within a given time. It is through the balance sheet that you are able to determine the growth of your business over the years.

Capital (CAP): The term capital is used to refer to the money or assets that the company can put into use. Working capital refers to the money that is currently available for the operations of the business. Working capital is calculated by subtracting current liabilities from Current assets.

Cash Flow (CF): The term cash flow literally means the flow of cash in your business. It is used to mean the revenue or expenses expected to be generated through business activities such as manufacturing, sales, procurement, etc. Cash flow statements are prepared within a given period of time.

Certified Public Accountant (CPA): The term certified public accountant is used when referring to an individual who has passed the standardized CPA exam and attained the required work experience. In other words, to become a CPA, you must meet certain terms, which include passing the exam and gaining work experience. The good news is that you do not have to pass any exams to become an accountant at your business.

Cost of Goods Sold (COGS): The cost of goods sold refers to the direct expenses related to the goods sold by a business. The cost of goods sold can be arrived at by using different formulas depending on the business model. For instance, the cost of goods sold in the retail business is as simple as the cost of purchasing the goods from the supplier. However, in a manufacturing business, the cost of goods sold might include the cost of raw material, labor, and power, among other factors.

Credit (CR): The word credit, as used in accounting, refers to an entry in the books of accounts that indicates a decrease in assets or an increase in liabilities and equity on a balance sheet. As we will see later, if you are using a double-entry method of bookkeeping, every transaction recorded must have two entries ( A debit and a credit entry).

Diversification: This refers to the process of allocating capital to various assets. In diversification, a company might choose to invest in different areas from its main operations in a bid to reduce risks

Enrolled Agent (EA): An enrolled agent is a tax expert who represents taxpayers when dealing with the Internal Revenue Authorities. You may hire an enrolled agent to help you process your taxes, or you may choose to process taxes yourself.

Expenses (fixed, variable, accrued, operation): The term expenses is used to refer to the amount of money used on a day to day business operations. There are 4 main types of expenses. We have fixed expenses (FE), which refers to payments such as rent that will happen regularly, whether the business is operational or not. Variable expenses (VE) represent expenditures such as labor that may change over a given period. We have accrued expenses (AE), which represent expenses that are yet to be paid. Lastly, we have operational expenses, which include expenses that are not directly related to the production of goods or services such as taxes, insurance, etc.

Equity and Owner's Equity (OE): In the simplest terms possible, equity refers to assets minus liabilities. The remaining value after subtracting liabilities from companies' assets is what we call equity; in other words, the portion of the company that is owned by the shareholders of the business. Owners' equity is defined as the percentage of stock a person has an ownership interest in the company.

Insolvency: A company can be declared insolvent if it cannot meet its debt obligations. A company that is insolvent has a negative owner's equity, in that the assets of the company are way lesser than the liabilities.

Generally Accepted Accounting Principles (GAAP): The GAAPs are just a set of rules that govern accountants and businesses. These rules are in place to ensure that there is coherence between financial reports produced by different businesses. Following the GAAPs is compulsory for all businesses but very crucial for publicly traded companies.

General Ledger (GL): The general ledger is an important book of accounting that presents a complete record of the financial transactions of a business over its life. When transactions are accurately recorded in specialty ledgers, the transactions are then summarized in the general ledger. For a business to have successful financial management, it must keep an accurate general ledger.

Trial Balance: A trial balance is a financial statement prepared by the contents of a general ledger. All the transactions in the general ledger are compiled into debit and credits to ensure that the company's bookkeeping system works. At any period of compilation, the credit and debit transactions of a business must balance. If the trial balance does not balance, chances are that there are transactions that have been mined or inaccurately entered.

Liabilities (current and long-term): The term liability is used to refer to all the debts a company incurred during business operations. Liabilities are divided into the current and long term. Current liabilities (CL) refer to the debts of a business that must be paid within 1 year, such as debts to suppliers. Long term liabilities (LTL) refer to debts of the company that can be paid over a longer period exceeding one year. An example of a long term liability is a long term mortgage loan.

Limited Liability Company (LLC): A limited liability company is a structure of business where the owners of the company cannot be held liable for the company's debts and liabilities. This type of business shields the owners from losing personal properties in case the business becomes insolvent.

Present Value (PV): The term present value is used to refer to the current value of a future sum of money. For example, if I told you I will give you $100 next year, or I give you $100 now, you will see the money being given now more valuable than the same amount 1 year later. If this money is owed to you, it must accumulate interest over the years to meet the current value 1 year later. Since money at hand has the ability to be invested and multiply, the present value helps us determine the value of cash in the future.

Profit and Loss Statement (P&L): The profit and loss statement is one of the most important financial statements. This statement is used to summarize a company's performance by reviewing revenues, expenses, and costs over a given trading period.

Return on Investment (ROI): Return on investment as a measure used to evaluate the performance of a business relative to the money invested. For instance, if you were to invest $1000 today in a business that generates $2000 in 1 year, your return on the same investment will be $1000. The return on investment helps us determine whether an investment is viable or not. The ROI is calculated by dividing net profit by the cost of investment.

Individual Retirement Account (IRA, Roth IRA): The term IRA is used to refer to a retirement savings plan. A traditional IRA arrangement allows employees to direct untaxed funds towards an investment that grows with deferred taxes. In IRAs, the tax obligation is just deferred but not neglected. Roth is a type of retirement investment vehicle where tax is not deferred. In other words, the eligible distributions are tax-free.

401K & Roth 401K: The 401K is a type of retirement savings vehicle that allows an individual to direct part of their compensation into an investment-based retirement account. The money deferred will not be subjected to taxation until time for withdrawal. However, any member with Roth 401K can still make contributions after taxes, which eliminates the need for taxation at the time of withdrawal.

Subchapter S Corporation (S-CORP): An S-Corp is a type of corporation that meets specific IRS requirements. Such corporations are taxed as partnerships as opposed to being taxed as corporations. Publicly traded companies are subject to double taxation of dividends, something that is exempted from the S-Corps.

Bonds and Coupons (B&C): A bond is a type of debt investment referred to as fixed security. A bond refers to when an investor, be it an individual, a company, or a local government, loans money to another entity with the promise of receiving the money back with interest. For all bonds, there is an annual interest that is paid. The annual interest paid on top of the bond is what we refer to as a coupon.

Retained Earnings (RE): Retained earnings refer to the profits of a business that are plowed back into the company after paying taxes and dividends. When a company makes profits, some of the money has to go into paying liabilities and paying dividends to shareholders. The money that remains and is retained in the business is referred to as retained earnings.

Accounting is the process of consolidating, summarizing, analyzing, and reporting financial records of a company. An accountant is responsible for ensuring that financial reports are prepared and analyzed accordingly. An accountant is also consulted in regard to interpreting and explaining the accounting records. On the other hand, bookkeeping is the practice of recording all the process of accounting.

A bookkeeper is an individual who is basically hired to maintain the database. Every transaction that takes place in a company must be recorded for future reference and proper accounting. It is the work of a bookkeeper to record and organize the transactions of a company. In general terms, both bookkeeping and accounting can be done by an accountant. The bookkeeper only comes into the picture to reduce the workload for the accountant. Essentially, all the work done by a bookkeeper can be done by an accountant effectively. However, since most businesses have so many transactions, they leave the task of recording transactions to bookkeepers and hand the task of analyzing the financial performance of a business to the accountant.

Although accountants and bookkeepers perform very different roles, they are complementary. The work of a bookkeeper will be useless unless consolidated and analyzed by an accountant. At the same time, an accountant cannot do any task unless he/she gets clear records from the bookkeeper. With that said, an accountant has a higher skill set and performs more complex tasks than a bookkeeper. For a person to qualify as an accountant, he/she must acquire a degree or CPA certification.

Since the bookkeeper provides the base documents or accounting, bookkeepers are required to know the basics of accounting too. Although it is not necessary for a bookkeeper to have formal training, the information they provide must be helpful to the accountant.

The duties of a bookkeeper vary depending on the employer. There are some employers that will require bookkeepers to handle general financial management, including recording and organizing financial records and also offering accountancy services. In other cases, a bookkeeper will only be required to record financial transactions and forward them to the accountancy office. If you are starting out in business, you may maintain your books personally, instead of hiring a bookkeeper. Most startups do not hire bookkeepers or permanent accountants. If you can track down all the transactions yourself, just do simple bookkeeping and only bring in an accountant for payroll and tax processing or consultancy.

Some of the duties carried out by bookkeepers include:

1. Recommend, implement, or manage accounting software: In most cases, bookkeepers are in charge of recording, organizing, and managing of data. Therefore, they are better suited to recommend the best software, manage it, and implement it so that it offers value to the company.

2. Recommend, implement, and monitor bookkeeping policies: The other duty of bookkeepers is to recommend policies that will make the process of bookkeeping smooth. At any level, a bookkeeper is required to reduce financial losses. The bookkeeper must look at loopholes and help employers deal with any discrepancies that may make the practice difficult.

3. Develop credit and debit accounts: The main duty of a bookkeeper is to maintain subsidiary books of accounts and the general ledger. For this duty, the bookkeeper must develop credit and debit accounts and assign expense categories.

4. Enter expenses and income into the software: It is the duty of the bookkeeper to ensure that all transactions are digitized. Since digital data is more reliable, modern bookkeepers will be required to digitize all documents, including checks and receipts.

5. Handle banking activities: In most companies, the bookkeeper is responsible for handling all banking activities. To ensure accountability and transparency, the bookkeeper is the center of cash flow. All the money coming and going outside the business must pass through the hands of the bookkeeper.

6. Train staff on the use of relevant bookkeeping software: If the company is using any bookkeeping software that requires all staff members to operate, the bookkeeper must train the other staff members on how to use the software.

7. Verify recorded transactions: It is the duty of a bookkeeper to consolidate the records and verify all the transactions. The bookkeeper has to look at the records and verify against documents such as receipts and checks that have been filled. If there are any discrepancies, the bookkeeper must correct them.

8. Verify the accuracy of the information and that the accounts balance.

9. Maintain records, and backup and archive, as necessary.

10. Assist the accountant in the preparation of financial statements: The bookkeeper may be required to help the accountant in preparing financial reports. In some companies, it is the bookkeeper that prepares financial reports. The first financial statement to be repaired is the trial balance and is always prepared by the bookkeeper.

11. Ensure bookkeeping adheres to accounting best practices and government regulations.

While the bookkeeper has so many duties, they are not as complex as those handled by the accountant. Some of the duties handled by accountants include:

1. Data Management: The accountant has the responsibility to oversee how data is recorded and stored. If the bookkeeper makes any mistakes in recording and storing financial transactions, it is the accountant who will suffer trying to prepare financial statements. To avoid such problems in the future, an accountant is required to ensure that all the data being recorded by the bookkeeper is recorded in the required formats and is credible.

2. Financial Analysis and Consultation: The other duty of the accountant is to offer advice on financial decisions. Once the financial statements are released, the accountant is better placed to interpret them and offer guidance on the best way forward for the company.

3. Financial Reports: The accountant is also responsible for generating financial reports required by the IRS and other bodies. Reports such as the balance sheet, the income sheet, etc., must be accurate and offer the true reflection of the company's performance. The accountant must ensure that any discrepancies that may occur along the way are handled and that the reports present the true figures of the company's net worth and earnings.

4. Regulatory Compliance: Lastly, it is the duty of the accountant to ensure that the company is compliant with regulations. In this regard, accountants will be required to file taxes for employers and the company, process payroll, educate the board and employees on best financial practices and ensure that the company follows all the regulations put in place.

For any person practicing accounting, there are rules that must be followed. These rules are important in ensuring that there is transparency and a correlation between financial statements. If you are new to accounting, you must first understand these principles. As a matter of fact, understanding the accounting principles will make your work of learning to account much easier. The Generally Accepted Accounting Principles GAAPs are regulations that guide the practices of bookkeeping and accounting across the US and other parts of the world. These principles include.

The first accounting principle is the assumption that every business is an economic entity. In other words, the business is operating with the aim of making a profit and growing in value. This assumption is vital in preparing financial statements. If we assume that an establishment is not interested in making a profit, there will be no need for preparing statements such as the profit and loss statement.

Another principle that guides accountancy states that all transactions must be recorded in the same currency. Although this principle does not dictate the currency to use, it requires that all transactions be recorded in one currency. For instance, you cannot record some transactions in British pounds then later change to US dollars. Even if a business operates offshore branches, the final financial reports must be presented in the same currency.

The other principle that guides accounting requires that all financial reports show results over a distinct period. Financial reports are not prepared in a vacuum. Every financial report must specify the period that is being reported. Some financial reports are prepared monthly, others quarterly, semi-annually, or annually. A business chooses the frequency of reporting in a year, in a bid to monitor its performances.

The other principle that governs accounting is the cost principle. It states that the cost of an item does not change in financial reporting, the time of reporting withstanding. In other words, if an item is purchased today at $100, it must be reported that it is $100 even if the financial report is prepared 4 months later when the cost of the same item has doubled. Every transaction is recorded as it is at the time of the first operation and should not change even if the cost of the item in question changes.

The principle requires that all information that relates to the function of a company's financial statements must be disclosed in notes accompanying statements. In other words, do not just provide financial statements without providing explanatory notes for items or figures that may not be understandable to all interested parties.

This principle requires that a business’ accounting be managed as if a business is a continuous entity that does not have an end in the near future. All businesses are assumed to have an infinite life and must be treated as such in accounting. Every counting period should give room for the transactions to occur in the following accounting periods.

This principle requires that all businesses should use the accrual method of accounting and report financial information using this method. There are two methods of bookkeeping; the accrual and the cash method. In the cash method, transactions are recorded once money changes hands, while in the accrual method, transactions can be recorded before money changes hands. For instance, if you buy goods on credit, you can record this as a complete transaction under the accrual method. However, the cash method will only recognize this method after you have paid for the good.

The other principle of accounting is that revenue should be reported when it is earned and not when it is received. This principle builds upon the accrual basis of bookkeeping. In this method, all transactions are deemed complete once they happen, regardless of whether money has been received or not. This principle mainly applies to limited companies and corporations. Smaller businesses such as sole proprietorships and partnerships may be exempted from some of the principles. A business that has revenue of less than $1,000,000 will not be subjected to most of these regulations.

The principle of materiality requires that accountants use their best judgment in case of an error. This principle recognizes the possibility of errors occurring in business transaction records. If the error is not significant, the accountants are required to take care of it by using their best judgment. In most cases, the accountants are expected to deal with the error in favor of the company as an entity they represent. However, errors that may have far-reaching effects cannot be corrected by assumptions. If the errors are too many, actions have to be taken to correct some.

This principle states that, if there is more than one way of recording a transaction, liabilities and expenses should be recorded first and gains and revenues recorded later. This principle aims at protecting businesses from excess taxation due to poor record-keeping. Every time revenue and gains are recorded, the business taxes grow. However, liabilities and expenses reduce the taxes that are likely to be paid. This principle ensures that businesses do not suffer losses due to delayed entries that may end up being forgotten. If the gains are recorded first, the expenses may be forgotten, which might mean that a business will end up paying too much taxes.

Understanding these accounting principles will make your job easier and will help you learn accounting much faster. Take some time to review them and make sure you understand them well before we move on to the next chapter.