Accounting Unplugged


Chart of Accounts – More on Accounting Types

<< Chart of Accounts – Organization >> General Ledger Accounts by Acctng Period

This post completes the basics in the discussion about methods of organizing transactions with the Chart of Accounts – specifically the method of Accounting Types. The Chart of Accounts is really just a list of the descriptions that you have chosen to use in transactions and the Accounting Types help to organize the descriptions (accounts) in meaningful ways. The most important concept to transactions is Double Entry but the Chart of Accounts makes sense of the transactions and provides mission critical information to owners and managers.

The Basic Accounting Types (In order) Are:

  • Assets – Things you own
  • Liabilities – Things you owe
  • Equity – Owners’ Stake in Company
  • Revenue – Income through Sales of the Products of the Business
  • Costs of Goods Sold – Costs to provide the service or to manufacture or acquire the product the business sells
  • Expenses – Things that are paid for that are consumable, they have no lasting value but are part of the cost of running a business
  • Other Revenue and Expenses – Revenue and Expenses that are unusual cases and are not directly related to the business product and are not usual costs of running a business.

There are at least 7 basic Accounting Types, but each Accounting Type can be categorized more simply under the 2 Double Entry Accounting Categories as either Funds/Uses of Funds or as Sources of Funds.

Funds/Use of Funds (Debit) Accounting Types:

  • Assets – Things you own
  • Costs of Goods Sold – Costs to provide the service or to manufacture or acquire the product the business sells
  • Expenses – Things that are paid for that are consumable, they have no lasting value but are part of the cost of running a business
  • Other Expenses – Expenses that are unusual cases and are not directly related to the business product and are not usual costs of running a business.

–finish reading this post on my new site—>>

Next Post:  >>Accounting Periods – General Ledger Analysis – The Big Picture

<< Chart of Accounts – Organization

**disclaimer:  All information posted on this blog is from my own experience and training.  The guidelines I present are general and in my experience, standard practice.  I do not write with authority from any Accounting Standards Boards.

Chart of Accounts – Organization

<< Chart of Accounts – Basics >>Chart of Accounts – More on Accounting Types

The Chart of Accounts is organized using three different methods.

  • First:  Accounting Types
  • Second:  Order of Liquidity – the ease of converting to cash
  • Third: Account Numbers

The 7 Basic Accounting Types (In order) Are:

  • Assets – Things you own
  • Liabilities – Things you owe
  • Equity – Owners Stake in Company
  • Revenue – Income through Sales of the Products of the Business
  • Costs of Goods Sold – Costs to provide the service or to manufacture or acquire the product the business sells
  • Expenses – Things that are paid for that are consumable, they have no lasting value but are part of the cost of running a business
  • Other Revenue and Expenses – Revenue and Expenses that are unusual cases and are not directly

Order of Liquidity:

The second method of organization is the Order of Liquidity.  Liquidity refers to the expectation that the item can be converted to cash at at least close to its current value within one year.

Accounts are listed in descending order of liquidity within their accounting types, with cash at the top of the list for Assets.   The liquidity classification is so important that Assets and Liabilities are divided into the Subtypes of Current and Long Term/Fixed to group items of similar liquidity together.

Assets
Current Assets
Cash
Receivables
Inventory
Fixed Assets
Liabilities
Current Liabilities
Long Term Liabilities

The Order of Liquidity rule is irrelevant when it comes to Revenue and Expenses because neither Type has lasting value or ability to convert to cash.  When sorting Revenue and Expense Accounts, organize them by general subjects. For example, you might want to group office expenses like Rent, Office Supplies and Utilities together.

The Accounts that were established in the previous Chart of Accounts Post, organized by Accounting Type and Order of Liquidity (ease of cash conversion) are:

Assets
Current Assets
Checking Account
Accounts Receivable
Fixed Assets
Office Equipment
Office Furniture
Liabilities
Current Liabilities
Accounts Payable
Revenue
Sales
Expenses
Rent
Office Supplies
Subscriptions
Utilities
Fuel
Repairs & Maintenance
Credit Card Interest & Fees

The final method of organization is Account Numbers.  Part of the strength of this method is the ability to recognize the Accounting Type and in some instances the Order of Liquidity simply by the Account Number assigned to the Account.

Assigning Account numbers starts by assigning a range of numbers to each Accounting Type.  The range that I like and use the most is ranges of 1000.  I like to assign numbers in the thousand ranges because the numbers contain a manageable amount of digits and it is unlikely (in a small to mid-size company) that you’ll run out of numbers to use for Accounts.  The number of digits will be important in your software system so when using ranges in the 1000’s there are 4 digits, and the Account Numbers would range from 1000 to 9999.

It really doesn’t matter how you assign ranges as long as you assign them in order by Accounting Type and are consistent but it is important to understand the industry standards for your business prior to assigning number ranges.  The reason it is important to understand industry standards is that different industries create their own Subtypes and will have a standard for assigning the number ranges to those Subtypes.

Generally I assign the number ranges in this order:

  • Assets: 1000’s
    • Current Assets 1000 – 1499
    • Fixed Assets 1500 – 1999
  • Liabilities: 2000’s
    • Current Liabilities 2000 – 2499
    • Long Term Liabilities 2500 – 2999
  • Equity: 3000’s
  • Revenue: 4000’s
  • Costs of Goods Sold: 5000’s
  • I leave the 6000’s open to allow for a Cost of Goods Sold Subtype
  • Expenses: 7000’s
  • Other Revenue: 8000’s
  • Other Expenses: 9000’s

Before assigning Account Numbers to individual Accounts, first sort by Accounting Type (and Subtype) and then by Order of Liquidity.  After the initial sorting, Accounts can be sorted and Account Numbers can also be assigned any way you like.  It is important to use intervals of at least 10 or 20 between similar Accounts and I try to skip to the next 100 for Accounts of different types (if one grouping ended at 7030, I’d start the next grouping at 7100).  This strategy gives good clues to the user about the type of account and it allows for the addition of new Accounts later.

The New Chart of Accounts – with Account Numbers.  This Chart of Accounts only contains accounts I’ve used in previous examples.  It is missing some standard accounts such as Equity and Cost of Goods Sold.  Those Accounts will be added in subsequent posts.

  • 1000  Checking Account
  • 1200  Accounts Receivable
  • 1500  Office Equipment
  • 1520  Office Furniture
  • 2000  Accounts Payable
  • 4000  Sales
  • 7000  Rent
  • 7020  Office Supplies
  • 7040  Subscriptions and Dues
  • 7060  Utilities
  • 7100  Fuel
  • 7200  Repairs & Maintenance
  • 7300  Credit Card Interest and Fees

Next Post: Chart of Accounts – More on Accounting Types

<< Chart of Accounts – Basics

**disclaimer:  All information posted on this blog is from my own experience and training.  The guidelines I present are general and in my experience, standard practice.  I do not write with authority from any Accounting Standards Boards.

Accounting System Overview

>>Double Entry Accounting Basics

The Accounting System we use today, The Double Entry System, was first published in Venice, Italy in 1494 by a mathematician named Luca Pacioli but it has been traced back at least as far as the 12th century and there is a good reason why it has endured.  It is based on the idea of a balanced financial picture.  That is, we should not only know how money has been spent, we should also know where it came from.

The basic rules and structure of the system are standard and simple, they do not attempt to predict the details of any given set of books, instead they provide the structure and functionality around which any set of books can be constructed.  Because of that, the double entry accounting system is universally relevant and successful as a Financial Accounting System.

Accounting is a valuable resource that is relevant to individuals as well as to business. It provides the feedback that can make all the difference in securing and managing your own finances and investments as well as those of businesses.

The One reason to use the Accounting System is for the Feedback in the form of Financial Reports and the One reason to learn the Accounting System is to learn how to put those Financial Reports to work for You and your Business. Having said that, let’s start with the basics of the system.

Two Functions of the Accounting System are:

  • To Collect Financial Transaction Data
    • Financial transactions are exchanges of things of value.  Transaction data is collected using the Double Entry principle of describing and recording both the use and source of money.
  • To Organize and Summarize Financial Transaction Data
    • Financial data is organized and summarized using The Chart of Accounts which is essentially a list of the descriptions used in recording transactions and is organized around the principles of Double Entry Accounting.

Once you understand the basic structure and principles of accounting, you will have a good, functional knowledge and be able to understand financial statements and reports.  Basic Accounting concepts and principles are universal.  Specific industries have their own unique differences and rules but with a basic understanding, the differences are easier to navigate.

****My posts are written for the Accrual Method of Accounting.

Accrual accounting is the most common system used in business and the greatest difference between Accrual Based Accounting and its alternative, Cash Based Accounting relates to time.  At this point, I will not be presenting Cash Based Accounting alternatives in my posts except to say that in Cash accounting, accounts such as Accounts Receivable and Accounts Payable are not used because the related Sales and Expense transactions are not posted until Cash changes hands.

In accrual accounting, transactions are posted when goods have been received (or ownership of the goods has transferred) or services have been performed.  That concept works in both cases of being the recipient or the provider of goods and services.  If cash is neither disbursed nor received at the time of the exchange, a substitute such as an invoice or note (payable or receivable) is posted in place of cash.

The first post in my series explains the Double Entry Transaction system.

Note:  There are two different aspects of the Accounting System, the two aspects are Structural and Content.  The aspect of the Accounting System that I address in the blog is Structural.  I will add Content for demonstration but the purpose of the information in the blog is related to Structure, not Content.

**disclaimer:  All information posted on this blog is from my own experience and training.  The guidelines I present are general and in my experience, standard practice.  I do not write with authority from any Accounting Standards Boards.

Chart of Accounts – The Basics

<< Double Entry Accounting – Practice >> Chart of Accounts – Organization

This post begins the explanation of the Chart of Accounts.  The Chart of Accounts performs the second basic function of the Double Entry Accounting System – to organize financial transaction data. The Chart of Accounts provides the organizational structure for another element, the General Ledger which summarizes the Financial Data and produces Financial Reports.

The purpose of this and the next two posts (4-6) is to introduce the organizational structure of the system and for that reason, I do not make a distinction between the Chart of Accounts and the General Ledger until Post # 7.

Review of the Double Entry Accounting Transaction Questions:

  1. 1.  How much money changed hands?
  2. 2.  Where did the money go?  What was either gained or paid for by this exchange?
  3. 3.  Where did the money come from?  What is the source of the value in this exchange?

The Chart of Accounts is basically a list of the descriptions used to answer Transaction Questions 2 and 3.   Each unique description is called an account.  One of the best features of the Chart of Accounts is that when you have a new type of transaction you can just add a new description (account).

From the transactions in the previous posts, we have started a Chart of Accounts

  • Rent
  • Checking Account
  • Office Supplies
  • Fuel
  • Repairs & Maintenance
  • Subscriptions
  • Accounts Payable (Credit Card)
  • Accounts Receivable
  • Sales

Let’s review the previous entries and create some additional entries to our transaction example and see how our Chart of Accounts starts to fill out.

The entries below the *******’s are new in this post and record:

  • the receipt of payment for the existing Accounts Receivable Invoice
  • the payment of the existing credit card balance
  • a utilities expense and payment
  • new credit card charges

Description Debit Credit
Rent $3,000
Checking Account $3,000
Office Supplies $300
Fuel $275
Repairs and Maintenance $500
Subscriptions $125
Printer $1,300
Accounts Payable (Credit Card) $2,500
Accounts Receivable $50,000
Sales $50,000
************************** ********* *********
Checking Account $50,000
Accounts Receivable $50,000
Accounts Payable (Credit Card) $2,500
Checking Account $2,500
Utilities $150
Checking Account $150
Chair $750
Desk $900
Credit Card Interest and Fees $50
Accounts Payable (Credit Card) $1,700
Totals: $109,850 $109,850

Current Chart of Accounts:

  • Rent
  • Checking Account
  • Office Supplies
  • Fuel
  • Repairs & Maintenance
  • Subscriptions
  • Printer
  • Accounts Payable (Credit Card)
  • Accounts Receivable
  • Sales
  • Utilities
  • Chair
  • Desk
  • Credit Card Interest and Fees

To keep the Chart of Accounts manageable and meaningful, it is important to strike a balance between having a long specific list and a short general list.  To accomplish this objective, the Chart of Accounts should have descriptions for types of things, and not for specific things.  You want the Accounts to be specific enough to be useful but not too specific because the fewer accounts you have the better overall picture you can have.

You wouldn’t add a new account for paper, pens and staples, you would just use one account called office supplies.  So, it is important to reuse accounts when possible, and to simplify entries into more general descriptions like “office furniture” instead of separating the chair and desk purchases.

So, now let’s look at the Chart of Accounts and its Account Balances.

Account Balances
Debit Credit
Checking Account $44,350
Accounts Receivable $0
Office Equipment (Printer) $1,300
Office Furniture $1,650
Accounts Payable $1,700
Sales $50,000
Rent $3,000
Utilities $150
Office Supplies $300
Subscriptions $125
Fuel $275
Repairs and Maintenance $500
Credit Card Interest and Fees $50
Totals $51,700 $51,700

You can see that for even the small number of transactions in this example, The Chart of Accounts is essential in understanding their financial impact.

Notice that the account balances are also separated into the debit/credit columns.  The amounts listed here are the difference between the total debit entries and the total credit entries for each account.  If the amount was higher on the credit side, then the balance is listed in the credit column.  It is also important to note that our Chart of Account balances meet the requirement that total debits equal total credits.

The Chart of Accounts is really comprised of three things for each Account – an Account Number, a Description and an Accounting Type.  The transactions and account balances are part of a ledger called the General Ledger.   The table above is more accurately described as the General Ledger.

** Important Note: Post #6 discusses debit and credit balances in accounts.  In this case, none of the balances in our accounts is cause for concern because their totals are in the correct column for their type.  Accounting Types are explained in more detail in Posts #5 and #6.  Post #7 begins the discussion of the General Ledger and its Balances and Reports.

Next Up: >>5. Chart of Accounts – Organization

<< 3. Double Entry Accounting – Practice

**disclaimer:  All information posted on this blog is from my own experience and training.  The guidelines I present are general and in my experience, standard practice.  I do not write with authority from any Accounting Standards Boards.

Double Entry Accounting – Transactions – 2 of 2

<< Double Entry Accounting – Basics >>Chart of Accounts – Basics

In these examples, we will continue to focus on the descriptions and the amounts of financial transactions so we will be making entries in a 3 column grid where the left column is for descriptions and the two remaining columns are numeric and are for debits and credits.

Since we’re focusing on only three aspects of the transaction, the three questions that must be answered for each financial transaction in double entry are:

1.  What is the value of the transaction in terms of dollars (how much money changed hands)?

2.  Where did the money go – What was gained or paid for by the exchange?

3.  Where did the money come from – what is the source of the value in this exchange?

The amounts that are associated with question 2 are always entered in the debit (left numeric) column and the amounts associated with question 3 are always entered in the credit (right numeric) column.

Money is not always directly involved in a transaction.  Sometimes the transaction involves a trade or sometimes it involves a money substitute, a promise of future money transfers – as with credit card purchases – but something of value is always exchanged for something else of value in a financial transaction.

In the previous post, the transaction was very simple and money was involved, there was a $3,000 rent charge that was paid in full from the checking account.

Description Debit Credit
Rent $3,000
Checking Account $3,000

What about in the case of a credit card statement where there are many different types of charges made to one credit card.

Answer 1 :            Total Charge on Statement = 2,500
Answer 2a:           Office Supplies
Answer 2b:           Fuel
Answer 2c:           Tires
Answer 2d:           Subscriptions
Answer 2e:           Printer
Answer 3 :            Credit Card

In this case, since there are multiple answers for question 2, the descriptions and the amounts related to each separate part of the answer are listed on separate lines but the total amount associated with Question 2 and with Question 3 will always be equal.

Description Debit Credit
Office Supplies $300
Fuel $275
Repairs & Maintenance (Tires) $500
Subscriptions (Trade Magazines) $125
Printer $1,300
Credit Card Payable $2,500
———- ———-
Totals: $2,500 $2,500

Sometimes the promise of future money is not a debt to be paid by you but a debt to be collected by you as in the case of a sale where you bill the customer.

Answer 1:  50,000   (The amount of the transaction)

Answer 2:  Accounts Receivable   (What was gained?  In this case the gain was a short term promise to pay.)

Answer 3:  Sales (Where did the money come from?  What is the source of the value?)

Description Debit Credit
Accounts Receivable $50,000
Sales $50,000

*for readability: traditionally, debits entries are listed above credit entries and the description for the credit entries are traditionally indented.

Double Entry requires a minimum of two lines, or accounts, to fully describe a financial transaction.  In cases where there are multiple answers to one of the questions, the term Double Entry can seem like an inaccurate description but Double Entry does Not refer to the number of lines or accounts required to record the transaction.  It refers to the left/right entries where the full amount of the transaction must be entered in the debit column and again in the credit column – double entry – regardless of the number of lines required to fully describe the transaction.  The philosophy of Double Entry is a balanced financial picture requiring that both the Uses and Sources of funds be recorded.  Debits, Credits and Accounts are just part of the Structure that helps to ensure that balance.

This post completes the most important concepts of double entry accounting transactions. Once transactions are posted, the Chart of Accounts helps to organize and summarize them.  The next post, explains the basics of the Chart of Accounts.

Next Up: >>Chart of Accounts – Basics

<< Double Entry Accounting – Basics

**disclaimer:  All information posted on this blog is from my own experience and training.  The guidelines I present are general and in my experience, standard practice.  I do not write with authority from any Accounting Standards Boards.

Double Entry Accounting – Transaction Basics

<< Accounting Overview >>Double Entry Accounting – More Transactions

The purpose of Accounting is to provide feedback about the financial position and activities of you and/or your investments and businesses. The reason to learn about it is so that you can understand the feedback and put it to work for you.

The feedback element of Accounting takes the form of Financial Reports and in order for you to rely on those reports, it is important to have a consistent and reliable system for gathering and organizing the information those reports are produced from.

The Double Entry System has endured since at least the 12th century because it is a simple, consistent and reliable system of gathering and organizing information and producing financial reports for financial management and for tax and reporting purposes.

The first task of the system is to gather data from financial transactions. Financial transactions are exchanges of things of value. Even if money is not part of the exchange, a dollar value must be used to represent the exchange.  Since a dollar value must represent the value of each exchange, I’ll often use the terms “money” or “funds” when referring to the value of each financial transaction.

In this post, I’ll explain the method of collecting and posting financial data in the Double Entry Accounting System.  The entire Double Entry System is built around the concept of balance, recording both the Use and the Source of funds.  Once the Double Entry concept is understood, the whole system of data collection, organization and summary is easily understood.  This method is standard and works the same way each time, no exceptions.

There are three basic questions that must be answered for the double entry accounting transactions, they are:

Question 1. How much money changed hands? What is the value of this exchange?

Question 2: Where did the money go?  How was the money used?  What was either gained or paid for by this exchange?

Question 3: Where did the money come from? What is the source of the value in this exchange?

Example 1:

Answer 1: 3,000.00
Answer 2: Rent
Answer 3: Checking Account

The answers for each of these questions are recorded in a grid. The columns of the grid collect a variety of information but for the purpose of this discussion, we’ll use three columns. One column for descriptions and two numeric columns for amounts. The left numeric column is called the “debit” column and the right numeric column is called the “credit” column.

The descriptions that answer questions 2 and 3 are always entered on separate lines to the left of the two numeric columns.

The amount associated with question 2 is entered on the same line as its description and it is always answered in the left (debit) numeric column. The amount associated with question 3 is entered on the same line as its description and it is always answered in the right (credit) numeric column.

Description Debit Credit
Rent $3,000
Checking Account $3,000

You see that the amount from question one is entered twice (double entry), once in the Debit Column and once in the Credit Column.  If you have answered all three questions for each transaction and both columns always add up to the same number, your books are in balance. This brings us to the most basic rule of accounting.

Rule # 1: Total Debits = Total Credits

To recap: Accounting requires that for each financial transaction, the basic questions of how much money is involved, where the money went and where the money came from are answered.

In order to ensure that these questions are always answered for each transaction, the Double Entry System is used.  The Double Entry Transaction System is a multi-line, two numeric columned system. The left numeric, or “debit” column is always the “where did the money go – what was gained or paid for” column and the right numeric, or “credit” column is always the “where did the money come from – what is the source of value” column. The total of one column must always equal the total of the other.

Double Entry does Not refer to the number of Accounts or Lines required to record a transaction.  Double Entry refers to Debits and Credits (two sides = double).  If you have fully described both the Use and the Source of Funds, you have accomplished the objectives of Double Entry.

Next up: >>Double Entry Accounting – More Transactions

<< Accounting Overview

**disclaimer:  All information posted on this blog is from my own experience and training.  The guidelines I present are general and in my experience, standard practice.  I do not write with authority from any Accounting Standards Boards.