Accounting Unplugged


Accounting System Structure – Financial Statement Ratios

For a quick overview of the Accounting System Structure including the Chart of Accounts, Journals and Ledgers please see my New Post (#16).

For More on How to Make use of Financial Statements and Financial Ratios, please see New Post # 17

General Ledger Analysis – Accounting Periods

<< Chart of Accounts – Accounting Types >>Financial Statements – Trial Balance

This is where the Double Entry System starts to Pay Off.  The addition of the time element introduced in this post completes the basics of how to organize and operate this system.  From this point forward, you will start to experience nothing but increasing rates of return on your investment of time in learning it.  The next few posts will introduce Financial Statements and how to put them to work for you and will complete the circle for the basics.

The General Ledger is more than just another important element in the Accounting System, it is where the goods are.  The General Ledger is the combination of the Chart of Accounts, Financial Transactions, Account Balances and Accounting Periods.  In practice, once the Chart of Accounts has been established, the term “Chart of Accounts” is considered more in terms of a report than as an object.  From this point forward, Accounts from the Chart of Accounts will be called General Ledger Accounts.

The General Ledger adds the essential organizational element of Time (Accounting Periods) to the Accounting System, so in addition to the original three organizational methods of the Chart of Accounts, the General Ledger is organized in four ways.

  • 1. Accounting Type
  • 2. Order of Liquidity
  • 3. Account Number
  • 4. Accounting Periods

Accounting Periods are generally date/time intervals of Months, Quarters and Years.  The term Accounting Period can mean any of those in different situations.  For purposes of this discussion, Accounting Periods will refer to Months within a given year.

If the General Ledger is going to organize around accounting periods, then we need to add dates to the data we gather with transactions.  There can be a variety of dates that are relevant to a transaction, the transaction date, the invoice date, the due date, the expiration date etc. but for purposes of this post, the date we’ll focus on is the transaction date.

The transaction grid introduced in the previous posts needs to be expanded to 5 columns to accommodate the new data requirements of date and account number.

Transaction Date Account Description Debit Credit
9/01/08 7000 Rent $3,000
1000 Checking Account $3,000

The Transaction Date is only required to be entered on the first line of a transaction (in a manual ledger) because it is assumed to be (and must be) the same for each entry in a transaction.  In addition to the requirement that total Debits = total Credits for each Transaction, Total Debits must also equal Total Credits for each Accounting Period. This requirement fulfills the original intent of double entry, a balanced view of uses and sources of funds (debits = credits) by Transaction, by Accounting Period and by default, Overall.

Both entries in the transaction post to their Accounts in Accounting Period 9/08.

This is a Comparison Trial Balance Report from the General Ledger and this is where you can take a step back from the details of transactions and see the larger picture.

Account Description Jun Jul Aug Sept Oct Nov Dec Total
1000 Checking $0 $0 $0 -$3,000 $0 $0 $0 $-3,000
….. ……….
7000 Rent $0 $0 $0 $3,000 $0 $0 $0 $3,000
Totals $0 $0 $0 $0 $0 $0 $0 $0

**This example starts with June because of space limitations here.

The only accounts listed are the two from the transaction example but they demonstrate the ability to compare accounts against themselves and against other accounts from period to period.  Notice that the totals on the bottom line are all zeros, this shows that the books are in balance because total debits (positive amounts on this report) combined with total credits (negative amounts on this report) = Zero.

When reports do not have two columns to display amounts, the credits will be displayed as negatives.  In reports like this, *Debit Accounts should have positive balances and Credit Accounts should have negative balances.  There is only cause for concern if the +/- of the amount does not match its accounting type.  In this case, the Checking Account is a Debit Account so that is an indication of trouble. (*See 6. Chart of Accounts – Transaction Types)

Accounting Periods are an essential analysis tool in accounting.  They provide the opportunity to compare account balances not just one account against another but also against itself over time.  Time analysis provides the data to detect unusual changes in account balances from period to period that may indicate errors or unintentional over or under payments of critical obligations such as taxes, rents, utilities, insurance etc.  Time analysis is also essential to management and owners for cash planning, establishing correlations between expenses and revenues to help make operational adjustments, and detecting changes that may indicate theft or fraud.

Next Up: >>Financial Statements – Trial Balance

<< Chart of Accounts – Accounting Types

**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 – 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.

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.