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THE ESSENTIALS OF ACCOUNTING BASICS

Bookkeepers, accountants, and business managers must have a firm grasp of


accounting fundamentals. Accounting is an essential business function that involves
recording transactions, summarizing data, and then reporting and analyzing the results
on a periodic basis.

1: The Difference between Bookkeeping and Accounting

Important! Every business and not-for-profit entity needs a reliable bookkeeping system based on
established accounting principles. Keep in mind that accounting is a much broader term than
bookkeeping. Bookkeeping refers mainly to the record-keeping aspects of accounting; it's essentially
the process of recording all the information regarding the transactions and financial activities of a
business.

Defining bookkeeping
Bookkeeping is an indispensable subset of accounting. Bookkeeping refers to the process of
accumulating, organizing, storing, and accessing the financial information base of an entity, which is
needed for two basic purposes:

Facilitating the day-to-day operations of the entity

Preparing financial statements, tax returns, and internal reports to managers

Bookkeeping (also called recordkeeping) can be thought of as the financial information infrastructure
of an entity. The financial information base should be complete, accurate, and timely. Every
recordkeeping system needs quality controls built into it, which are called internal controls.

Defining accounting
The term accounting is much broader; going into the realm of designing the bookkeeping system,
establishing controls to make sure the system is working well, and analyzing and verifying the
recorded information. Accountants give orders; bookkeepers follow them.
Accounting encompasses the problems in measuring the financial effects of economic activity.
Furthermore, accounting includes the function of financial reporting of values and performance

measures to those that need the information. Business managers, investors, and many others
depend on financial reports for information about the performance and condition of the entity.
Important! Accountants design the internal controls for the bookkeeping system, which serve to
minimize errors in recording the large number of activities that an entity engages in over the period.
The internal controls that accountants design are also relied on to detect and deter theft,
embezzlement, fraud, and dishonest behavior of all kinds.
Accountants prepare reports based on the information accumulated by the bookkeeping process:
financial statements, tax returns, and various confidential reports to managers. Measuring profit is a
critical task that accountants perform a task that depends on the accuracy of the information
recorded by the bookkeeper. The accountant decides how to measure sales revenue and expenses
to determine the profit or loss for the period.

2: Bookkeeping and Its Basic Purpose


Bookkeeping, when done properly, gives you an excellent gauge of how well your business is doing.
Bookkeeping also provides financial information throughout the year so you can test the success of
your business strategies and make course corrections to ensure that you reach your year-end profit
goals.

TIP! Bookkeeping can become your best system for managing your financial assets and testing
your business strategies, so dont shortchange it. Take the time to develop your bookkeeping system
with your accountant before you even open your businesss doors and make your first sale.

Choosing your accounting method


The two basic accounting methods you have to choose from are cash-basis accounting (also called
just cash accounting) and accrual accounting. The key difference between these two accounting
methods is the point at which you record sales and purchases in your books:

If you use cash accounting, you record transactions only when cash changes hands. For
example, you dont record a purchase from a vendor until you actually lay out the cash to the
vendor.

If you use accrual accounting, you record a transaction when its completed, even if cash
doesnt change hands. For example, you record a purchase from a vendor when you receive the
products, and you also record the future debt in an account called Accounts Payable.

Understanding assets, liabilities, and equity


Every business has three key financial parts that must be kept in balance:

Assets include everything the company owns, such as cash, inventory, buildings, equipment,
and vehicles.

Liabilities include everything the company owes to others, such as vendor bills, credit card
balances, and bank loans.

Equity includes the claims owners have on the assets based on their portion of ownership in
the company.

Important! The formula for keeping your books in balance involves these three elements:
Assets = Liabilities + Equity

Introducing debits and credits


To keep the books for your business, you need to revise your thinking about two common financial
terms: debits and credits. Most non-bookkeepers and non-accountants think of debits as
subtractions from their bank accounts. The opposite is true with credits people usually see these
as additions to their accounts, in most cases in the form of refunds or corrections in favor of the
account holders.
Debits and credits are totally different animals in the world of bookkeeping. Because keeping the
books involves a method called double-entry bookkeeping, you have to make a least two entries
a debit and a credit into your bookkeeping system for every transaction. Whether that debit or
credit adds or subtracts from an account depends solely upon the type of account.
Important! You cant just enter transactions in the books willy-nilly. You need to know where exactly
those transactions fit into the larger bookkeeping system. Thats where your Chart of Accounts
comes in; its essentially a list of all the accounts your business has and what types of transactions
go into each one.

3: Basic Bookkeeping Terms and Phrases


Get a firm understanding of key bookkeeping and accounting terms and phrases before you begin
work as a bookkeeper. Bookkeepers use specific terms and phrases everyday as they track and

record financial transactions from balance sheets and income statements to accounts payable
and receivable. The following sections list bookkeeping terms that you'll use on a daily basis.

Balance sheet terminology


Here are a few terms youll want to know when working with balance sheets:

Balance sheet: The financial statement that presents a snapshot of the companys financial
position as of a particular date in time. Its called a balance sheet because the things owned by
the company (assets) must equal the claims against those assets (liabilities and equity).

Assets: All the things a company owns in order to successfully run its business, such as
cash, buildings, land, tools, equipment, vehicles, and furniture.

Liabilities: All the debts the company owes, such as bonds, loans, and unpaid bills.

Equity: All the money invested in the company by its owners. In a small business owned by
one person or a group of people, the owners equity is shown in a Capital account. In a larger
business thats incorporated, owners equity is shown in shares of stock.
Another key Equity account is Retained Earnings, which tracks all company profits that have
been reinvested in the company rather than paid out to the companys owners. Small
businesses track money paid out to owners in a Drawing account, whereas incorporated
businesses dole out money to owners by paying dividends.

Income statement terminology


Here are a few terms related to the income statement that youll want to know:

Income statement: The financial statement that presents a summary of the companys
financial activity over a certain period of time, such as a month, quarter, or year. The statement
starts with Revenue earned, subtracts the Costs of Goods Sold and the Expenses, and ends
with the bottom line Net Profit or Loss.

Revenue: All money collected in the process of selling the companys goods and services.
Some companies also collect revenue through other means, such as selling assets the business
no longer needs or earning interest by offering short-term loans to employees or other
businesses.

Costs of goods sold: All money spent to purchase or make the products or services a
company plans to sell to its customers.

Expenses: All money spent to operate the company thats not directly related to the sale of
individual goods or services.

Other common bookkeeping terms


Some other common terms used in bookkeeping include the following:

Accounting period: The time period for which financial information is being tracked. Most
businesses track their financial results on a monthly basis, so each accounting period equals
one month. Some businesses choose to do financial reports on a quarterly or annual basis.
Businesses that track their financial activities monthly usually also create quarterly and annual
reports.

Accounts payable: The account used to track all outstanding bills from vendors,
contractors, consultants, and any other companies or individuals from whom the company buys
goods or services.

Accounts receivable: The account used to track all customer sales that are made by store
credit. Store credit refers not to credit card sales but rather to sales in which the customer is
given credit directly by the store and the store needs to collect payment from the customer at a
later date.

Depreciation: An accounting method used to track the aging and use of assets. For
example, if you own a car, you know that each year you use the car its value is reduced (unless
you own one of those classic cars that goes up in value). Every major asset a business owns
ages and eventually needs replacement, including buildings, factories, equipment, and other key
assets.

General Ledger: Where all the companys accounts are summarized. The General Ledger is
the granddaddy of the bookkeeping system.

Interest: The money a company needs to pay if it borrows money from a bank or other
company. For example, when you buy a car using a car loan, you must pay not only the amount
you borrowed but also interest, based on a percent of the amount you borrowed.

Inventory: The account that tracks all products that will be sold to customers.

Journals: Where bookkeepers keep records (in chronological order) of daily company
transactions. Each of the most active accounts including cash, Accounts Payable, and
Accounts Receivable has its own journal.

Payroll: The way a company pays its employees. Managing payroll is a key function of the
bookkeeper and involves reporting many aspects of payroll to the government, including taxes to
be paid on behalf of the employee, unemployment taxes, and workmans compensation.

Trial balance: How you test to be sure the books are in balance before pulling together
information for the financial reports and closing the books for the accounting period.

4: Responsibilities of an Accounting Department


Most people dont realize the importance of the accounting department in keeping a business
operating without hitches and delays. Thats probably because accountants oversee many of the
back-office functions in a business as opposed to sales, for example, which is front-line activity,
out in the open and in the line of fire.
Folks may not think much about these back-office activities, but they would sure notice if those
activities didnt get done. On payday, a business had better not tell its employees, Sorry, but the
accounting department is running a little late this month; youll get your checks later.
Important! Typically, the accounting department is responsible for the following:

Payroll: The total wages and salaries earned by every employee every pay period, which
are called gross wages or gross earnings, have to be calculated. Based on detailed private
information in personnel files and earnings-to-date information, the correct amounts of income
tax, social security tax, and other deductions from gross wages have to be determined.
Stubs, which report various information to employees each pay period, have to be attached to
payroll checks. The total amounts of withheld income tax and social security taxes, plus the
employment taxes imposed on the employer, have to be paid to federal and state government
agencies on time. Retirement, vacation, sick pay, and other benefits earned by the employees
have to be updated every pay period.
In short, payroll is a complex and critical function that the accounting department performs.
Many businesses outsource payroll functions to companies that specialize in this area.

Cash collections: All cash received from sales and from all other sources has to be
carefully identified and recorded, not only in the cash account but also in the appropriate account
for the source of the cash received. The accounting department makes sure that the cash is
deposited in the appropriate checking accounts of the business and that an adequate amount of
coin and currency is kept on hand for making change for customers.

Accountants balance the checkbook of the business and control who has access to incoming
cash receipts. (In larger organizations, the treasurer may be responsible for some of these cash
flow and cash-handling functions.)

Cash payments (disbursements): In addition to payroll checks, a business writes many


other checks during the course of a year to pay for a wide variety of purchases, to pay
property taxes, to pay on loans, and to distribute some of its profit to the owners of the business.
The accounting department prepares all these checks for the signatures of the business officers
who are authorized to sign checks. The accounting department keeps all the supporting
business documents and files to know when the checks should be paid, makes sure that the
amount to be paid is correct, and forwards the checks for signature.

Procurement and inventory: Accounting departments usually are responsible for keeping
track of all purchase orders that have been placed for inventory (products to be sold by the
business) and all other assets and services that the business buys from postage to forklifts.
A typical business makes many purchases during the course of a year, many of them on credit,
which means that the items bought are received today but paid for later. So this area of
responsibility includes keeping files on all liabilities that arise from purchases on credit so that
cash payments can be processed on time.
The accounting department also keeps detailed records on all products held for sale by the
business and, when the products are sold, records the cost of the goods sold.

Property accounting: A typical business owns many substantial long-term assets


called property, plant, and equipment including office furniture and equipment, retail display
cabinets, computers, machinery and tools, vehicles (autos and trucks), buildings, and land.
Except for small-cost items, such as screwdrivers and pencil sharpeners, a business maintains
detailed records of its property, both for controlling the use of the assets and for determining
personal property and real estate taxes. The accounting department keeps these records.

Important! The accounting department may be assigned other functions as well, but this list gives
you a pretty clear idea of the back-office functions that the accounting department performs. Quite
literally, a business could not operate if the accounting department did not do these functions
efficiently and on time. To do these back-office functions well, the accounting department must
design a good bookkeeping system and make sure that it is accurate, complete, and timely.

5: How Accounting Focuses on Transactions


Important! Business accounting focuses on transactions. A good bookkeeping system unfailingly
captures and records every transaction that takes place. Understanding accounting, to a large
extent, means understanding how accountants record the financial effects of transactions. They also
record events that have an economic impact on a business.

Counting on transactions
The immediate and future financial effects of some transactions can be difficult to determine. A
business carries on economic exchanges with six basic types of persons or entities:

Its customers, who buy the products and services that the business sells.

Its employees, who provide services to the business and are paid wages and salaries and
provided with benefits, such as a retirement plan, medical insurance, workers compensation,
and unemployment insurance.

Its suppliers and vendors, who sell a wide range of things to the business, such as legal
advice, products for resale, electricity and gas, telephone service, computers, vehicles, tools and
equipment, furniture, and even audits.

Its debt sources of capital who loan money to the business, charge interest on the amount
loaned, and are due to be repaid at definite dates in the future.

Its equity sources of capital, the individuals and financial institutions that invest money in
the business and expect the business to earn profit on the capital they invest.

The government, or the federal, state, and local agencies that collect income taxes, sales
taxes, payroll taxes, and property taxes from the business.

Here's a look at the interactions between a business and the other parties in its economic
exchanges.

Transactions between a business and the parties it deals with.

6: Accounting for events


Even a relatively small business generates a surprisingly large number of transactions, and all
transactions have to be recorded. Certain other events that have a financial impact on the business
have to be recorded, as well. These are called events because theyre not based on give-and-take
bargaining unlike the something-given-for-something-received nature of economic exchanges.
Events such as the following have an economic impact on a business and are recorded:

A business may lose a lawsuit and be ordered to pay damages. The liability to pay the
damages is recorded.

A business may suffer a flood loss that is uninsured. The waterlogged assets may have to be
written down, meaning that the recorded values of the assets are reduced to zero if they no
longer have any value to the business. For example, products that were being held for sale to
customers (until they floated down the river) must be removed from the inventory asset account.

A business may decide to abandon a major product line and downsize its workforce,
requiring that severance compensation be paid to the laid-off employees.

At the end of the year, the accountant makes a special survey to make sure that all events and
developments during the year that should be recorded have been recorded, so that the financial
statements and tax returns for the year are complete and correct.

7: Balance Sheet Basics and the Accounting Equation


TECHNICAL STUFF! One type of accounting report is a balance sheet, which is based on the
accounting equation: Assets = Liabilities + Owners Equity. The balance sheet also called
a statement of financial condition is a Where do we stand at the end of the period? type of
report. The header of a balance sheet lists the date that it was prepared.

Balance sheet fundamentals


A balance sheet shows two sides of the business, which you could think of as the financial yin and
yang of the business:

Assets: On one side of the balance sheet the assets of the business are listed, which are
the economic resources owned and being used in the business. The asset values reported in the
balance sheet are the amounts recorded when the assets were originally acquired.
An asset is written down below its historical cost when the asset has suffered a loss in value.
Some assets are written up to their current fair values. Some assets have been on the books
only a few weeks or a few months, so their reported historical values are current. The values for
other assets are their costs when they were acquired many years ago.

Sources of assets: On the other side of the balance sheet is a breakdown of where the
assets came from, or their sources. Assets come from two basically different
sources: creditors and owners.
Businesses borrow money in the form of interest-bearing loans that have to be paid back at a
later date, and they buy things on credit that are paid for later. So, part of total assets can be
traced to creditors, which are the liabilities of a business.
Every business needs to have owners invest capital (usually money) in the business. Also,
businesses retain part or all of the annual profits they make, and profit increases the total assets
of the business. The total of invested capital and retained profit is called owners equity.

An accounting equation example


Suppose a business reports $2.5 million in total assets. The total of its liabilities, plus the capital
invested by its owners, plus its retained profit, adds up to $2.5 million. Otherwise, its books would be
out of balance, which means there are bookkeeping errors.
Continuing with this example, suppose that the total amount of the liabilities of the business is $1.0
million. This means that the total amount of owners equity in the business is $1.5 million, which
equals total assets less total liabilities. The total owners equity may be traceable to capital invested
by the owners in the business as well as profit retained in the business. The total of these two
sources of owners equity is $1.5 million.
The financial condition of the business in this example is summarized in the following accounting
equation (in millions):
$2.5 assets = $1.0 liabilities + $1.5 owners equity
Looking at the accounting equation, you can see why the statement of financial condition is called
the balance sheet; the equal sign means the two sides balance.
Important! Double-entry bookkeeping is based on the accounting equation the fact that the total
of assets on the one side is counterbalanced by the total of liabilities, invested capital, and retained
profit on the other side. Double-entry bookkeeping means that both sides of transactions are
recorded. For example, if one asset goes up, another asset goes down or, alternatively, either a
liability or owners equity goes up. This is the economic nature of transactions. Double-entry
means two-sided, not that the transactions are recorded twice.

8: The Eight Steps of the Accounting Cycle


As a bookkeeper, you complete your work by completing the tasks of the accounting cycle. Its called
a cycle because the accounting workflow is circular: entering transactions, manipulating the
transactions through the accounting cycle, closing the books at the end of the accounting period,
and then starting the entire cycle again for the next accounting period.
The accounting cycle has eight basic steps, which you can see in the following illustration. These
steps are described in the list below.

1.

Transactions
Financial transactions start the process. Transactions can include the sale or return of a product,
the purchase of supplies for business activities, or any other financial activity that involves the
exchange of the companys assets, the establishment or payoff of a debt, or the deposit from or
payout of money to the companys owners.

2.

Journal entries
The transaction is listed in the appropriate journal, maintaining the journals chronological order
of transactions. The journal is also known as the book of original entry and is the first place a
transaction is listed.

3.

Posting
The transactions are posted to the account that it impacts. These accounts are part of the
General Ledger, where you can find a summary of all the businesss accounts.

4.

Trial balance
At the end of the accounting period (which may be a month, quarter, or year depending on a
businesss practices), you calculate a trial balance.

5.

Worksheet

Unfortunately, many times your first calculation of the trial balance shows that the books arent in
balance. If thats the case, you look for errors and make corrections called adjustments, which
are tracked on a worksheet.
Adjustments are also made to account for the depreciation of assets and to adjust for one-time
payments (such as insurance) that should be allocated on a monthly basis to more accurately
match monthly expenses with monthly revenues. After you make and record adjustments, you
take another trial balance to be sure the accounts are in balance.
6.

Adjusting journal entries


You post any corrections needed to the affected accounts once your trial balance shows the
accounts will be balanced once the adjustments needed are made to the accounts. You dont
need to make adjusting entries until the trial balance process is completed and all needed
corrections and adjustments have been identified.

7.

Financial statements
You prepare the balance sheet and income statement using the corrected account balances.

8.

Closing the books


You close the books for the revenue and expense accounts and begin the entire cycle again with
zero balances in those accounts.
Important! As a businessperson, you want to be able to gauge your profit or loss on month by
month, quarter by quarter, and year by year bases. To do that, Revenue and Expense accounts
must start with a zero balance at the beginning of each accounting period. In contrast, you carry
over Asset, Liability, and Equity account balances from cycle to cycle.

9: Choosing an Accounting Method for Your Business


Different businesses make different accounting decisions. Some businesses choose conservative
accounting methods while others choose liberal accounting methods. Accounting is more than just
reading the facts or interpreting the financial outcomes of business transactions. Accounting also
requires accountants to choose between alternative accounting methods.
Similar to the conservative states and liberal states addressed in politics, accounting has:

Conservative accounting methods: These accounting methods delay the recording of


revenue and accelerate the recording of expenses. Profit is reported slowly.

Liberal accounting methods: These accounting methods accelerate the recording of


revenue and delay the recording of expenses. Profit is reported quickly.

In general terms, conservative accounting methods are pessimistic, and liberal methods are
optimistic. The choice of accounting methods also affects the values reported for assets, liabilities,
and owners equities in the balance sheet.
Accounting methods must stay within the boundaries of Generally Accepted Accounting Principles
(GAAP). A business cant conjure up accounting methods out of thin air. GAAP isnt a straitjacket; it
leaves plenty of wiggle room, but the one fundamental constraint is that a business must stick with
its accounting method when it makes a choice.
Consistency is the rule; the same accounting methods must be used year after year. The Internal
Revenue Service (IRS) allows businesses to change their accounting methods once in a while, but
the justification has to be persuasive.
A new business with no accounting history has to make accounting decisions such as the following,
for the first time:

If the business sells products, it has to select which cost of goods sold expense method to
use.

If the business owns fixed assets, it has to select which depreciation method to use.

If the business makes sales on credit, it has to decide which bad debts expense method to
use.

Important! The choices of accounting methods for these three expenses cost of goods sold,
depreciation, and bad debts can make a sizable difference in the amount of profit or loss recorded
for the year. Choosing conservative accounting methods for these three expenses can cause profit
for the year to be lower by a relatively large percent compared with using liberal accounting methods
for the expenses.

10: The Basics of Double-Entry Bookkeeping


All businesses, whether they use the cash-basis accounting method or the accrual accounting
method, use double-entry bookkeeping to keep their books. A practice that helps minimize errors
and increase the chance that your books balance, double-entry bookkeeping gets its name because
you enter all transactions twice.
Important! When it comes to double-entry bookkeeping, the key formula for the balance sheet
(Assets = Liabilities + Equity) plays a major role.

In order to adjust the balance of accounts in the bookkeeping world, you use a combination
of debits and credits. You may think of a debit as a subtraction because youve found that debits
usually mean a decrease in your bank balance. And, youve probably found unexpected credits in
your bank or credit card account that mean more money has been added in your favor. Now forget
what youve learned about debits or credits. In bookkeeping, their meanings arent so simple.
Important! The only definite thing when it comes to debits and credits in the bookkeeping world is
that a debit is on the left side of a transaction and a credit is on the right side of a transaction.

Transaction #1: Purchasing an item with cash


Heres an example of the practice in action. Suppose you purchase a new desk that costs $1,500 for
your office. This transaction actually has two parts: You spend an asset cash to buy another
asset furniture. So, you must adjust two accounts in your companys books: the Cash account
and the Furniture account. Heres what the transaction looks like in a bookkeeping entry:

Purchasing a New Office Desk


Account
Furniture

Debit

Credit

$1,500

Cash

$1,500

In this transaction, you record the accounts impacted by the transaction. The debit increases the
value of the Furniture account, and the credit decreases the value of the Cash account. For this
transaction, both accounts impacted are asset accounts, so, looking at how the balance sheet is
affected; you can see that the only changes are to the asset side of the balance sheet equation:
Assets = Liabilities + Equity
Furniture increase = No change to this side of the equation
Cash decrease
In this case, the books stay in balance because the exact dollar amount that increases the value of
your Furniture account decreases the value of your Cash account. At the bottom of any journal entry,
you should include a brief description that explains the purpose for the entry.

Transaction #2: Purchasing items on credit


To show you how you record a transaction if it impacts both sides of the balance sheet equation,
heres an example that shows how to record the purchase of inventory. Suppose that you purchase
$5,000 worth of widgets on credit.
These new widgets add value to your Inventory Asset account and they also add to your Accounts
Payable account. (Remember, the Accounts Payable account is a Liability account where you track
bills that need to be paid at some point in the future.) Heres how the bookkeeping transaction for
your widget purchase looks:

Purchasing Widgets for Sale to Customers


Account
Inventory

Debit

Credit

$5,000

Accounts Payable

$5,000

Heres how this transaction affects the balance sheet equation:


Assets = Liabilities + Equity
Inventory increases = Accounts Payable increases + No change
In this case, the books stay in balance because both sides of the equation increase by $5,000.
Important! You can see from the two example transactions how double-entry bookkeeping helps to
keep your books in balance as long as you make sure each entry into the books is balanced.
Balancing your entries may look simple here, but sometimes bookkeeping entries can get very
complex when more than two accounts are impacted by the transaction.

11: Key Basic Accounts for Balance Sheets and Income Statements
A bookkeeper tracks all the financial transactions of a business and is responsible for identifying the
account in which each transaction should be recorded. Accounting provides the structure you must
use to organize these transactions, as well as the procedures you must use to record, classify, and
report information about your business.

In most cases, the accounting system will be set up with the help of an accountant to be sure the
information generated by that system will be useable and meets the requirements of solid
accounting principles.
Important! A bookkeeping system is designed based on the data needed for the two key financial
reports the balance sheet and the income statement. The balance sheet gives you a snapshot of
a business as of a particular date. The income statement gives you a summary of all transactions
during a particular period of time, usually a month, a quarter, or a year.
The key balance sheet accounts include:

Assets: Everything the business owns in order to operate successfully is considered an


asset. This includes cash, buildings, land, tools, equipment, vehicles, and furniture. Each type of
asset has a separate account. Another asset is the Accounts Receivable account (money due
from customers who bought on credit).

Inventory: Products on hand that the business plans to sell.

Liabilities: All the money the company owes to others are considered liabilities. This
includes unpaid bills (called Accounts Payable account), loans, and bonds. Each type of liability
will have a separate account.

Equity: All the money invested in the company by the owners or stock holders is considered
equity. Each type of equity, and possibly each owner in a small business, will have a separate
account.

The key income statement accounts include:

Revenue: All the money a business receives in selling its products or services is called
revenue or sales and tracked in these accounts.

Cost of goods sold: All money the company must spend to buy or manufacture the goods
or services it sells to customers is tracked in these accounts. An account called Purchases is
used to track goods purchased.

Expenses: All money that is spent to run the company that is not related specifically to a
product or service being sold is tracked in expense accounts. For example, Office Supplies,
Advertising, Salaries, and Wages are all types of expense accounts.

12: Understanding a Bookkeepers Chart of Accounts


The Chart of Accounts is the roadmap that a business creates to organize its financial transactions.
Essentially, this chart lists all the accounts a business has, organized in a specific order; each
account has a description that includes the type of account and the types of transactions that should
be entered into that account.
Important! Every business creates its own Chart of Accounts based on how the business is
operated, so youre unlikely to find two businesses with the exact same Charts of Accounts.
However, some basic organizational and structural characteristics are common to all Charts of
Accounts.
The organization and structure are designed around two key financial reports: the balance
sheet, which shows what your business owns and what it owes, and the income statement, which
shows how much money your business took in from sales and how much money it spent to generate
those sales.
The Chart of Accounts starts first with the balance sheet accounts, which include:

Current Assets: Includes all accounts that track things the company owns and expects to
use in the next 12 months, such as cash, accounts receivable (money collected from
customers), and inventory.

Long-term Assets: Includes all accounts that track things the company owns that have a
lifespan of more than 12 months, such as buildings, furniture, and equipment.

Current Liabilities: Includes all accounts that track debts the company must pay over the
next 12 months, such as accounts payable (bills from vendors, contractors, and consultants),
interest payable, and credit cards payable.

Long-term Liabilities: Includes all accounts that track debts the company must pay over a
period of time longer than the next 12 months, such as mortgages payable and bonds payable.

Equity: Includes all accounts that track the owners of the company and their claims against
the companys assets, which includes any money invested in the company, any money taken out
of the company, and any earnings that have been reinvested in the company.

The rest of the Chart of Accounts is filled with income statement accounts, which include:

Revenue: Includes all accounts that track sales of goods and services as well as revenue
generated for the company by other means.

Cost of Goods Sold: Includes all accounts that track the direct costs involved in selling the
companys goods or services.

Expenses: Includes all accounts that track expenses related to running the businesses that
arent directly tied to the sale of individual products or services.

When developing the Chart of Accounts, you start by listing all the Asset accounts, the Liability
accounts, the Equity accounts, the Revenue accounts, and finally, the Expense accounts. All these
accounts come from two places: the balance sheet and the income statement.
Important! You should develop an account list that makes the most sense for how youre operating
your business and the financial information you want to track. The Chart of Accounts is a money
management tool that helps you track your business transactions, so set it up in a way that provides
you with the financial information you need to make smart business decisions. Youll probably tweak
the accounts in your chart annually and, if necessary, you may add accounts if you find something
for which you want more detailed tracking. You can add accounts during the year, but its best not to
delete accounts until the end of a 12-month reporting period.

EXTRAS
Connecting the Income Statement and Balance Sheet
When an accountant records a sale or expense entry using double-entry accounting, he or she sees
the interconnections between the income statement and balance sheet. A sale increases an asset or
decreases a liability, and an expense decreases an asset or increases a liability.
Therefore, one side of every sales and expense entry is in the income statement, and the other side
is in the balance sheet. You cant record a sale or an expense without affecting the balance sheet.
The income statement and balance sheet are inseparable, but they arent reported this way!
To properly interpret financial statements, you need to understand the links between the statements,
but the links arent easy to see. Each financial statement appears on a separate page in the annual
financial report, and the threads of connection between the financial statements arent referred to.
The following figure shows the lines of connection between income statement accounts and balance
sheet accounts. When reading financial statements, in your minds eye, you should see these lines
of connection. Because financial reports dont offer a clue about these connections, it may help to
actually draw the lines of connection, like you would if you were highlighting lines in a textbook.

Connections between income statement and balance sheet accounts.


Heres a quick summary explaining the lines of connection in the figure, starting from the top and
working down to the bottom:

Making sales (and incurring expenses for making sales) requires a business to maintain a
working cash balance.

Making sales on credit generates accounts receivable.

Selling products requires the business to carry an inventory (stock) of products.

Acquiring products involves purchases on credit that generate accounts payable.

Depreciation expense is recorded for the use of fixed assets (long-term operating resources).

Depreciation is recorded in the accumulated depreciation contra account (instead decreasing


the fixed asset account).

Amortization expense is recorded for limited-life intangible assets.

Operating expenses is a broad category of costs encompassing selling, administrative, and


general expenses:

Some of these operating costs are prepaid before the expense is recorded, and until
the expense is recorded, the cost stays in the prepaid expenses asset account.

Some of these operating costs involve purchases on credit that generate accounts
payable.

Some of these operating costs are from recording unpaid expenses in the accrued
expenses payable liability.

Borrowing money on notes payable causes interest expense.

A portion (usually relatively small) of income tax expense for the year is unpaid at year-end,
which is recorded in the accrued expenses payable liability.

Earning net income increases retained earnings.