Basics  on the three disciplines upon which WebSBA was build. 1) business planning and control, 2) basic accounting and 3) Information Technology principles.

Introduction

Following the introduction of the PC in the early 1980s, some Small Businesses moved from pencil and paper to computerize accounting, others have stayed with the old method because they lacked resources. In a typical small business environment the task of acquiring installing and maintaining a computerized system is often daunting. Computerizing a "brick and mortar" small business requires an on going investment in computer equipment software and change in methodology. Acquiring and maintaining knowledge in a dynamic technical environment (which is not often related to the business's functions) is sometimes perceived as a non-justifiable investment.

The small businesses that have made the move to computerization have incurred substantial expenses in equipment programs and personnel over the years. They have, however, reaped benefits similar to the ones of large companies as a result of their investment in technology. Computerized accounting improved productivity and contributed to their readiness to enter world markets following the explosion of the Internet in the mead 1990s.

Now with the introduction to fast Internet access, small businesses can make their presence in the Web in a similar manner larger businesses do. Those who don't want to make the investment in in-house technology, (computers, programs and personnel) can hook up to a resource in the Internet to perform their basic accounting functions and or make their goods available to the world. With a minimum of one computer connected to the web and a current browser, a small business can do the following:

1. Customize a chart of accounts.
2. Create and inventory item list (parts and services) including multilevel Bill of Material using component average cost, labor and overhead for building assemblies.
3. Create receive and track purchase orders.
4. Produce accounts payable reports.
5. Make Accounts Payable payments from multiple checkbooks.
6. Make journal entries for accounting adjustments.
7. Write checks for expenses outside of the Accounts Payable system.
8. Produce sales orders and sales invoices as need.
9. Produce Accounts Receivable reports.
10. Receive payments to accounts receivable or cash on hand from goods sold or other income.
11. Produce a "components needed over a certain horizon" list based on forecasted sales on assemblies.
12. Produce finical statements as needed.
13. Make products in the item list available for sale on the web using an on line-shopping cart.

The WebSBA application was developed for the aforementioned small businesses as well as for larger business lacking an in-house production management application.

Before entering the detail explanation and operating procedures for the application one may benefit from a review of the basics  on business planning and control, basic accounting as well as Information Technology principles. 

SECTION -ONE

I. ACCOUNTING, CONTROL, AND PLANNING

With the introduction of the Personal Computer (PC's)a number of accounting software packages have become available and are now used by small businesses as accounting and control tools.

Integrated software applications for small businesses that allow for planning, controlling, and accounting require hardware resources and experienced personnel for effective use. Many small businesses lack both and thus use simple packages with basic accounting functions for monitoring of income and expenses

This Profit and loss accounting has been known from very early, and is often referred to by the ungracious term of "bean counting".

II. PLANNING AND THE PLANNING PROCESS.

A Business Plan has been recognized as a must for any organization, large or small to be successful. Planning and controlling are critical functions for every enterprise and should be part of its operating climate. However in most situations any planning that is done is limited to financial planing and sales forecasting, in support of a budget. Performance comparisons are generally done at the end of fiscal periods based on accounting reports and budget forecasts. This is really a look backward at performance and does not allow for corrective actions at the point in time when the process starts to drift off track.

A definition of the function of planning within an organization, encompasses the following:

             3. Definition of products or services and markets to be pursued.

Planning is known as the process of deciding, on the objectives of the organization, on the resources needed to attain these objectives, and on the policies that are to govern the organization, including use and disposition of its resources. It is the process having to do with the formulation of long range strategic plans and policies that determine or change the character or direction of the organization. All other plans should be based on and be consistent with the long range plans. The long range plan in turn should reflect the Mission Statement for the organization or the "reason for being" of the enterprise. This should be a concise statement of why it is here? what does it have to offer? where does it want to go? If these three questions can not be clearly answered there is little hope for the organizations survival--Why are you in business?

1. Components of a Business Plan: There are several elements that are essential to every business plan. Different aspects are emphasized depending on the nature of the enterprise but in general the following areas must be covered.

2. Controlling the Management Plans: There would be no need for control if there were no goals and objectives. Almost all organizations have some controlling mechanism in place usually developed around accounting budgets. In the absence of any business plans the focus evolves around fiscal expenditures hence the term Controller in most organizations.

The function of Controlling is to monitor all plans and budgets to provide for intervention when necessary to redirect strategies or operations toward the accomplishment of set goals. The primary element for monitoring progress is real time reporting. That is, reporting accurate and timely enough to permit for effective corrective actions when necessary.

The tools for controlling an organization are the various financial reports that are made available to management on some regular basis. Modern computerized accounting packages have greatly simplified the task of preparing the these reports and a large variety of powerful accounting tools are now available to even the smallest enterprise.

An overview of business and accounting concepts, guidelines, and practices is outlined in the following sections to facilitate understanding of the information needs of a business and the availability of integrated management software. The discussion is intended to provide an introduction to some basic business and accounting concepts as well as terms and practices. The processes and procedures that follow apply to all types of organizations and are at the heart of most professional accounting software available in the marketplace.

Specialty packages appeal to certain types of businesses for they appear to be developed specifically with them in mind. A major retail store prefers an accounting system which emphasizes the inventory control capabilities through a point of sale function. The retail requirement appears different from that of a doctors office which focuses on services and insurance payments. The manufacturing business on the other hand focuses on inventory (raw materials and finished goods), labor, and investment for equipment and plants. The manufacturing facility is additionally concerned with capital equipment expenditures. The general accounting guidelines are valid on all three. However manufacturing incorporates additional concepts which are applicable only to it.

3. THE CONCEPT OF THE BUSINESS MODEL AND THE TRANSACTION CYCLE: Accounting systems are empty shells until the categories and groupings that need to be tracked and reported are decided upon. Depending on the end products the emphasis of the system will vary, a service industry has different control points than a producer of goods, as does a retail merchandiser differ from a financial institution. In the final analysis the accounting system must track the process.

A business model can be a useful tool to illustrate the order in which transactions and information moves through a company.

A merchandizing business acquires inventory from a vendor with the intent of reselling it at a profit. Upon acceptance of the shipment of goods from its supplier the merchandizing company incurs a cost for the goods which are now part of its inventory. In the accounting system all money paid for inventory is categorized in a line item as cost of inventory. When the inventory is sold to customers, it is said to have produced revenue for the business. In the organizations Financial Statement there is always a line item specified for "cost of goods sold". Income is categorized in another line item as revenue.

In a merchandizing business the inventory is the main source of revenue. If the business is a service, labor is the source for revenue. When certain inventory no longer has asset status, that is when its potential to produce future revenue is lost, at that point it becomes an expense. Rents, taxes, utilities, depreciation, labor, etc. are also expenses. Matching of expenses against revenue for a given time period gives the operators and investors a good idea of the health of the enterprise.

4. THE TRADITIONAL ACCOUNTING FUNCTION

In any business or organization the discipline which assists management with the task of monitoring revenues and expenditures is called accounting. Accounting is the process of recording, summarizing, reporting and interpreting financial information.

In practice accounting is a series of transactions consisting of debits and credits which equal each other. The transactions are journalized by entering them into books of original entry called "Journals". The data is later transferred or posted to the General Ledger which is a summary file that serves as the source document for the preparation of financial statements. These financial reports reflect the current asset versus liability positions of the company and a serve as a summary of its operations over a given period of time.

A. ACCOUNTING CONCEPTS: Accounting is an old profession and is based on certain generally accepted concepts. Accounting records are kept and interpreted according to Generally Accepted Accounting Principals (GAAP) and general statements accepted by members of the accounting profession. The current principles are issued by the Financial Accounting Standard Board.

The "Business Entity Concept" assumes that a business enterprise is separate and distinct from the person or persons who supply the assets. Each business is it's own entity. As a separate entity the accounting records must relate only to the business and should be kept separate from the owners personal records at all times. This concept applies to all businesses.

The "Unit of Measurement" concept accepts that the effects of business transactions should be expressed in monetary terms. Money is both the common factor of all business transactions and the only feasible unit of measurement that can be used to achieve uniform and comparative financial data.

The concept of double entry accounting relates to the "Fundamental Accounting Equation". The equation states that what is owned, that is the assets, must equal the claims against those assets, which is known as liabilities and owner's equity. The accounting equation is expressed as follows:

ASSETS= LIABILITIES + OWNER'S EQUITY.

This equation remain always in balance for it is based on a fundamental accounting equation of double entry accounting DEBIT = CREDITS. We will return to this equation later and discuss the types of accounts that make up its various elements. 

Double entry accounting, simply stated, means that a transaction must affect at least two accounts in the accounting equation. It must be stated in dollar amounts, and that the equation must maintain its equality (debits must equal credits). It is possible to have a transaction that would affect only one side of the equation i.e. one asset amount is increased while reducing another asset amount. In this case there is no net change to the accounting equation, the accounting equation maintains its equality.

The "Matching Principle" requires that the revenues earned in one accounting period be matched against the expenses incurred in earning that revenue over the same accounting period. The expenses must be compared against the related revenues to accurately state the fair amount of net income (or net loss) earned by the business during the accounting period. Accounting periods are generally thought of as a period of one year - a 12-month passage of time. It need not be a regular calendar year ending on December 31. If other than a calendar year is adopted it is referred to as a fiscal year. The accounting period may also be broken down into 52 weeks, 13-week quarters, or 12 months.

We must recognize that for effective management of the business, as well as for proper disclosure of the operations to the absentee owners or shareholders, financial reports are needed more frequently. Such reports are known as interim statements, and the time spanned by interim reports covers less than a year.

B. ACCOUNT TYPES AND CLASSIFICATIONS: In the fundamental accounting equation, assets, liabilities, and owner's equity are known as "elements" of the equation. Within each element is a type of account.

An account is a record or file used to collect financial changes. These changes are a result of "transactions," which are financial events that cause the accounts in the accounting equation to change. In their simplest form there are six types of accounts. They are the asset, liability, owners equity, revenue, cost, and expense accounts.

These six accounts can be further subdivided into Permanent and Temporary accounts. The asset, liability, and owners equity accounts are classified as "permanent accounts" In that they normally maintain a balance and their balances are carried forward from one accounting period to the next. They are an expression of the financial position of the enterprise at a given point in time and are reported on in the balance sheet.

1. Assets: Assets are anything of monetary value owned by a business. The six basic categories of assets are cash, receivables, inventories, plant, and equipment. Assets are listed on the balance sheet as either "current" or "fixed". Current assets are cash, other assets are those that may reasonably be expected to be realized in cash, by being sold, or used up, usually within one year or less through normal operations of the business.

Building and equipment assets are called permanent tangible or fixed assets. Except for land, these assets gradually wear out or otherwise lose their usefulness with the passage of time. This is known as depreciation. The expense associated with depreciation is refereed to as depreciation expense.

Included in each of the asset accounts are:

2. Liabilities: Liabilities are claims against the assets of a business by creditors as a result of buying or borrowing on credit. Liabilities are identified by the word "Payable" attached to the account title and like assets are classified as current or as long-term.

Current liabilities are debts that must be paid within one year of the balance sheet date and include accounts payable, notes payable, loans payable, and federal income taxes payable. Debts that are not due within one year of the balance sheet date are considered long-term or fixed liabilities. Mortgage payable represents a long-term liability. Owner's equity represents the owner's claim against the assets of a business. This financial interest by the owner is derived from the fundamental equation by subtracting the liabilities from the assets as:

ASSETS - LIABILITIES = OWNERS EQUITY

Examples of owner's equity accounts include capital, capital stock, paid-in capital, retained earnings, and treasury stock,

3. Temporary Accounts: Revenue, cost, and expense accounts are classified as "temporary accounts" because they collect information for only one accounting period. Their balances are then transferred to the Owner's Equity (capital) account during closing procedures at the end of the accounting period. These temporary accounts are an extension of owner's equity and represent the net result of current operations. Revenues increase the owner's equity account as a result of the selling of goods and/or services. Sales, fees, and commissions are names which identify revenue accounts. The closing process zeroes the books for the next accounting period.

Costs decrease the owner's equity account as they are subtracted from revenues in determining "gross profit". They represent the cost of goods purchased for resale to customers. A cost account commonly used is the purchases account. Other cost accounts include transportation, purchase returns and allowances, and purchases discounts. Expenses decrease the owner's equity account as they are subtracted from revenues and represent the purchases of goods and services used to operate or manage the business. Expenses are also known as expired costs. Expense accounts are generically named and include such titles as delivery, insurance, payroll taxes, rent, salaries, supplies, telephone, and utilities.

4. Transactions: All changes in an organizations financial position begins with a transaction. A transaction is a financial event that causes the fundamental equation to change. For example, if the owner started his business with a cash investment of $10,000, the equation and accounts would be affected as follows:

ASSETS = LIABILITIES + OWNERS EQUITY OR Cash = liabilities + Capital

$10,000 = $0 + $10,000

Assume the owner also purchases office equipment on credit for $5,000. The equation is now expanded to:

ASSETS = LIABILITIES + OWNERS EQUITY OR

Cash + Furniture = Accounts Payable + Capital

$10,000 + $5,000 = $5,000 + $10,000

Notice the double entry concept and how the equation remains in balance after both transactions have been recorded.

5. Debits and Credits: The concept of "debit" and "credit" as used in accounting is easily illustrated with the use of the "T". A "T" divides the account into two sides, the left side is the "debit" side, and the right side is the "credit" side.

Left Side                 Right Side

L----------------------------------------R

Debits                          Credits

By convention debit amounts are placed on the left side of the account. Credit amounts are placed on the right side of the account. Assets are on the debit side of the ledger and liabilities and owners equity are placed on the credit side. The abbreviations Dr and Cr are used to indicate debit or credit respectively.

6. Permanent Accounts: Balance sheet accounts represent the worth of the organization. The Balance Sheet is the current status of the asset, liability, and owner's equity capital accounts. Depending on the type of account debited or credited the dollar amount either increases or decreases. There are rules for increasing and decreasing balance sheet accounts. These are the permanent accounts.

The balances of the permanent accounts are carried forward from one accounting period to the next. An account balance is the difference between the total debits and credits to an account. If the debit side is larger, then the account has a "debit balance"; if the credit side is larger, the account has a "credit balance". The account balances represent the financial condition of the business as of a specific date, and are reported on in the balance sheet.

The rules for debiting and crediting are developed from the accounting equation. All accounts making up the equation have a "normal balance side". The normal balance side is that side (debit or credit) of an account in which the balance would appear if an account has monies placed in it.

Again we can use the T" accounts to illustrate this principle. It is difficult for non-accountants to remember when a transaction should be a debit or credit to the account. The following are some rules to assist in remembering when to increase or decrease the Balance Sheet Accounts.

ASSETS =           LIABILITIES  -  OWNERS EQUITY

 Debit Increase   Debit Decrease   Debit Decease   

Normal  Balance   Normal Balance  Normal Balance

 Debit                        Credit                   Credit

7. Temporary Accounts: Revenue, cost, and expense accounts are known as "temporary accounts" because their balances are closed (zeroed) out at the end of the accounting period to permit the separation of one accounting period to the next.

Revenue, cost, and expense accounts are reported on in the financial statement called the income statement.  This report reflects the financial activity of the company for a particular length of time known as an accounting period. (Refer to discussion of accounting periods.)

The recording of all revenues (sale, fees commissions, etc.), costs (cost of goods, etc.), and expenses into the owner's equity capital account is not practical. For proper control all entries in the account would need to be sorted in order to separate each different revenue, cost, and expense transaction, which would be time consuming and confusing.

A better solution is to provide a separate account for each revenue, cost, and expense transaction permits the collection of expenditures by specific types - advertising expense, rent expense, salaries expense, utilities expense, and so on. The individual amounts of each revenue, cost, and expense account are then distinguishable and readily available.

Since revenue increases an owner's equity, revenue accounts have their normal balance side on the right (credit) and the same rules apply for the increasing and decreasing as the owner's equity account. Revenue accounts are increased on the right (credit) side and decreased on the left (debit) side.

As costs and expenses decrease the owner's equity, their normal balance side is on the opposite side of the revenue account as their balances are subtracted from revenue. The balances in these accounts are increased on the debit (left) side because owner's equity is decreased on the debit (left) side and the balance decreased on the credit (right) side.

Liabilities and owner's equity are on the right side of the equation. Their normal balance side would be on the right (credit) side. Their increase and decrease sides are opposite that of assets. They are increased on the right side (credit side) of the account, and decreased on the left side (debit side).

Below are the rules for increasing and decreasing Income Statement (temporary) Accounts.

REVENUE                         COSTS                              EXPENSES

(Credit Increase)               (Debit Increase )             (Debit Increase)   

Normal  Balance               Normal Balance              Normal Balance

 Credit                            Debit                              Debit 

C. PREPARING A TRANSACTION: All transactions should be analyzed to indicate their proper debit and credit parts before being entered into the accounting system. The following steps can be used to assist in identifying which accounts to debit and credit:

Using the above transaction analysis, the transaction example given below would be analyzed and journalized as follows:

Paid $1500 cash for the January Rent.

1. Accounts Identified are: Rent Expense, Cash

2. Elements Affected: Owner's Equity, Asset

3. Increase or Decrease: Decrease, Decrease

4. Identify Debit/Credit Debit Credit

5. Journal Entry: Credit Cash $1500 Debit Rent $1500

a. Charts of accounts: The first step in setting up an accounting system is to prepare a chart of accounts. A chart of accounts is a listing of those accounts that make up your accounting system, subdivided into sections. These should match the accounting equation element types (assets, liabilities, owner's equity, revenues, costs, and expenses) but could be given more specific names. The chart has the added feature of displaying the account title and account number assigned to each of the accounts used.

A simple analogy would be to picture a filing cabinet with six drawers numbered one through six. Each drawer would represent one of the six types of accounts. Each drawer would contain file folders for collecting the financial activity information (transactions). A file folder is made up for each account title listed on the chart of accounts and placed into its proper drawer in the filing cabinet with each file folder having the assigned name (title) of the account and the account number displayed.

Displayed below is a sample chart of accounts. Notice that the first number from the left indicates the type of account. A "1" indicates an asset account, "2" indicates a liability account, "3" indicates owners equity, and so on.

b. Sample chart of accounts:

• ACCOUNT NO. ACCOUNT NAME

ASSETS

• 10000 Cash in bank
• 11000 Accounts Receivable
•  12000 Merchandise Inventory 
•  1300000 Machinery and Equipment
•  14000 Furniture and Fixtures
• 15000 Accumulated Depreciat.- Furn.& Fixtures 
• 1600000 Building
• 17000 Prepaid Insurance

LIABILITIES

• 20000 Accounts Payable
• 21000 FICA Taxes Payable
• 22000 Federal Withholding Taxes Payable
• 23000 Sales Taxes Payable

OWNER'S EQUITY

• 30000 Capital Stock
• 31000 Retained Earnings
• 39000 Mortgage Payable

REVENUES

• 40000 Furniture Sales
• 41000 Income from Repairs

COSTS

• 50000 Materials
• 51000 Labor
• 52000 Freight-In

EXPENSES

• 60000 Advertising Expense
• 61000 Depreciation Expense
• 62000 Insurance Expense
• 63000 Maintenance Expense
• 64000 Miscellaneous Expense
• 65000 Office Supplies Expense
• 66000 Rent Expense
• 67000 Salaries Expense
• 68000 Utilities Expense

After the chart of accounts is prepared , the next step is to record transactions into the system. Entering data into the accounting system is accomplished by recording the data into a journal. A "journal" is a book of original entry where the financial information is first recorded. The information contained in the journal is then transferred (posted) to the accounts. The most common journal is called the "general journal" which can be used to record all possible transactions.

c. THE JOURNALS: The process of recording financial data into the journal is called "journalizing". The data entered is the "journal entry". All journal entries must contain a date, a debit account and amount, a credit account and amount, and an explanation or reason for the transaction.

All entries in a journal must be substantiated by showing proof or a reason for the entry. The evidence used to support the entry is a source document which is a written or printed form containing data about the transaction. Checks, invoices, cash register tapes, and memoranda are examples of source documents. The documents help provide an "audit trail" which assists in tracing data from its origination to its destination, or vice versa. Rather than using just one general journal, large enterprises may choose to break this up into four special journals to enter data: sales journal, cash receipts journal, purchases journal, and cash payments journal. Each journal is designed to collect specific types of transactions.

The sales journal records all sales on credit, while the purchases journal records the purchases of all merchandise on credit for resale to customers. The cash receipts journal records all monies received, and the cash payments records all monies disbursed or paid out. Special journals may also be set up for any function the accountant may feel needs a separate book of original entry, such as a payroll journal or a detailed fixed assets and depreciation journal.

Journals may have more than one debit part and credit part which is known as a compound journal entry. As in the case of an owner purchasing a building for $20,000 paying $5,000 cash, and incurring a mortgage payable (liability) for the balance.

As stated in step 5 of the Preparing a Transaction section, the debit part of the transaction is recorded first. After the debit information is transferred (posted) to the ledger, it is necessary to place in the journal the account number to which the debit part of the entry was posted. Repeat the above process, posting any additional debits. When the debit part(s) of the entry have been posted, continue posting the credit part(s) of the entry. Then move on to the next entry.

1. Types of Journal Entries: There are different types of journal entries. The entries most commonly used are adjusting, closing, and correcting entries.

a. Adjusting entries: Certain asset accounts must be adjusted at the end of an accounting period because the final balance in the account is not the true balance. For example, assume that an insurance policy was prepaid for the entire year by paying a premium of $1200 on January 1. The journal entry would be to debit (increase) the asset account called "prepaid insurance," and credit (decrease) the asset account "cash."

At the end of January, one month or one/twelfth of the premium has expired. The asset account, "Prepaid Insurance," shows 12 months' premiums. An adjustment must be made in the journal to increase the insurance expense account and decrease the prepaid insurance account by $100.

After journalizing and posting the entry to the General Ledger, the prepaid insurance account will show a balance of $1100 on February 1, which represents 11 months' coverage remaining. The insurance expense account now reflects the proper amount to be charged against the revenue for the month of January.

Other accounts that may need to be adjusted at the end of the accounting period include receivables, merchandise inventory, supplies, and any assets that must be depreciated, as well as any other assets requiring adjustment.

b. Closing entries: Closing entries are those entries used to close (transfer) amounts in the temporary owner's equity accounts to the permanent owner's equity account, usually referred to as the "capital account". These temporary accounts are the revenue, costs, and expense accounts.

The balances in these temporary accounts are transferred to the owner's equity capital account during the closing process. The closing process brings the temporary accounts back to zero in preparation for gathering the next accounting period's information. The final amount transferred to the owner's equity capital account represents the net income or the net loss for the business for the current accounting period. The amounts in the temporary accounts are first transferred to a temporary owner's equity account called income and expense summary. The only time this account is used is during the closing process at the end of each accounting period. After all the revenue, cost, and expense totals are transferred to the income and expense summary account, the total of the debit side is compared to the total of the credit side.

Income and Expense Summary

L----------------------------------------R

Cost and Expense Side ¦ Revenue Side

                                Dr ¦ Cr

If the debit side is larger, there is a net loss as costs and expenses are greater than the revenue. If the credit side is larger, there is a net income, because revenue is greater than the costs and expenses. The balance of the income and expense summary account is then transferred to the capital account. To close an account, enter an amount on the opposite side of the account that makes the balance equal to zero. Refer to the following illustration of closing entries used at the end of the accounting period.

Given:

Sales $500

Rents $500

Utilities $300

Closing entries are prepared based upon the following three-step procedure:

Step 1

Close the revenue account(s) and transfer the total to the credit side of the income and expense summary account.

Dr Sales $1300 Cr Income & Expense Summary $1300

Sales

L ---------------------------------------- R

 1300 T  1300

Income & Expense Summary

L------------------------- R

(L) 900 ¦ 1300(R)

Step 2

Close the expense accounts and transfer as a total to the income and expense summary account.

Dr Income & Expense Summary $900

Cr Rent Expense $600

Cr Utilities Expense $300

Rent Expense Utilities

l--------------- R    L---------------R

600 ¦ 600 (L) 300 ¦ 300 (R)

Step 3

Close the income and expense summary account to the capital account.

Dr Income and Expense Summary $600 Cr Capital $600

c. Correcting entries: A correcting entry is used to transfer an amount from one account to another. Examples of the need for a correcting entry would be a posting to the incorrect account or having to make a prior period adjustment.

Lets assume the debit was recorded to the advertising expense account instead of to the insurance account. A correcting entry should be recorded in the general journal and posted. The insurance expense account (the account that should have been increased) should then be debited, and the advertising expense account credited (decreased) to reduce the amount that was incorrectly entered.

A prior period adjustment is needed when an error has been detected which has a major affect on any prior period financial statements. For example, assume the bookkeeper recorded the rent for January as $5,000 instead of $500, but the error was not detected until April. The rent expense was debited (increased) and accounts payable was credited (increased).

Rent Expense Accounts Payable

L--------------------R  L--------------------R

5,000 ¦ ¦ 5,000 Dr ¦ Cr Dr ¦ Cr

This is a major error, as the expenses for January are overstated

by $4,500, and the income for January is understated by $4,500. A correcting entry needs to be recorded and posted to January, as this is the accounting period that is in error. The financial statements for January and succeeding months would require adjustment to reflect the new information. The correcting entry would require a debit (decrease) to accounts payable for

$4,500 and credit (decrease) to Rent Expense for $4,500.

d. Discounts: A discount is a reduction in the amount to be received from a charge customer or paid to a vendor, depending on whose accounting books you are addressing. To the seller a discount is a reduction to sales, and to the buyer the discount is a reduction to purchases.

Some businesses offer credit terms such as 2/10, net 30 to induce the customer to pay his bill in full before the end of the credit period. The terms 2/10, net 30 mean that the customer may reduce the amount he must pay the seller by two percent if he pays the full amount (less the discount) of the invoice within 10 days from the date of the invoice. If the full amount is not paid within the discount period, the buyer must pay the full, or net amount, within 30 days from the date of the invoice. Should the customer take advantage of the discount, the seller must reduce the revenue account, because a lesser amount will be received than what was originally recorded in the revenue account at the time of the sale. As an example, assume the customer purchased merchandise for $300 on credit. at the time of sale the seller would increase (debit) the accounts receivable account and increase (credit) the revenue account. The buyer would increase (debit) the purchases account and increase (credit) accounts payable. 

e. The Ledger:

1. Ledger vs. Journals: Journals are referred to as books of original entry, where they serve as a diary in which each transaction, or batch of similar transactions, are recorded intact. The next step is to record these same transactions over again in the "ledger", or book of final entry. The difference is that each part of the entry recorded in the journal is posted (copied) to its own ledger account. Therefore, if a journal entry is made up of five parts, those five parts will each be posted to a separate ledger account. The group consisting of asset, liabilities, owner's equity, revenue, cost, and expense accounts, is known as the "General Ledger."

The Journal is organized as a chronological record of transactions in the order of their occurrence. The Ledger is organized into as many different pages (or accounts) as needed to accumulate the postings from the various journals, but classified according to significant financial elements instead of chronology.

The General Ledger is used in the preparation of the Financial Statements as all pertinent information needed to prepare these reports is stored in the accounts in the General Ledger. In our previous example, the six filing drawers including the file folders represents the General Ledger.

2. Subsidiary Ledgers: Another type of ledger used in accounting is called a "subsidiary ledger". It contains detailed information about an account that is summarized in the General Ledger.

Examples of two subsidiary ledgers are the accounts receivable and accounts payable ledgers. The general ledger contains two "controlling accounts" called accounts receivable and accounts payable which show only the total amount that will be received from customers on account and the total amount owed to creditors.

The controlling accounts do not list all names of the customers or the creditors. Therefore, a separate ledger (filing drawers) is required to track the individual names and the amounts to be received or paid. The subsidiary ledger can be arranged alphabetically or numerically and must be updated constantly to reflect current balances in the accounts. The sum totals of the subsidiary ledgers must equal the total of the controlling accounts. Refer to the examples below:

GENERAL LEDGER ACCOUNTS RECEIVABLE

ASSETS LEDGER

Accounts IBM CO $5,000

Receivable Xerox Corp $2,000

DEC $4,000

State CA $3,000

SCE $6,000

$20,000 $20,000

GENERAL LEDGER ACCOUNTS PAYABLE

LIABILITIES LEDGER

Accounts ABC Co. $1,000

Payable CPZ Corp. $ 500

IBSB Co. $1,500

$7,000 XYZ Co. $4,000 

3 Cash Basis vs. Accrual Basis Accounting: Cash basis accounting differs from accrual basis accounting in the way it relates to the time that the actual transaction is recorded. Cash basis accounting recognizes the revenues, costs, and expenses only upon the receipt or payment of cash. In contrast, accrual accounting records the revenues, costs, and expenses when the commitment is made, even though cash has not yet been received or paid out.

While accrual accounting is not perfect, it is far superior to accounting on a cash basis. Under the cash basis system, neither receivables, payables, nor the sales or purchase of merchandise are recognized until the related cash changes hands. There are no revenues, costs, or expenses except as they flow in the form of cash. The accrual basis of accounting recognizes the revenues, costs, and expenses even though they may have been paid for in advance of, at the time of, or in some cases, after delivery.

Under the accrual concept, revenues are generated, and it matters not when the actual payment takes place. In short, revenues, costs, and expenses accrue and are realized at the time of sale, whether or not cash is received. Expenses are also accrued when using the accrual method, rather than being recorded only on a cash basis. An expense is accrued in the accounting period that should logically be charged with the expense, although the related cash outlay may or may not occur in whole or in part in that same period. A worthwhile accounting principle is the "matching principle". This Principle states that one should strive to bring together in the same accounting period the revenues earned in that period and the expenses that were incurred to produce those revenues.

It is fairly easy to determine which accounting period should get credit for a given sale or other revenue-producing act, but it is a much tougher job to determine how much of each of the many variations of expenses should be accrued in the same period.

Revenues tend to dominate the process of income determination as they are "realized" by sale, and expenses are accrued to match.

f.  Financial Statements: Financial statements are prepared from account balances in the General Ledger. Three common financial reports are the income statement, balance sheet, and the statement of financial change.

Financial statements are prepared on a regular schedule as determined by management policies. They are usually prepared monthly and can be prepared at anytime, but whenever they are prepared they are only accurate as of the date of posting to the ledger.

1 Trial Balance: In order to prepare the financial statements, the summarized balances from the general ledger must be in balance, that is the "debits" must equal the "credits". To prove the equality of the posting to the general ledger, a "trial balance" is prepared. This is made up of a listing of all the accounts in the general ledger, including both the account title and the account balance. This is known as a formal trial balance.

A calculator can also be used to conduct a "quick" trial balance by entering the debit balances as a plus (+) and credits as a minus (-). After all debits and credits have been entered, the calculator should show a zero balance. This is known as "zero proof".

2 Worksheet: A form known as a "worksheet," is also used. This is a ten- column tabular form similar to a computer spreadsheet. The first two columns of the worksheet are the trial balance debit/credit columns. The total of the trial balance debit column must equal the total of the trial balance credit column. The next two columns are used for planning the adjustments. After the adjustments are calculated, the extended balances are entered into the adjusted trial balance debit/credit columns. The adjusted trial balance columns should also be equal.

1 The Income Statement: Businesses report the measurement of their income in an income statement also known as a profit and loss statement. A company will measure its revenues, costs, and expenses on a regular basis (monthly, quarterly, yearly). These are known as accounting periods. We generally think of the accounting period as a year, or a 12-month passage of time. We must recognize that for effective management of the business, as well as for effective disclosure of operations, financial reports are needed more frequently. Such reports are known as interim statements; the time spanned by these reports, as has been pointed out, is less than a year.

Income is measured by matching costs and expenses against revenue that has been realized in the same accounting period. The income statement reports this matching of the revenue to costs and expenses.

2 Balance Sheet: The balance sheet represents an extension of the accounting equation:

Assets = Liabilities + Owner's Equity

The balance sheet is a historical report in that most of the data represents the result of past and completed transactions. It does not contain projected or budgeted data.

Comparing the income statement to the balance sheet is like comparing a moving picture to a still photo. The income statement spans a given period of time rather than a snapshot at a given instant. The information needed to prepare the financial statements is taken from the worksheet which uses the information in the General Ledger.

3 Assets section: The assets section of the balance sheet is usually divided into current assets, and intangible assets. Current assets are those asset accounts which are cash, or other resources which are reasonably expected to be realized into cash, or consumed, during the normal operating cycle of the business, which is usually one year. A sample list of current assets would include cash, marketable securities, account-receivables, inventories, and prepaid assets.

Fixed assets are those assets which are defined as having usefulness because of their physical characteristics. They are used or consumed during the operation of the business, over a period of time which is normally longer than the accounting cycle. These assets include buildings, furniture, land, machinery, equipment and trucks.

Intangible assets are those which have no physical existence, although they may be evident through various tangible documents. This type of asset would include patents, copyrights, goodwill, leasehold improvements, research and development costs, licenses, franchises and organizational costs.

4 Liabilities section: Current liabilities are those obligations whose liquidation is reasonably expected to require the use of existing resources, properly classified as current assets, or the creation of other current liabilities.

As a balance sheet category, the classification is intended to include obligations for items which have entered into the operating cycle, such as payables (expenses) incurred in the acquisition of materials and supplies to be used in the production of goods, or in providing services to be offered for sale. Collections received in advance of the delivery of goods or performance of services, and debts which arise from operations directly related to the operating income, would be classified as current liabilities. Other liabilities whose regular and ordinary liquidation is expected to occur within a relatively short period of time, usually twelve months, are also intended for inclusion. This would include items such as short-term obligations, amounts required to be expended within one year under sinking fund provisions, and agency obligations arising from the collection or acceptance of cash or other assets for the account of third persons.

Current liabilities should not include any long-term notes or bonds whose maturity is greater than one year. Typical accounts to be found under current liabilities are accounts payable, notes payable, accrued expenses, and taxes payable.

Long-term liabilities are debts which will not be paid until more than one accounting cycle has passed. The most common of these types of debts are long term notes, mortgage loans, mortgage and debenture bonds, and installment purchases.

5 Equities section: The three basic types of equity accounts used in a corporate form of business ownership are capital stock, paid-in capital, and retained earnings.

Capital stock reflects the summary, at face value, of each share of stock that has been issued by the company. There may be several types of capital stock issued within one business; therefore, each type or class of stock must be reported in a separate account.

Paid-in capital is the sum of the amounts contributed to the company over the face value of the stock or perhaps the funds contributed where no stock was issued. It represents a permanent contribution of funds.

Retained earnings represent the net worth of the company, or profit added from its operations. This would be the sum of the net profit of the company since it started, not for just one accounting period. A negative or debit balance in the retained earnings account is commonly called a deficit.

The equity section for a sole proprietorship and a partnership differs from the corporate form of business ownership section. The business owner is identified by a single "capital" account for a sole owner, and a separate "capital" account for each partner of a partnership as illustrated below:

Sole Owner: OWNER'S EQUITY

John Doe, Capital

Partnership: PARTNER'S EQUITY

John Doe, Capital

Peter Peters, Capital

6 Statement of Changes in Financial Position: The statement of changes in financial position, also referred to as a "funds statement," details changes in assets and liabilities by focusing on changes in working capital. The excess of a business' total current assets over its total current liabilities at the same point in time may be termed its "net current assets" or "working capital". Indications of changes in financial position as reported on the balance sheet can be determined by comparing the individual items on the current balance sheet with the related amounts on the earlier statements. However, significant changes in the financial position may be overlooked and appear completely undisclosed by the statements. Therefore a separate report, the Statement of Changes,is issued to focus on current assets.

This statement reports all sources of funds, provided from both operating and non-operating sources, as well as the application of such funds.

7 The Accounting Cycle: The accounting cycle is the set of monthly procedures used to input and extract financial data. Although a specific bit of accounting data will typically flow through the various stages of the cycle in consecutive order, such bits of data are being introduced into the accounting system at all times throughout the period and thus, within the business as a whole several parts of the cycle will be undergoing activity simultaneously.

The accounting cycle:

1. Source documents are checked for accuracy, and transactions are analyzed into debit and credit parts.

2. Transactions from information on source documents are recorded in a journal. 3. Journal entries are posted to ledger. 4. The worksheet, including a trial balance, is prepared from the ledger.

5. Financial statements are prepared from the worksheet.

6. Adjusting and closing entries are journalized from the worksheet and posted to the ledger.

7. A post-closing trial balance of the ledger is prepared.

9. The cycle is started over.