BOOKKEEPING SYSTEM

Business owners and financial managers must be familiar with the basic elements of design, implementation, and maintenance of an effective and accurate bookkeeping system, which represents one of the most critical management tasks.

There are manual and computerized Bookkeeping Systems widely available to small business owners. 

At this stage, a Manual Bookkeeping System will be discussed to improve your understanding about the basic bookkeeping principles. This system, also known as a Double-Entry Bookkeeping System, consists of Sets Of Records, or Sets Of Books, and formal instructions for placing information in those books.

THE BASIC RULE OF THE DOUBLE-ENTRY BOOKKEEPING SYSTEM

The Basic Rule Of Double-Entry Bookkeeping states the following:

"Every transaction affects at least two accounts"

DEFINITION OF AN ACCOUNT

Each Account represents one item that appears on the financial statements, i.e. an asset, liability or owner's equity.

In its simplest form, an account consists of three parts, as outlined below. This form of the account is termed a "T"- Account because of its similarity to the letter "T". An ordinary "T"-Account is illustrated below.

THREE PARTS OF AN ACCOUNT

THREE PARTS OF AN ACCOUNT

DEFINITION OF LIABILITIES

Liabilities represent the total creditors' claims against assets utilized by the organization.

In other words, liabilities represent the total debt of the organization. Such a debt may include money owed by the organization to its employees, suppliers, banks, tax authorities, and various creditors.

Thus, according to the Basic Accounting Equation:

Liabilities = Creditors’ Claims = Assets - Shareholders’ Equity

DEFINITION OF SHAREHOLDERS' EQUITY

Shareholders' Equity represents the owners' interest in the organization and is equal to the net worth of the company.

The total value of the shareholders' equity represents the excess of total company assets over total company liabilities. 

Thus, according to the Basic Accounting Equation:

Shareholders’ Equity = Net Worth = Assets - Liabilities

DEFINITION OF REVENUES

Revenues represent the total value earned (not necessarily collected) by an organization during a specified accounting period. 

Service organizations, for example, earn revenue by rendering service to customers. The revenue earned may be in either the form of cash or as a receivable. Merchandising and manufacturing organizations, on the other hand, earn revenues as a result of delivering goods to customers. Thus:

Revenues = Total Fees Earned By An Organization

DEFINITION OF EXPENSES

Expenses represent the total cost incurred (not necessarily paid) for services rendered or goods sold by an organization during a specified accounting period. 

Thus:

Expenses = Total Cost Of Sales Incurred By An Organization

THE BASIC REQUIREMENT OF A DOUBLE-ENTRY BOOKKEEPING SYSTEM

The basic requirement of a Double-Entry Bookkeeping System is the equality of all debits and all credits, i.e.:

Total Debits = Total Credits

Thus, according to this requirement:

Equal amounts of debit and credit entries must be recorded for every business transaction.

A method of recording these transactions for different types of accounts is presented below.

The fundamental rules for recording transactions in a Double-Entry Bookkeeping System are illustrated below.

THE FUNDAMENTAL RULES FOR RECORDING
TRANSACTIONS IN A  DOUBLE-ENTRY ACCOUNTING SYSTEM

THE METHOD OF RECORDING TRANSACTIONS

THE METHOD OF RECORDING TRANSACTIONS

APPLICATION OF TRANSACTION RULES IN A DOUBLE-ENTRY ACCOUNTING SYSTEM

STANDARD BOOKKEEPING PROCEDURE

A STANDARD BOOKKEEPING PROCEDURE IN AN ACCOUNTING CYCLE

GENERAL JOURNAL

Every Business Transaction must be analyzed and entered into the appropriate journal, or an accounting book.

At the outset of a company's development, the number of transactions is usually very small. For this reason, all transactions can be entered into one Journal, known as the General Journal. 

When the company grows, however, more and more transactions take place. This growth necessitates the introduction of several journals and the recording of transactions on the following basis outlined below.

RANGE OF ACCOUNTING BOOKS

ACCOUNTS POSTING PROCEDURE INTO THE LEDGER

The next step in a manual bookkeeping procedure entails posting each journal entry to an appropriate account in the ledger.

In a manually operated accounting system, a Ledger consists of a set of individual pages, or Ledger Cards, that are placed together in a special book or file. Each ledger card contains a record of every transaction pertinent to a particular account.

All accounts, in turn, are classified under suitable headings and coded numerically for easier reference. A ledger card summarizes all increases and decreases to a single account in a chronological sequence. There is one ledger card for "Cash", one for "Inventory", one for "Accounts Payable", and so on.

A typical example of posting of data to the ledger account is presented below. In this example, $10,000 is debited to the "Cash" account No. 101 and the same amount is credited to the "Jack Jones, Capital" account No.300 in the general ledger.

Note:

If you use a computerized bookkeeping system and an accounting software package, such as Quicken ®, Quicken Pro ®, PeachTree ®, or Clarisys ®, you will be able to appreciate what such a package can do. All explanations related to the manual bookkeeping system are merely designed to explain to you what is involved in the standard bookkeeping process (and what you will avoid doing if you have a good accounting package...)

TRIAL BALANCE

First, the individual balance of each ledger account at a specified date must be entered into the "Trial Balance" column in the work sheet. 

All Debits (Dr.) and Credits (Cr.) must be summarized and a trial balance obtained. 

Sometimes, however, bookkeepers experience difficulty in balancing books of account as a result of erroneous journalizing or posting of a particular business transaction. For this reason, it is necessary to double-check all entries and to identify the recording error in a specific account. 

Once the error is identified, an adjustment must be entered into the "Adjustments" column. This adjustment necessitates addition of all corresponding balances recorded in the first two columns and enables the bookkeeper to balance all debits and all credits in an "Adjusted Trial Balance" column.

Again, in a computerized bookkeeping system with an accounting software package such as Quicken ®, Quicken Pro ®, PeachTree ®,or Clarisys ®, the Trial Balance will be done automatically, thereby making the whole bookkeeping task much easier. The same also applies to the Financial Statements and to the After-Closing Trial Balance which are discussed next.

PRELIMINARY FINANCIAL STATEMENTS

The next stage of the bookkeeping procedure entails preparation of Preliminary Financial Statements - namely: the Income Statement and the Balance Sheet. 

In order to accomplish this task, it is necessary to extend the adjusted balances of all revenue and expense accounts to the "Income Statement" column, and all assets, liabilities, and shareholders' (owners) equity to the "Balance Sheet" column. Doing so will enable the bookkeeper to prepare preliminary financial statements which will remain subject to verification by the company's auditors (CPAs).

AFTER-CLOSING TRIAL BALANCE

The last stage of the bookkeeping procedure entails adjusting and closing the appropriate accounts in the journals and the ledger. 

Once this procedure is accomplished, the bookkeeper may prepare an After-Closing Trial Balance, thereby providing the company's auditors with tangible proof of accurate recording of all business transactions.

ADVANTAGES OF COMPUTERIZED BOOKKEEPING

Once you understand what is involved in traditionally manual bookkeeping procedures, you will be able to appreciate the importance and usefulness of modern computer software accounting programs that are widely available for use in the marketplace.

These programs, mentioned earlier, such as Quicken ®, Quicken Pro ®, PeachTree ®, or Clarisys ®, and others will enable you and your management team to maintain accurate and cost-effective bookkeeping and accounting procedures to satisfy the requirements of your company's auditors and the Internal Revenue Service (IRS).

Computerized Financial Management is discussed in detail in Tutorial 3.