..of Duane & Eva's Old Kentucky Home PageDuane Bristow (duane@kyphilom.com)
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Accounting for the Small Business
by Duane Bristow
duane@kyphilom.com
http://www.kyphilom.com/
Albany, Kentucky 42602
October 30, 1999
I have been developing accounting systems and training
bookkeepers for small businesses in towns of rural Kentucky
since about 1980. This is an overview of both principles of
such accounting and use of my computer system, PGAS, to do such
bookkeeping. It should be useful to anyone who owns a small
business or is responsible for accounting for a small business.
Although the examples given use my computer accounting system,
the principles apply to any business using any valid accounting
system from manual books to generalized off the shelf accounting
packages. The main differences between these and the PGAS
system is that the PGAS system is completely customizable to
handle special needs of particular businesses. For instance it
is set up to account for quantities and numbers as well as
dollars, to handle multiple profit centers, and to handle
sales of products made from raw materials or with specialized
taxing requirements. Examples are bulk fertilizer sales and
gasoline sales. The profit center accounting and quantity and
number accounting are especially useful for farmers.
The purpose of accounting is to keep track of items of value
including goods, cash, and financial obligations in their
current state and in their flow or change over time so that
reports useful in making management decisions are available to
the managers of a business or other accounting entity.
Accounting is based on the concept of a financial transaction. A
financial transaction occurs whenever the status or ownership of
a thing of value changes.
Here are a few examples of financial transactions:
A check is written from a bank account.
A deposit is made to a bank account.
A purchase is made and cash is paid.
A purchase is made on credit.
A payment is made to an account payable or receivable.
An asset deteriorates.
An asset appreciates.
An employee is paid.
Sales tax or other taxes are collected.
A tax obligation is incurred.
An inventory item is lost or stolen.
A tax refund is received.
Crops grow.
A product is manufactured or assembled from raw
materials.
The local price of real estate changes.
Market prices change.
There are many others.
The first step in accounting is to know a business well enough
to understand the types of financial transactions well enough to
design an accounting system (chart of accounts) that will be
most useful for that particular business. See the fictional
business called Joe's Old Shoe Shop that is an example
of this process.
Since accounting consists of keeping track of financial
transactions, this is done by categorizing these transactions.
For example some involve cash or bank accounts. Some involve
inventory or other asset values. Some involve payroll to
employees. Some involve receivables from customers or payables
to suppliers.
A chart of accounts is a list of the categories of financial
transactions for a particular business. These categories are
grouped as:
1. Asset Accounts - things of value owned by the
business.
2. Liability Accounts - amounts owed to outsiders.
3. Owner's Equity Accounts - amounts owed by the
business to its owners (profit). If the
business loses money the owners may owe
additional money to the business.
4. Revenue Accounts - Sources of income.
5. Expense Accounts - Payments necessary to run the
business.
Proper accounting practice requires a double entry accounting
system. This means that each value input into the system is a
credit (-) to one general ledger account and a debit (+) to
another. Since each entry affects two accounts by the same
amount, debiting one and crediting another, the accounts are
always in balance. Another way to look at accounting is to view
the chart of accounts as a row of jars lined up along a wall
with a label on each jar. The first jar might be labeled "Bank
Account". One further down the line might be labeled "Phone
Expenses". If a phone bill is paid the accounting system takes
an amount of money out of the "Bank Account" jar and puts it
into the "Phone Expenses" jar. Thus it can be seen that the sum
of the credits will always be equal to the sum of the debits
meaning the books will be in balance or the sum of the debits
and credits together will be zero.
One might wonder where the money comes from to be transferred
between jars. The point is that the jars (or accounts) start
out empty and they stay empty to the extent that the sum of the
money in the jars is always zero. A credit to one account is
offset by a debit to another so that we have +1-1=0.
In general
asset accounts carry a debit balance (+)
liability accounts and owner's equity accounts carry a credit balance (-)
revenue accounts carry a credit balance (-)
expense accounts carry a debit balance (+)
credits=-debits
assets=-(liabilities+owner's equity)
owner's equity=capital input+profit
profit=revenues+expenses
(revenues are negative and expenses are positive)
assets+liabilities+capital input+revenues+expenses=zero
The general ledger is a report showing for each GL account in
order for a specified period of time, such as a month or a year,
the change in the balance in that account and listing all the
transactions which contributed to and made that change.
See the general ledger summary and the general ledger detail reports attached.
The two primary reports produced by an accounting system are the
Balance Sheet and the Profit and Loss or Earnings report.
The types of accounts in a chart of accounts are actually of two
general kinds:
1. Those that make up the Balance Sheet: Assets, Liabilities,
and Owner's Equity.
2. Those that make up the Profit and Loss report: Revenues
and Expenses.
I like to refer to those accounts of type 1, Balance Sheet, as
"above the line" accounts and those of type 2, Profit and Loss,
as "below the line" accounts.
Any transaction that does not affect below the line accounts
does not affect earnings. For example purchase of goods to be
sold affects the two asset accounts: Bank Account, and
Inventory, both above the line, and has no effect on earnings.
If you purchase goods to be sold you have simply converted one
type of asset, cash in the bank, to another type of assets,
goods in inventory. No profit or loss can be made until those
goods are actually sold or otherwise disposed.
The Balance Sheet is a report that shows for a specific point in time such as the end of a month or a year or some other date the financial position or status of the business. Looking at the Balance Sheet another way, it is a statement of the situation if the business were to immediately go out of business. If that were to happen all assets would be sold (hopefully at book value) and converted to a pile of cash. Immediately the size of that pile of cash would be reduced by paying off all creditors eliminating all liabilities. Any cash left in the pile after this would belong to the owners and would represent their equity or profit in the business. If, however, the cash pile produced by sale of the assets was not large enough to pay off all liabilities and the owners were then required to come up with money out of their pockets to finish satisfying the creditors the business would have a loss rather than a profit.
The P&L report is a report showing total revenues and expenses by account over a specified period of time such as a week, month, or year. Revenues are credits (-) and expenses are debits (+) so that if the business makes a profit (revenues exceed expenses) the total earnings is a credit (-). This total shows on the balance sheet as an earnings amount in an owners' equity account meaning that the business owes that amount to the owners. A P&L report can be thought of as a statement for a specific period of time showing how a profit or loss occurred.
Besides the primary reports described above an accounting system
produces many other reports necessary for management of a
business. One of the ledgers subsidiary to the General Ledger is
the Accounts Receivable Ledger or subsystem. The purpose of
accounts receivable is to keep data on amounts owed to the
business by its customers for goods sold on credit.
A cash sale results in a debit (+) or deposit to the bank
account and a credit (-) to the proper sales revenue account. A
credit sale is posted as a debit (+) or increase in the asset
Accounts Receivable account and a credit (-) to the sales
revenue account. Since the profit or loss which is the sum of
revenues and expenses is carried into the balance sheet as
current earnings, such a sale becomes a credit (-) to current
earnings because it is an amount owed by the business to its
owners or a part of owners equity.
The accounting system, in the case of accounts receivable, will
require the identification of a customer or vendor for the
transaction. This allows the system to keep a separate ledger
for transactions involving each customer with credits or payments
made by the customer and debits or charges incurred together
with a running receivable balance.
The Accounts Receivable system then allows three primary
reports:
1. A ledger or report for a single customer.
2. An Aged accounts report which is a listing of total
amounts owed by all customers together with aging
columns showing how old unpaid amounts are in terms
of months usually.
3. A statement or bill to customers usually printed and
mailed on a monthly basis.
The accounting system also allows for carrying charges to a
customer or vendors account for amounts not paid on a timely
basis.
The Accounts Payable ledger or subsystem is the mirror image of the Accounts Receivable ledger. It keeps data on amounts owed by the business to its suppliers of goods and services. While AR generally carries a debit (+) balance, AP carries a credit (-) balance or a liability balance. AR is an asset account and AP is a liability account. While the AR system produces bills to customers, the AP system produces checks to pay to suppliers. It also includes a detailed ledger for each supplier and an aged accounts report showing amounts owed by number of months elapsed since unpaid purchases.
The payroll system exists to pay employees, to keep a ledger of payments to each employee, to withhold taxes and other amounts properly from employees pay and to post withheld amounts to the general ledger as liabilities to be paid to government entities and others on behalf of the employee. Gross pay is made up of the net amount paid to each employee plus all withheld amounts. Gross payroll is posted to an expense payroll account while net pay is a credit (-) to the bank payroll account and withholdings are liabilities of the business. Besides payroll ledgers for each employee, the payroll system usually also produces various payroll reports useful in satisfying liabilities for withholdings.
Accounts receivable and inventory are the two items most likely to cause financial problems for small businesses. If accounts receivable age without being collected or if inventory grows with large quantities sitting on shelves unsold the business will soon see profits dwindle or disappear. The purpose of accounting inventory control subsystems is to account for each item or type of item in inventory by enabling the manager to know how much is selling and at what times of the year, how great is the sales margin, how much is in stock, as well as when and how much should be reordered. Maximum profits occur when the proper amounts are ordered at the proper times and prices are set properly to maximize profits. Either not having the item to sell or stocking too many unsold items will decrease profits. Inventory control is essential for businesses that sell large quantities of retail goods. Inventory control accounting is more difficult and takes more attention to detail than other accounting subsystems. It is also essential that a system of reconciling accounting system inventory figures to real-world information through a periodic physical inventory be in place.
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Last revised November 26, 1999.
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