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A Bookkeeping and Accounting Primer

For Small Business Owners & Bookkeepers

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                Accounting for the Small Business
                    by Duane Bristow
                    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 
        The local price of real estate changes.
        Market prices change.
        There are many others.

Chart of Accounts:

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 
        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 
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 (+)

assets=-(liabilities+owner's equity)
owner's equity=capital input+profit
     (revenues are negative and expenses are positive)
assets+liabilities+capital input+revenues+expenses=zero

General Ledger:

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.

Balance Sheet:

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.

Profit and Loss or Earnings Report:

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.

Accounts Receivable:

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 
        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 

Accounts Payable:

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.

Payroll System:

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 

Inventory Control:

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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Duane Bristow (duane@kyphilom.com)

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All contents copyright (C) 1999-2008, Duane Bristow. All rights reserved.