If you have heard of the term bookkeeping but did not understand it, then here is your chance for understanding what bookkeeping means. This article is our attempt at covering the basic concepts related to bookkeeping.
What Is Bookkeeping?
Bookkeeping involves keeping a record of financial transactions, storing these records, and being able to retrieve these records when required by a business. Bookkeeping requires you to possess knowledge about debits and credits along with financial accounting. There are many tasks that come under bookkeeping. For example, paying the suppliers, keeping a record of the receipts from customers, and providing financial reports are some of the tasks involved with bookkeeping. Other tasks of bookkeeping include adjusting entries, keeping records of supplier invoices, and billing for goods that have been sold to the clients.
Bookkeeping Before the Advent of Accounting Software
Earlier, when there were no computers bookkeeping involved handwritten entries into journals. This was the case for small businesses. Journals were where the entries were made initially. Eventually, special journals were introduced known as cash receipts journal, sales journal, cash payments journal, and purchases journal. The entries were made according to date. Once this was done, the entries were written in the general ledger to the particular accounts. For example loans payable, rent expense, and cash were some of the accounts. The balance of every account was individually calculated and these were used for making the financial statements.
A trial balance was prepared because when everything was handwritten, there was bound to be at least some calculation errors when done manually. A trial balance consists of the name of the account and the balance of each account. The balance of each account was written in the debit and credit columns. The totals were then calculated for each column; the credit column and the debit column. When the two columns were the same, it meant there were no errors. However, even if there was a small difference then it meant there was a mistake. Retracing was the only option to find the mistakes in the entries.Once this was done, it meant correcting the errors and once the correction was complete it meant bookkeeping was completed. The accounting phase was next and this is when the accountant prepared the adjusting entries. Once this was done, the financial statements were prepared by the accountant. When this was completed, it was time for the closing entries. The closing entries were required to make the income statement account balances to be zero. The stockholder’s retained account or proprietor’s capital account was where the total income statement account balance was transferred eventually.
After the advent of computers and accounting software tools, some lines blurred when it came to bookkeeping and accounting. You might think that now many things are not as distinct as they once used to be. That is because of the automatic update feature that helps to make changes to a lot of things. Let us take the example of creating a sales invoice. This will first update the accounts in the general ledger such as sales and cost of goods that have been sold. At the same time the customer’s information will get updated. Another thing that will happen is that information will be automatically carried over in relevant financial statements without the need to reenter the same data.
Accounting software’s biggest advantage is that it has eliminated the errors that occurred when manual calculations were done. This is because of the accuracy of the accounting software. For this reason the trial balance will always be in balance and so there is no more time wasted looking for errors. The accounting software has been made such that each transaction that occurs has a credit amount that equates to the debit amount. However, the accounting software cannot detect errors if some transactions were not included or if something was entered twice. Moreover, internal controls are required to ensure there are no fraud transactions entered.
Remember that adjusting entries might still be required even if you are using accounting software. This is because of what you did not enter in the software such as assets that were earned or expenses that took place. A human is the one who is ultimately responsible for adjusting entries because without human intervention, the software might lead to financial statements that are not so accurate. Once the financial statements are complete, the income statement account balances are transferred to either the stockholder’s retained earnings account or sole proprietor’s capital account. Just like it used to happen in the past, the balance will be zero of the income statement accounts.
Are Bookkeeping And Accounting The Same?
Is there a difference between bookkeeping and accounting? Accounting is a broad term that includes bookkeeping. Bookkeeping is all about gathering data, organizing the records, and being able to access or retrieve the data. This data is required for enabling day-to-day operations and for helping prepare the financial statements and reports. The need for internal controls is essential in bookkeeping because all the financial records should be complete and accurate. In addition they need to be recorded in a timely manner in order for them to be accurate and to make sense. Bookkeeping is also known as recordkeeping.
Accounting is the next step of bookkeeping as explained earlier and it ensures that the recorded financial information is correct. Analysis and verification is done as part of accounting. Hence, a bookkeeper is responsible for getting the information into the general ledger. Depending on the type of company, the responsibilities of a bookkeeper might differ. For example, a bookkeeper is responsible for receivables, payables, and payroll among other things in a small company. However, in a larger company, the responsibilities and duties of a bookkeeper might be given to a payroll clerk, a payable clerk, and an accounts receivable clerk.
Accountants are responsible for taking a look at the entries in the general ledger made by the bookkeeper. An accountant is the one who prepares the adjusting entries and he is the one who will prepare the financial statements. The accountant is the one who will give orders to the bookkeeper. The accountant is the one who will go through the financial statements along with the owners and the management. Moreover, the accountant is the one who will be responsible for operations budgeting and cost accounting among other responsibilities. An accountant is paid better than a bookkeeper.
Methods Of Bookkeeping
There are two methods in which bookkeeping is done; the cash method and the accrual method. The cash method is where the revenue is recorded at the time when the cash is received in the income statement. The expenses are recorded when the cash is paid. On the other hand, the accrual method is when the revenue is recorded when it is earned instead of when the cash is received. With the accrual method, for example, the revenue will be recorded even if the customer hasn’t paid the money yet because he will in the future. Similarly, when it comes to expenses, the goods and services are recorded even though the cash hasn’t been paid yet.
Let us give an example to better make you understand the difference between cash method and accrual method. Let us say that you sell dog food. If you sell Rs. 1 lakh worth of dog food then according to the cash method there will be no record until you receive the cash of Rs. 1 lakh from your customer. Using the accrual method, Rs. 1 lakh will be recorded even if you did not receive the money from the customer yet. You might receive the money months later but still the record will be there when the accrual method is used. This is the same for expenses where in the cash method you record it only when you pay cash but in accrual you record it when you receive the bill.
Mostly, it is the accrual method of accounting that is preferred and so most companies use this method of bookkeeping. There are two reasons why this is the case. The first reason is that it provides a realistic reporting approach to the net income, revenues, and expenses of the company. The second reason is that the accrual method of accounting enables a more comprehensive reporting of the stockholder’s equity, assets, and liabilities of the company. However, you need to know that smaller companies may make use of cash method instead of accrual method of accounting as this can give them some sort of income tax benefit.
One of the ways in which transactions are recorded is known as double entry bookkeeping. The double entry bookkeeping is a 500 year old system. This method states that when there is a transaction, there will be two accounts that will be affected in the general ledger accounts. In one of the accounts, the amount that will be entered as a debit and in one of the accounts the amount that will be entered as credit. Moreover, the total amount of debits should be equal to the total amount of credits. The bookkeeping equation will be balanced when this is done.
You will understand this method of bookkeeping with some examples. Let us say that you purchase some goods on credit. The first account that will be affected will be the inventory account and the second account that will be affected will be the accounts payable. Let us take another example where your business borrows money. The first account to be affected will be the cash account and the second account that will be affected will be the loans payable. A third example is that you are a company who pays the rent. The first account to be affected is the cash account and the second account will be the rent expense account.
Debit And Credit
When talking about account bookkeeping or double entry bookkeeping, the terms debit and credit are used a lot. Debit is associated with an entry that is made on the left side of the account while credit is associated with an entry that is made on the right side of the account. In order to make it easier for people to understand the double entry bookkeeping, there are some golden rules that will help you understand how you need to record the transactions. You need to know what the three types of accounts are before you understand the golden rules of accounting. The three types of accounts are real accounts, personal accounts, and nominal accounts.
A real account is also known as a permanent account. A real account is one that is carried forward and it isn’t closed at the end of the year. Some examples are stockholders’ equity accounts, asset accounts, and liability accounts. A real account can be tangible or intangible. The second type of account is a personal account. This type of account is related to people, companies, and firms. The third type of account is nominal account which is also called temporary account. The nominal account is closed at the accounting year’s end and so starts with a nil balance when the new accounting year starts. Examples of nominal accounts include losses, revenues, gains, and expenses.
Here are the golden rules of accounting with examples.
The golden rule with respect to the real account is to debit what comes in and credit what goes out. For example, purchasing goods for Rs. 50,000 will involve two accounts; the goods account and the cash account. The goods account will be debited by Rs. 50,000 and the cash account will be credited by Rs. 50,000.
The golden rule with respect to the personal account states that debit the receiver and credit the giver. For example, you have paid ABC a sum of Rs. 60,000 by check. The ABC account will have a debit of Rs. 60,000 while the bank account will have a credit of Rs. 60,000.
The golden rule with respect to the nominal account says to debit the losses and expenses while it says to credit the gains and incomes. For example, you purchased something for Rs. 70,000 in cash. In this case the purchase account will have a debit of Rs. 70,000 and the cash account will have a credit of Rs. 70,000.
When you choose accounting software that is dependable, it will have the rule debits should equal to credits. That means, it will already be coded such that it will check if debits are equal to debits. Whether a transaction is accepted and processed depends on whether the debits amounts are equal to credits amounts. Hence, this will mean that the trial balance will always be in balance. Note that even though the accounting software minimizes errors in calculations, there are still some errors that can go undetected such as a transaction being entered multiple times, omission of a particular transaction, and incorrect entries in both credit and debit or either of them.
A company’s general ledger is where transactions are stored after being sorted using accounts. While there are different ways to arrange the general ledger, there are seven classifications that are generally used.
- The first is assets such as cash, equipment, accounts, and receivable.
- The second is stockholders’ equity which includes retained earnings.
- The third is liabilities which include bonds payable and loans payable.
- The fourth is the operating expenses which include rent expense.
- The fifth is the operating revenues which includes service fees and sales.
- The sixth is the non-operating gains and revenues, and
- the seventh if the non-operating losses and expenses.
Balance sheet accounts include the assets, liabilities, and owner’s or stockholders’ equity. These are also termed as permanent accounts or real accounts. The balances of these accounts are reported on a balance sheet which is essentially a financial statement. The operating expenses, operating revenues, non-operating losses and expenses, and non-operating gains and revenues are income statement accounts. Income statement accounts are also known as temporary accounts. The balances in these accounts are reported on the income statement which is a financial statement. Note that the balances at year-end of the income statement accounts will be combined to give the ‘Retained Earnings’.
Chart of accounts
Another important term is the chart of accounts. Chart of accounts has the list of all the accounts that you use for transaction recording in the business. The chart of accounts will have a higher number of accounts than the general ledger because zero balance accounts will not be recorded in the general ledger but will be recorded in the chart of accounts. In the chart of accounts, the balance sheet accounts are written first and then the income statement accounts are written. This is similar to how the general ledger is organized. The chart of accounts does not have any account balances or entries.
The purpose of the chart of accounts is to enable you to find the account’s name and its associated details such as the account number and a description of it. When there are any changes that happen in the organization then it is important that the appropriate changes are made to the chart of accounts. The chart of accounts can increase or change depending on the changes made to the organization such as addition of accounts. There are some accounting software tools where the chart of accounts might be helpful in selecting where exactly in the financial statement the account will be reported.
The accounting equation is vital for accounting and bookkeeping as it can provide information about the debits and credits. The basic accounting equation for a sole proprietorship is
‘Assets = Liabilities + Owner’s equity’
The basic accounting equation for corporations is
‘Assets = Liabilities + Stockholders’ equity’.
The double entry accounting states that the accounting equation must be in balance at all times. That is, the debits must be equal to credits. Asset account balances and expenses are on the accounts’ left side. The liabilities, stockholders’ equity and revenue balances are on the right side.
Let us explain with some examples.
Let us say that you borrow Rs. 1 lakh from the bank. The asset cash will be debited by Rs. 1 lakh while the liability loans payable will be credited by Rs. 1 lakh. This is the case because cash is debited when cash is received and a credit increases with liabilities. Another example is when you pay a rent of Rs. 50,000. The rent expense will have a debit of Rs. 50,000 while the asset account will have a credit of Rs. 50,000. Another example is when you repay a loan of Rs. 70,000. The liability loans payable will have a debit of Rs. 70,000 while the asset cash will have a credit of Rs. 70,000.
How Transactions Are Recorded
The accounting or bookkeeping software enables you to enter minimal data while updating the relevant records. The accounting software automatically updates the general ledger and stores all the information accurately so that when retrieval is done, everything is as it should be. For example, when you enter vendor invoices using the accounting software then the software will update the ‘Accounts Payable’. You will need to specify which account or accounts you want the debit to take place from. Another example is sales on credit. When you use the accounting software to prepare an invoice then the software will update the customer’s detail, credit sales and debit accounts receivable in the general ledger.
Back in the day bookkeeping was a task that was associated with time-consumption and errors. Today, thanks to accounting software like Giddh, this is not the case anymore. This means not as many people are required for the bookkeeping and accounting process. When there are less people who are handling tasks then it can mean that there is a higher chance of malpractice. In order to safeguard assets, internal controls are used. These help minimize the chances of fraud. Some corporations use internal auditors that enable separating duties so that fraud is less likely to occur. Smaller companies should know about internal controls to ensure misappropriation doesn’t occur.
Modern times call for modern tools. By leveraging the power of cloud accounting software, business owners can focus their attention on things they are passionate about and leave the tedious task of accounting and bookkeeping to these tools.