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Module: 10

How to make sense of your accounts?

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This module looks into how to make sense of your accounts. We explain how and why you should

organize your financial information, what the accounting cycle is, how the accounting cycle works,

benefits of using computers for accounting and how computerized accounting works. By gaining an

understanding and respect for where the money is going and how to report that information you will

be on the road to understanding a pivotal aspect of all business. At the end of this module you will

be able to confidently discuss your or your business’ financial position.

What you’ll learn in this module:

10.1 Organizing your Accounts

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10.2 The Accounting Cycle

10.2.1 Identify

10.2.2 Analyze

10.2.3 Record

10.2.4 Post

10.2.5 Report

10.4 How does computerized accounting work?

10.4.1 Advantages of computerized accounting

10.1 Organizing your Accounts

Often business owners struggle to get a handle on their finances. Trying to make sense of their

accounts on their own while not impossible does raise challenges. If they are unfamiliar with how the

basic accounting process works, it is easy to begin to feel overwhelmed right at the beginning of the

year. Before they know it, they are knee deep in paper and it is halfway through the year. Thinking

that they can get away without making a plan to track their money is a major downfall. Taking the

time to plan and organize your financial information will help make the process less painful and more

fruitful. Practicing weekly or monthly habits while tracking expenses and income will make your end

of month and end of year closings that much easier.

On another note, it is imperative to maintain a separation of business finances and personal

finances. Some people tend to think that the line can be blurred and grey however the

consequences for misrepresenting your business profits by any margin can be crippling to a

company and is always unethical. Business expenses should always be separated from personal

expenses. When setting up your account organization make a separate system for both business

and personal expenses.

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The first step in organizing your accounts is organizing your paperwork.

1. Decide what you need to keep – You will have to look at every piece of paper – the proverbial

financial puzzle

2. Set up a filing system that works for you

3. Reconcile and file receipts (3-step process)

4. Have an action file to store receipts that need to be reconciled

a)When bank & credit card statements come in make a habit of reconciling collected receipts

immediately before filing

b) If a receipt requires further action, set it aside (e.g. Items you need to return or charge disputes)

c)Choose a central and safe place to store your investment papers and bank documents

Once identified, take care of credit card issues as soon as possible. When reconciled file the

paperwork away.

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10.2 The Accounting Cycle

Understanding the basic mathematical principles of addition and subtraction are an important part of

accounting but not enough to get you to the end of the business cycle. Put simply, working with

numbers isn’t the only aspect of accounting. It is also about being able to follow guidelines in order

to accurately draw a picture of your finances. The accounting cycle allows you to follow a detailed

instruction manual if you will of how to communicate your business activity over the course of time to

the outside world.

The generally accepted accounting cycle is a series of 9 procedures in the collecting, processing,

and communication of financial information. They are;

1. Analyze source documents & record business transactions in a journal – the chronological record

of how the transactions affect the balances of applicable accounts

2. Post journal entries to the ledger accounts – a transaction is entered in each account that it affects

and sorted in the ledger

3. Prepare a Trial Balance – simple listing of all accounts from the ledger with their balances

4. Gather adjustment data and record adjustments in the worksheet

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5. Prepare & complete the worksheet

6. Create financial reports from data in the worksheets

7. Record adjusting entries

8.Record closing entries

9. Prepare the post-closing trial balance.

At first glance these steps can seem overwhelming and technical. They can be condensed into 5

easy to understand steps or categories.

Being able to understand and implement these 5 steps is tantamount to making sense of your

accounts. Understanding the need for and the background behind each step will give you the

confidence you need to manage your own accounts. The self-gratification of knowing where your

money goes without relying on someone else to tell you may be one of the best feelings you have in

the operation of your business.

The next few sections of this module will walk you through the accounting cycle.

10.2.1 Identify – Source Documents

In the first part of the module you learned about organizing your incoming paperwork related to

finances. This is the part where having a well-organized and up to date system will come in to play.

The first part of the accounting process is all about knowing which document holds the data you

need and how to classify or identify it. Every cent earned and spent can be classified into a

corresponding account. The big picture purpose of these accounts will be covered later in the

course. For now, it is important to be able to identify things like office expense, payroll expense &

taxes etc. From there you sort your source documents into identifiable categories.

A source document is defined as the original document that supports the transaction to be recorded.

So what kind of document classifies as a source document? Any document showing money spent or

earned is a source document. This includes things like receipts, bank statements, credit card

statements and utility bills for expenses. This is not an all-inclusive list. For income you should have

things like invoices, bills of sale, any records of asset sales or liquidations, rent income records,

bank deposit slips and anything else pertaining to business income.

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10.2.2 Analyze – The Journal Entries

Analyzing the data found on the source documents culminates in journal entries. The journal entry is

an analysis of the effects of a transaction on the accounts and is usually accompanied by an

explanation of the transaction. The analysis identifies the accounts to be debited and credited. A

journal entry includes the date of the transaction, the title of the account debited, the title of the

account credited, amount of the debit and credit and the description of the transaction. It is important

to remember that your debits and credits must equal each other for each transaction entered in the

journal.

A journal entry requires the following steps:

1. Identify the transaction you wish to journal from the source documents 2. Specify the accounts affected 3. Apply debit/credit rules to determine which accounts are to be debited and those to be credited. 4. Record the transaction with a description.

a. Enter the date in the first column (date column) b. Under the description column enter the name of the accounts affected c. In the Dr and Cr columns enter monetary amounts respectively to the corresponding accounts. d. The Ref column should include the numerical identifier of the account affected e. Include a narration (brief description of the transaction) in the description column after the

affected accounts have been recorded.

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The journal entries are the basis upon which the financial statements are built. It is imperative that

the data is entered or recorded correctly the first time. The computations based on these amounts

will carry across every sheet in the financial statements. Ensuring accuracy early on will cut down on

problems farther along in the accounting cycle.

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10.2.3 Record – Ledger (T-accounts)

The Ledger contains all of the transactions that are first entered in to the journal. It is in effect a

summary of all the transactions entered in the journal but they are sorted by account versus being listed

by date. In this manner, you can finally start to see where the money is going and where it is coming

from. Every transaction moves to one or more ledgers. The summary data totals from the ledger will be

used to generate the company’s financial statements.

Tips & Steps for creating and posting to a Ledger:

If you are using a paper ledger be sure to include at least one page for each account. Include more if you

think you will need the space. All of the transactions that affect the accounts during the accounting

period must fit on to the ledger pages.

Begin by setting up the page to receive posting entries. This includes writing the name of the account

across the page and drawing a horizontal line underneath across the page.

Draw a second line in the middle of the horizontal line going vertically down the page. The result should

be two columns that resemble a “T”, hence the term T-accounts.

Always record transactions as they occur. This means that any time a journal entry is made you should

immediately post it to the ledger. Making this a habit will make your closing more efficient and timely.

Remember each transaction will affect a minimum of two accounts.

The accounting ledger can also be used to record additional information about each transaction. Do this

by creating a third or fourth column. Additional information could be a running total account balance or

notes on the transaction.

10.2.4 Post – Trial Balance

Now that you have created your journal entries and recorded them in the ledger, it is time to find the

bottom line. The net effect all of the debits and credits in an account are ultimately reflected in the

account balance. With this in mind it follows that the trial balance is calculated by summing the

balances of all the ledger accounts. Doing so gives the most accurate picture of all of the data

contained in the journal entries.

When preparing your trial balance you must total your credits and debits for each ledger account.

Keep the following in mind while doing this:

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If the credit total is larger, you must subtract the debit total from the credit total to arrive at your ledger

account total. This total will be entered in the credit column of the trial balance.

If the debit total is larger, you must subtract the credit total from the debit total to arrive at your ledger

account total. This total will be entered in the debit column of the trial balance.

Place the ledger account total in the credit or debit column of your trial balance based on the

information provided above.

Once you have completed the totalling of all debits and credits for each ledger account, add all of

your credit totals to get a credit grand total and do the same with the debits, adding all of your debit

totals to get a debit grand total. These two numbers make up your trial balance. If everything is in its

proper place these two numbers should equal each other.

If for some reason you have an unbalanced trial balance, then you have an error somewhere in the

accounting process. The following are some examples of how an unbalanced trial balance can

occur:

Adding the debits and credits for the trial balance incorrectly

Omitting a ledger account balance from the trial balance worksheet

Mistakenly putting the credit and debit account balances in the wrong columns in the trial balance

Miscalculating the ledger account balances

Posting a journal entry incorrectly to the general ledger, whether transposing a number or getting your

debits and credits mixed up on the T-accounts

You could also have made a mistake in your original journal entry whether you used the wrong number

or forgot to enter an affected account in the journal entry

So now you can see how those first two steps of the accounting cycle can have such a lasting

impact on the process. It is possible to have a balanced trial balance and still have made errors.

These errors will be discovered later in the accounting process.

A trial balance may balance even if:

a transaction is not entered in a journal entry

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an incorrect journal entry is posted

a journal entry is duplicated

accounts are used incorrectly in the journal entry or when posted to the ledger

if the errors made in recording offset the amount in the transaction

10.2.5 Prepare – Financial Statements

The financial statements are the compilation of all of your source documents. This is the beautiful

part of the accounting process. It is like a dance or a painting. All of the movements or brush strokes

build a bigger picture to communicate the heart of artist or dancer. Think of the financial statements

as the completed choreographed dance of accounting. All of the moving parts have come to rest in

this final act of expression.

The financial statements will always include:

The Income Statement

The Balance Sheet

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Income statement –

Summarizes the activities of the business’ operations over a period of time

Shows the total revenues and expenses for the defined time period and is laid out in the following order:

o Revenue is listed first – the total monetary income received by sales

o Cost of Goods Sold is listed second – includes things like the costs of raw material, labor and

contractors

o Gross Profit is listed and calculated by subtracting the total of costs of goods sold from the total

revenue

o Expenses are listed next

Selling, General, & Administrative Expenses

Fixed Expenses

Depreciation Expense

o EBIT – Earnings before interest and taxes (aka Operating Income) is calculated by subtracting the

expenses from the Gross Profit

o Interest Expense – interest paid on the firm’s debt

o Earnings before taxes – shows income generated without including taxes calculated by subtracting

interest expense from EBIT

o Taxes- calculated by multiplying an assumed percentage against the Earnings before taxes

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From all of the above we come to the bottom line – Net Income, which is calculated by subtracting

taxes from earnings before taxes.

Shows different measures of profit through the calculations listed above

Is prepared for different time periods throughout the year including monthly, quarterly & annually

Balance Sheet – a snapshot of the business calling out the current assets, liabilities and equity

Assets – are typically things that a business owns and are placed on the top or left side of the balance

sheet

o Current Assets – Short Term

o Fixed Assets – Long Term

Liabilities – are the debts of the business and are typically placed below the assets or alternatively on

the right side of the balance sheet

o Current Liabilities – Short Term

o Long-Term Liabilities – Long Term/life

Equity – is arrived at by comparing what the business owns versus what the business owes other

entities and is entered below the assets and liabilities sections

10.3 Using Computers for Accounting

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As with anything, to understand where we are now we have to make an effort to understand where

we started. To begin this section of the module we will cover manual accounting and what it means

to help illustrate the convenience and ease of using computers for accounting.

What is manual accounting? In a manual accounting system, the steps in the accounting cycle are

performed by hand. Accordingly transactions are entered into a journal and then posted to the

ledger. This is all done by hand. Financial Statements are then derived from many manual

computations using the different account balances located on the ledger. Every number is

transcribed by hand and carried over from one place to another.

Accounting has been performed this way for centuries. For centuries there have also been many

accountants that have made errors in the early stages of the recording process only to find their

error at the end of the accounting cycle. This inevitable occurrence undoubtedly had varying

repercussions dependent on when they lived and who they worked for and how much power that

person possessed. Imagine being the bookkeeper for the King of England for example and

transcribing a single digit incorrectly that resulted in a war being started perhaps over presumed

stealing from the king. While this kind of extreme consequence is not the norm in this day and age, it

is still important to understand the risks and how to mitigate them.

Fast forward to today and you have the advent of using computers for accounting. Initially people

would spreadsheets to maintain their accounts. This is basically a digital version of manual

accounting stile requiring the user to manually create every step of the accounting cycle.

True computerized accounting is done with accounting software. Accounting software is a whole

class of computer programs that perform accounting operations. Accounting software is application-

based software that records and analyses accounting transactions within modules labelled such as

accounts receivable & payable respectively, trial balance and payroll. This computer software

programs allow the whole accounting cycle to be run on the computer.

10.4 How Does Computerized Accounting Work?

Computerized accounting programs can perform functions such as invoicing, dealing with payments,

paying wages and providing regular accounting reports on things such as trading and profit and loss

accounts and balance sheets.

A typical computerized accounting software package will be able to complete a number of different

functions and provide various reports for financial reporting. Ideally your accounting software will be

able to complete every step in the accounting process and finish with professional looking financial

statements. These final reports can be given to any entity looking for information on your financial

health.

Some features to look for in accounting software are:

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The ability to create sales invoices in the system and have that data automatically populate in the

journal and ledger

The automatic updating of customer accounts after data input in the ledger

Recording of suppliers’ invoices (accounts payables) in the ledger

Automatic updating of all accounts affected by data entry in the ledger

Recording of all bank receipts – often you can link your bank accounts and download this information

directly to the software

Some software may be capable of making payments for expenses although this feature will certainly not

be inexpensive

Automatic updating of the general ledger from data input from invoices and bills entered into the system

Integration of a existing business database with the accounting program to allow for greater data

analysis and more complex reporting

Performs the automatic calculations of payroll and associated entries after required data entry

Computerized accounting programs can provide instant reports for management accounting, for

example:

Aged accounts receivable summary – a summary of customer accounts showing overdue & current

amounts Traditionally these are labelled and categorized as Current, 30 Days, 60 Days, 90 Days and in

some cases will call out 120 Days overdue.

Trial balance, trading and profit and loss account and balance sheet

Sales analysis – profit margins etc.

Budget analysis – including forecasting options for next year and comparison of last year’s numbers

Payroll analysis including things like taxes, benefits, wages & commissions

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10.4.1 Advantages of using a computerized accounting system

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Speed – First and foremost the amount of time saved by using a computerized accounting system versus

manual accounting is monumental. You can in fact put a price on it if you tracked how long it took

someone to do the accounting process manually versus on the computer. The savings on this alone is

worth investing in good accounting software.

Automated document publishing – Easily publish fast and accurate invoices. Create credit notes and

purchase orders with just a few clicks. Automatic generation makes printing statements and payroll

documents a breeze.

Accuracy – with accounting software there is less room for errors because the data entry only has to

happen once. Whereas a manual system must have numerous entries thus creating more room for error.

Up-to-date information in real time – Automatic updating of the accounting records ensures that account

balances will always be current with the most recent information.

Accessibility of entered information – the data entered into the accounting software is available in real

time and can be accessed by different users in different locations simultaneously.

Management information – reports can be produced which will help management see the business at a

glance, for example the aged accounts receivable will show which customer accounts are overdue.

Legibility – the onscreen and printed data will always be legible, avoiding errors caused by poor

handwriting.

Efficiency – better use is made of resources and time; cash flow should improve through better debt

collection and inventory control.

Cost savings – investing in a computerized accounting program will reduce staff time. The process of

maintaining accounts will be streamlined which will reduce potential audit expenses because records

are neat and accurate.

Expand your business globally – new accounting software allows you to deal in multiple currencies

making the goal of expanding your business globally that much more attainable.