103 APPENDIX D SOME COMMENTS ABOUT AN ACCOUNTING AND BOOKKEEPING SYSTEM Refer to the Preface of this manual (page 3) for an outline of the bookkeeping knowledge that you will need in order to effectively use CPA-LEDGER. We assume that you have that knowledge and that you know how to apply it properly in your business. Remember this. The more complex that your business transactions become, the more bookkeeping and accounting knowledge you should have. We are not attempting to alarm you or to convince you that you should rely on others to maintain your accounting system. However, you should know that bookkeeping does require technical knowledge and that you should possess that technical knowledge BEFORE attempting to maintain a double-entry bookkeeping system. In the following discussion we will briefly cover several areas that you should consider before designing your accounting and bookkeeping system. . First, we will distinguish between the cash basis and the accrual basis of accounting. . Second, we will cover some important procedures and controls that should be considered for any accounting system. . Third, we will present an overview of the accounting cycle and tell you where CPA-LEDGER fits into the picture. . Fourth, we will briefly discuss the Balance Sheet and the Income Statement. . Fifth, we will tell you about the account classifications that CPA-LEDGER uses in the Balance Sheet and the Income Statement. We will also tell you about the types of accounts that are typically included in each classification. . Sixth, we will make some suggestions on how you can decide on the specific accounts to be included in your accounting system. 104 CASH VERSUS ACCRUAL BASIS OF ACCOUNTING. The "cash basis" of accounting is used if: . Income is recorded when cash is COLLECTED, and . Expenses are recorded when cash is PAID. The "accrual basis" of accounting is used if: . Income is recorded when it is EARNED (regardless of when cash is collected), and . Expenses are recorded when they are INCURRED (regardless of when cash is paid). Thus, you have two choices for your accounting system - the cash basis or the accrual basis. The method that you choose should be the one that results in an accurate measurement of your company's operating results. The cash basis of accounting may not be acceptable if failure to record "accruals" and "deferred" items will result in material misstatements in the financial statements. Accruals and deferred items are discussed in the section of this appendix entitled, "ADJUSTING ENTRIES". The cash basis has advantages, including simpler and more economical bookkeeping. However, it has disadvantages also. Unless cash receipts less disbursements closely approximates your true earnings and financial condition, the cash basis of accounting may result in materially inaccurate financial statements - as compared to similar statements that would result from the accrual basis. A complete discussion of the advantages and disadvantages, including income tax considerations, of these two methods of accounting is beyond the scope of this appendix. The accounting method that you choose is extremely important, from both an income tax standpoint and from the standpoint of managing your business. Consult with your local CPA if you cannot decide which method is best for you. 105 PROCEDURES AND CONTROLS. The importance of good accounting procedures and controls cannot be overemphasized. Following is an outline of major points that you should consider. . Decide when your accounting entries will be recorded and who will record them. Set a schedule and stick to it. . Make sure that anyone assigned accounting duties is properly trained. . If feasible, do not allow any one employee to have responsibility for any two or more of the following four functions - (1) authorization of a transaction, (2) recording the transaction in the accounting records, (3) custody of the assets involved, and (4) periodic reconciliation of existing assets to recorded amounts. . Decide on all forms that you will need and train your employees how to use them. The forms should be of two types - (1) SOURCE DOCUMENT forms, discussed in a section of this appendix to follow and that is entitled, "THE ACCOUNTING CYCLE", and (2) forms to assist in summarizing entries to be entered in your accounting system. Summarizing forms suggested for CPA-LEDGER are contained in Appendix E. . Decide on cost effective internal controls that are to be followed in making sure that all transactions are authorized according to approved company policy and that each entry in your accounting system is: . Complete and supported by proper documentation. . Calculated in the proper amounts. . Entered into the proper accounts. . Recorded in the proper period. You should also establish controls to be sure that no valid transactions are omitted from your accounting system. . Decide on procedures to be followed in: . Limiting access to assets, important records, documents, and blank forms to only authorized personnel. 106 . Periodic comparison of amounts recorded in your accounting system with independent evidence of existence and valuation. Examples include counts of cash on hand, counts or securities, and reconciliation of bank accounts. Your controls should also provide for action to be taken on any differences resulting from the comparison. As you can see, designing an accounting system is not an easy task. Selecting the proper accounts to be included requires both technical knowledge and informed judgement. Then, there are the accounting controls that you will need. Without a good balance of cost effective controls, one takes an undue chance that the accounting system will not produce accurate results. If you do not feel comfortable in designing your accounting system or controls, consult with your local CPA. Know that designing effective internal controls requires professional knowledge. Seek professional assistance if you do not understand how to design effective internal controls in an accounting system. THE ACCOUNTING CYCLE. The accounting cycle begins with collecting economic information about transactions that occur in your business and ends with preparation of formal financial statements. An accounting system should be designed to accurately assemble the economic information in a manner that is both understandable and meaningful. Perhaps it would be helpful to step through this "assembling" process so that you will have a better understanding of the accounting cycle. STEP 1 - COLLECTING ECONOMIC INFORMATION. Economic information is collected in an accounting system by means of SOURCE DOCUMENTS. Examples are: . Evidence of transactions involving outside parties, such as sales invoices, paid checks, notes signed by debtors, invoices received from creditors, and deposit slips. . Other economic events that do not involve outside parties and which must be recorded because they have an impact on the company. Examples are depreciation and estimates of bad debt expense. These source documents are the "documentation" which support entries made in the accounting system. However, the entries cannot be made until the source documents are analyzed and a decision is made as to the transaction that occurred and which accounts were affected. 107 STEP 2 - ANALYZING SOURCE DOCUMENTS. This step involves analyzing the source documents to assess their impact on the business in terms of revenues, expenses, gains, losses, assets, liabilities, and owners' equity. The analysis forms the basis for developing an ACCOUNTING ENTRY. For example, a cash sale increases both an asset (cash) and revenues (sales). The accounting entry should be a debit (increase) to cash and a credit (increase) to sales. It is very important that source documents be analyzed thoroughly in order to determine the proper accounting entry. This often requires a high degree of accounting skill. The accuracy with which it is done determines the reliability of the financial statements. STEP 3 - RECORDING THE TRANSACTION. Recording the transaction in the accounting system basically involves showing the date of the transaction, account(s) debited, account(s) credited, dollar amounts, reference information, and a short explanation for future recall. You Use CPA-LEDGER's DAILY Option 1 to record transactions in your accounting system. Various types of records are used to record accounting transactions. Manual systems usually have (1) a general journal, (2) several special journals to accommodate like-kind transactions such as cash receipts, cash disbursements, accounts payable, and (3) a general ledger. The general ledger has an account for each type of asset (such as cash, account receivable, and buildings), liability (such as accounts payable, wages payable), owners' equity, revenues, expenses, gains and losses. At the end of each accounting period (usually monthly), information in the general journal and in the special journals is transferred to the general ledger. This process is often referred to as "posting". The general ledger is used for preparing financial statements. Some computerized accounting systems do not use a general journal or the special journals. Rather, accounting entries are posted directly to the general ledger and the general journal and special journals are reconstructed from a detailed transaction file. This is the process followed by CPA-LEDGER. STEP 4 - PREPARING AN UNADJUSTED TRIAL BALANCE. At the end of each accounting period (usually a month), after all entries have been posted to the general ledger, an unadjusted trial balance is usually prepared. An unadjusted trial balance is a listing of all accounts in the general ledger, and their respective debit and credit balances, before any adjusting entries have been posted. CPA-LEDGER's DAILY Option 2 is used to automatically print an unadjusted trial balance. 108 STEP 5 - ADJUSTING ENTRIES. If your accounting system is kept on the accrual basis (see the above section of this appendix entitled, CASH VERSUS ACCRUAL BASIS OF ACCOUNTING), you will need to make several adjusting entries to amounts in your general ledger before preparing a Balance Sheet or an Income Statement. Remember, when the accrual basis is used: . Income should be recorded when EARNED, regardless of when cash is received. . Expenses should be recorded when INCURRED, regardless of when cash is paid. Adjusting entries can be viewed as falling into these categories: . ACCRUED EXPENSES. During the accounting period, certain expenses may have been incurred even though payment is not made until the next accounting period. An example is rent expense that is not billed until the month following occupancy. . ACCRUED INCOME. Certain income may be earned during the accounting period even though cash has not been collected. An example is rental income that is not billed until the month following occupancy. . DEFERRED EXPENSES. Expenses may have been recorded that will not to be used up in the current accounting period. An example is rent expense that is paid in advance. . DEFERRED INCOME. You may collect income in advance of when it due. An example is rental income that is collected in advance. . ESTIMATED ITEMS. Some adjusting entries are estimated because they depend on future events. Examples are estimates for depreciation expense and bad debt expense. . INVENTORIES. Physical inventories must be taken at the end of each accounting period to determine the inventory amount to be reported on the Balance Sheet and the Income Statement. If perpetual inventory records are kept, there still should be some procedure to ensure that the perpetual amounts are accurate. With the exception of inventories, use CPA-LEDGER's DAILY Option 1 to record your adjusting entries. DAILY Option 3 asks for the ending inventory value and uses the value to make the necessary adjusting entry. Remember that. REMEMBER THAT OPTION 3 MAKES THE ADJUSTING ENTRY FOR ENDING INVENTORY. 109 Determining the proper adjusting entries is not as easy task. It requires detailed knowledge of (1) bookkeeping procedures being followed, (2) transactions that have and that have not been recorded, and (3) careful analysis. The unadjusted trial balance is often helpful in identifying account balances that require adjustment, but it must be supplemented with (1), (2), and (3) mentioned above. To assist you in gaining a firmer grasp on adjusting entries, following are some illustrations. . ACCRUED EXPENSES. Your company has a Note Payable, in the amount of $10,000, recorded on the Balance Sheet. Interest in the amount of $1,200 is payable each March 31, for the preceding 12 month period. On December 31 (the date of your financial statements), $900 of the $1,200 ($100 per month times nine months) in unpaid interest is unrecorded and is properly chargeable to the current accounting period. The adjusting entry to record the accrued interest is: Interest Expense $900.00 Interest Payable $900.00 . ACCRUED INCOME. Assume the same facts shown above, except that the Note Payable is a Note Receivable. The adjusting entry would be: Interest Receivable $900.00 Interest Income $900.00 . DEFERRED EXPENSES. Assume the same facts as shown for ACCRUED EXPENSES, except that the $1,200 was paid and recorded at the BEGINNING of the interest period. The following entry was made on March 31: Interest Expense $1,200.00 Cash $1,200.00 The adjusting entry on December 31 would be: Interest Expense Paid in Advance $300.00 Interest Expense $300.00 Notice that, after the adjusting entry, $900.00 remains in the Interest Expense account. Interest Expense Paid in Advance is shown on the Balance Sheet as a Current Asset. (Some accountants would use the title "Prepaid Interest Expense" in lieu of Interest Expense Paid in Advance.) 110 . DEFERRED INCOME. Assume the same facts as shown for DEFERRED EXPENSES, except that the note is a Note Receivable and that the following entry was made on March 31: Cash $1,200.00 Interest Revenue $1,200.00 The adjusting entry on December 31 would be: Interest Revenue $300.00 Interest Collected in Advance $300.00 Notice that $900.00 remains in the Interest Revenue account. Interest Collected in Advance is shown on the Balance Sheet as a Current Liability. (Some accountants would use the title "Prepaid Interest Income" in lieu of Interest Collected in Advance.) . ESTIMATED ITEMS. As mentioned, the amounts of some adjusting entries must be estimated. This is because the amount of the actual expense is dependent upon some future condition or event. Examples are provisions for depreciation, bad debts, and warranty expense. Consider depreciation as an example. Assuming that the "straight line" method is used, the annual depreciation charge is based on an estimated useful life of the asset. Bad debt expense is based on an estimate of amounts that will prove to be uncollectible. Warranty expense is based on an estimate of the volume of claims against the warranty. Sample adjusting entries are shown below, along with the estimates used to compute the amount of the adjustment. An item of equipment, costing $82,000 is estimated to have a useful life of 10 years. It is estimated that the equipment will have a salvage value of $2,000 at the end of the 10 year period. Using the straight line method of depreciation, the annual depreciation charge would be ($82,000 less $2,000, or $80,000 divided by 10 years): Depreciation Expense - Building $8,000.00 Allowance for Depreciation - Building $8,000.00 After reviewing outstanding Accounts Receivable, it is estimated that $10,000 will prove to be uncollectible. The account Allowance for Doubtful Accounts has a current balance of $8,000.00 The adjusting entry would be: Bad Debt Expense $2,000.00 Allowance for Doubtful Accounts $2,000.00 111 . INVENTORIES. Some accountants do not consider recording the ending inventory as an "adjusting entry". We are including it just to be sure that you do not overlook it. We will not allow theoretical arguments get in the way of our understanding what needs to be done. As already mentioned, if perpetual inventory records are not maintained, the ending inventory should be recorded before financial statements are prepared. In a manual system, the following entry is usually made: (Assume that the ending inventory is valued at $50,000.00.) Inventory $50,000.00 Income Summary $50,000.00 When you use CPA-LEDGER's DAILY Option 3, the computer system asks you to enter the inventory value and it makes the appropriate adjusting entry. To further assist you in identifying adjusting entries that need to be made before preparing financial statements, following is a list of areas that you should consider. (The list is not intended to be complete because each business usually has its own unique characteristics.) . Any expense or loss that should be recorded in the current accounting period but which has not yet been recorded. . Any revenue or gain that should be recorded in the current accounting period but which has not yet been recorded. . Any expense that is paid in advance and that should be recognized as an expense in some other accounting period. . Any revenue that is collected in advance and that should be recognized as revenue in some other accounting period. . Depreciation expense. . Bad debt expense. . Warranty expense. . Ending inventory. 112 . STEP 6 - CLOSING ENTRIES. In a manual accounting system, closing entries are prepared so that all revenue, expense, gain, and loss accounts will be reduced to zero and be ready for the next accounting period. You do not have to worry about closing entries when you use CPA-LEDGER. It automatically makes the closing entries for you. . STEP 7 - PREPARING THE FINANCIAL STATEMENTS. After the adjusting and closing entries have been posted to the general ledger, you are ready to prepare the financial statements. CPA-LEDGER's DAILY Option 3 prepares the statements for you, automatically. . STEP 8 - PREPARING A POST-CLOSING TRIAL BALANCE. After all adjusting and closing entries have been posted to the general ledger, a post-closing trial balance may be prepared. It is used to verify that debits and credits are equal at the start of the coming accounting period. DAILY Option 9 will print a post-closing trial balance for you. Use it as a guide in determining the accounts to be included in the new general ledger for the accounting period that is about to start. See Chapter 13. . STEP 9 - REVERSING ENTRIES. Reversing entries are used, sometimes, to back out adjusting entries that were made at the end of the previous accounting period. Reversing entries are never mandatory, even in a manual accounting system. Their purpose is to simplify a subsequent accounting entry. If one remembers the adjustments, and makes subsequent accounting entries correctly with the adjustments in mind, there is no requirement for reversing entries. Reversing entries are never made when using CPA-LEDGER. There is no need for them. That is because a new general ledger is started at the beginning of each accounting period. See Chapter 3 of the User's Manual for details. THE BALANCE SHEET AND THE INCOME STATEMENT. The Balance Sheet, also sometimes called the Statement of Financial Position, summarizes the financial position of a business as of a specific point in time. It presents the assets, liabilities, and owners' equity. The Income Statement, on the other hand, summarizes revenues, expenses, gains, and losses for a specified period of time - a month, a quarter, or a year. 113 ACCOUNT CLASSIFICATIONS USED BY CPA-LEDGER. Refer to Chapter 3 of the User's Manual for a list of the account classifications used by CPA-LEDGER. To assist you while using SETUP Option 1 (also see Chapter 3), the following is a brief description of the types of accounts that should be included in each of the classifications. We will take up the Balance Sheet classifications first. . CURRENT ASSETS are cash and other assets that are reasonably expected to be (1) converted to cash, (2) to be sold, or (3) to be used by the business during its normal operating cycle or within one year from the Balance Sheet date, whichever is longer. Examples of current assets are cash, accounts receivable, merchandise inventory, short-term investments, and prepaid expenses. . INVESTMENT AND FUNDS include assets acquired for financial or investment purposes and funds that are set aside for future needs. Examples include investments in real estate, stocks, and bonds. Funds set aside for future needs includes monies reserved for purchasing a future building site and for redeeming long-term liabilities. . OPERATIONAL ASSETS are those facilities and equipment which are needed (and are being used) by a business in its on-going major or central operations. Examples include land, buildings, delivery vehicles, machinery, equipment, and furniture and fixtures. . INTANGIBLE ASSETS are those assets which provide an exclusive right which has a monetary value and the monetary value is not dependent upon the assets' physical substance. Examples include goodwill, copyrights, patents, trademarks, and a franchise. . OTHER ASSETS are those assets that are not easily classified in any one of the above asset classifications. Examples include long-term receivables from employees and idle operational assets. . DEFERRED CHARGES are for expenses that have been paid in advance and that will benefit future accounting periods. Examples include machinery rearrangement costs and long-term insurance prepayments. Deferred charges are distinguished from prepaid expenses shown under CURRENT ASSETS by the time period involved. Prepaid expenses pertain to the next accounting period. Deferred charges pertain to a longer time. 114 . CURRENT LIABILITIES are those liabilities that will require the use of existing current assets or that will require the creation of other current liabilities. Examples include accounts payable, revenue collected in advance, short-term notes payable, current maturities of long-term debt, and accrued expenses for taxes, interest, and payroll. . LONG-TERM LIABILITIES are liabilities that will not require the use of current assets during the next operating cycle or one year from the Balance Sheet date, whichever is longer. Examples include long-term bonds payable and long-term notes payable. . OWNERS' EQUITY. Depending on the version of CPA-LEDGER that you ordered, you will see differing formats in the OWNERS' EQUITY section of the Balance Sheet. For a sole proprietorship, you will see CAPITAL and DRAWING accounts. For partnerships, you will see a separate CAPITAL and DRAWING account for each partner. The CAPITAL account represents ownership interest in the business. The DRAWING account represent withdrawals from the business during the current accounting period. The OWNERS' equity section for a corporation is more extensive and the account classifications are presented separately below. . CONTRIBUTED CAPITAL reports the stated or legal capital of the corporation. This is represented, usually, by the par value of outstanding capital stock. The corporation's Articles of Incorporation and state law specify the legal capital. See your attorney if you have any questions regarding legal capital requirements. CPA-LEDGER's SETUP Option 1 asks you how many CONTRIBUTED CAPITAL accounts that you want to create. You should create one account for each class of outstanding capital stock. SETUP Option 3 assigns values to each of the accounts. . OTHER CONTRIBUTED CAPITAL includes transactions that are related to CONTRIBUTED CAPITAL. Examples include amounts received in excess of par or stated value of capital stock outstanding, treasury stock transactions, and retirements and conversion of stock. . RETAINED EARNINGS is the corporation's accumulated earnings, less losses and dividends to date. 115 . ALL OTHER EQUITY is used, primarily, to report unrealized losses and loss recoveries from application of the lower-of-cost- or-market rule for long-term investments in equity securities. This rule is discussed in Financial Accounting Standards Board (FASB) Statement 12, and it is quite technical. We recommend that you consult with your local CPA before using the ALL OTHER EQUITY classification to comply with FASB Statement 12. Also consult with your CPA before using this classification for any other transaction. This is because the ALL OTHER EQUITY classification should be used only in rare cases, and very technical rules cover its use. These rules are beyond the scope of this appendix. This concludes discussion of the Balance Sheet classifications. Income Statement classifications follow. . SALES is represented by assets received or liabilities liquidated (or a combination of both) in the sale of products or services that are related to the business' ongoing major or central operations. For CPA-LEDGER purposes, Sales, Sales Returns and Allowances, and Sales Discount are included in the SALES classification. . PURCHASES AND RELATED ACCOUNTS are used to accumulate costs merchandise that will be held for resale to others and that is related to the business' ongoing major or central operations. Accounts under this classification include Purchases, Purchase Returns and Allowances, and Purchase Discounts. . OPERATING EXPENSES are outflows or other using up of assets or incurrence of liabilities (or a combination of both) resulting from rendering services, delivering or producing goods, or carrying out other activities that constitute the business' ongoing major or central operations. Examples of accounts included in this classification include Salary and Wage Expense, Supplies Expense, Depreciation Expense, Entertainment Expense, Insurance Expense, and Rent Expense. . OTHER REVENUES AND GAINS are derived from activities other than those that constitute the company's ongoing or central operations. Examples include Interest Income, Rent Income, and Gain on Sale of Nonproductive Assets. 116 . OTHER EXPENSES AND LOSSES are incurred from activities other than those that constitute the company's ongoing or central operations. Examples include Interest Expense and Loss on Sale of Nonproductive Assets. . EXTRAORDINARY GAINS AND EXTRAORDINARY LOSSES are gains and losses that (1) are unusual in nature and that (2) do not occur frequently. Before a gain or a loss may be considered "extraordinary", stringent rules must be applied. These rules, which almost eliminate the extraordinary classification, are covered in Accounting Principles Board Opinion 30. We recommend that you consult with your local CPA before using the extraordinary classification. . INCOME TAX EXPENSE is represented by income tax levied by Federal, State, and local jurisdictions. ACCOUNTS TO BE INCLUDED IN YOUR ACCOUNTING SYSTEM. The number and type of accounts maintained for a specific business are affected by considerations such as what is owned and owed, the nature and volume of operations, and the type of information which is needed for decisions, tax purposes, and credit purposes. For example, one salary expense account may suffice for your company. Another company may opt to set up separate expense accounts for executive, office, and sales salaries. As a general rule, the financial and other reports needed by a business owner provide a clue as to what accounts need to be included in the accounting system. Accounts for assets, liabilities, and equity will be needed for the Balance Sheet. Accounts for revenues, expenses, gains, and losses will be needed for the Income Statement. The level of detail in each of these account classifications will be determined, to a large extent, by the business owners' needs. Some elaboration of revenue and expense accounts may be needed for Internal Revenue purposes. Other details may be required by creditors. The major question is this - What specific accounts do you need for the information requirements of your business? You can answer that question by considering your type of business, your financial information requirements, and the past and anticipated operations of your company. If available, review financial statements of businesses similar to yours. Review your own past financial statements. Read trade journals and other publications that discuss accounting systems for your type of business. If you think you may be borrowing funds in the near future, consult with potential creditors. These sources should give you some good ideas.