Wednesday, 7 April 2010

Accounting Starts with Book Keeping

In the last post, we learnt that accounting provides different kinds of information about a business. In this post let us look how the process of generating all this information starts.

Business transactions like sales and purchases, or incurring an expense, are evidenced in some form. For example, sales invoices provide details of sales transactions, purchases are detailed in supplier invoices and payments are evidenced through checks and acknowledgments from payees. These evidencing documents are usually stored in date order in thick folders.

However, documents stored thus do not provide us any ordered information. The ordering of information starts with entering meaningful details from the records into Books of Prime Entry:

  • Day Books such as Sales Day Book and Purchases Day Book into which details from sales invoices and purchase invoices respectively are entered. Note that only credit sales and purchases are entered into these.
  • Cash book records details of cash and bank payments and receipts, including cash sales and purchases
  • A general Journal records transactions that are not covered by the day books or cash book. For example, salaries due to employees at the end of the month but not paid until next month can be recorded in the journal (so that all expenses of a month are accounted in that month itself). The journal also allows rectification of errors, as when a transaction is moved to the correct account from a wrong account where it was recorded originally by mistake.
The transactions recorded in the books of prime entry are then "posted" to a separate sets of books called Ledgers. Ledgers will have "accounts" for different kinds of things, such as:
  • Customers to whom we sell on credit, so that we can know how much money is due from each customer
  • Suppliers from whom we buy on credit, so that we know how much money we have to pay to each supplier
  • Income accounts such as sales by categories, consultancy fees, and any other
  • Different types of expenses such as salaries, rent, travel, local taxes, and many others
  • Cash
  • Different banks
  • Owners' capital
  • Borrowings from banks and others
Modern accounting systems observe the principle of "double entry" when posting transactions from books of prime entry to ledgers. The concept underlying double entry is that every business transaction involves both receiving and giving of some value. For example:
  • A credit sales transaction involves not only giving something of value to your customer but also receiving a right to recover the agreed price for that value from the customer
  • A cash sales transaction involves giving value to the customer and getting immediate cash from the customer
In the ledgers, these giving and receiving are recorded thus:
  • "Debit" the customer's account and "Credit" sales account in the first case
  • "Debit" cash account and "Credit" sales account in the second case
Every business transaction can be analyzed as above and Debits and Credits are made to concerned accounts. A trained book keeper will know which account to debit and which to credit for each transaction. 

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