We opened this chapter with three questions that every business asks: Accounting for Managers 6

Key Concepts “Gozinta” and “gozouta” are sophisticated accounting terms representing the generic

sum of all inputs into an entity and the generic sum of all outputs from that same entity.The smart manager keeps in mind that those liquid assets are just coming into or going out of the business.Those are the basics in accounting.• How much money came in? • Where did the money go? • How much money is left? However, to get to the answer to these questions, we need to

understand several ideas. We’re going to start from the simplest and work our way up to the financial statements that will answer our questions. Our explanation of accounting will also follow history; accounting developed slowly over the last 500 years to the sophisticated computer systems and highly specialized accounting standards we use today.

Double Entry: The first principle of accounting we need to understand is called double-entry bookkeeping. Each transaction made in the accounting system is entered twice. No, this does not mean we are keeping two sets of books. We enter every transaction twice, to show where the

money comes from and where it is going. An Italian monk, Luca Pacioli, gets the credit for developing double entry in 1494, although it first appeared some 50 years earlier. Next time you think you’re getting confused by double entry, remember this. It’s been around for more than 500 years. Most of the people who used it didn’t know how to program VCRs. You are way ahead at the start. Financial statements: A set of accounting documents prepared for a business that cover a particular time period and describe the financial health of the business. Transaction: Any event that affects the financial position of the enterprise and requires recording. In some transactions, such as depositing a check, money changes hands. But in others, such as sending an invoice to a customer, no money changes hands.Account: A place where we record amounts of money involved in transactions.An account shows the total amount of money in one place as a result of all transactions affecting that account. Assets: What a business owns or is owed. Examples are

real property, equipment, cash, inventory, accounts receivable, and patents and copyrights.

Liabilities What a business owes. Examples are debt, taxes, accounts payable, and warranty claims. Equity: Cash that owners or stockholders have put into the business plus their accumulated claims on the assets of the business.Also known as owner’s equity or stockholder’s equity, depending on how the business is organized.

Accounting is concerned with three basic concepts: • assets • liabilities • equity .Let’s use a series of T accounts to trace a small job all the way through a business. Let’s say you do some work for a customer and you take along a contractor as an assistant. You invoice the client; the client pays. Also, the contractor bills you. How does this look in double-entry bookkeeping, illustrated with

T accounts? Let’s walk through it one step at a time. Your customer calls you and asks you to do the work. You plan the job, put it on the schedule, and arrange for the contractor to come with you. All of this is important business, but none of it shows up in accounting. No transaction has happened yet; if the appointment falls through, you will not get paid anything. T Account: A T account let you visualize both sides of an account. We use T accounts in pairs to set up the double entry.

The left side of the T is called the debit and right side is the credit.Later on, we’ll explain why some entries always go on the left and others on the right. Here’s a pair of T accounts for writing a check to buy $100 of office supplies. Notice that we always record a date for each transaction.

Assets: Corporate Checking: Debit - Credit6/7 $100. Expenses: Office Supplies: Debit6/7 $100 - Credit.

You go and do the work and the contractor comes with you. The customer tells you he is happy with the work and looks forward to receiving your invoice, which he’ll pay promptly. The contractor says she’ll send you a bill and you promise to pay within one month. Still, no transaction has occurred. If no invoices are sent, and no one gets paid, then it’s as if you’d worked for free.The next day, you write up an invoice for $1,000 and mail it to the customer. The invoice has gone out; now a transaction has occurred. In a pair of T accounts, it looks like this. Income: Consulting Services: Debit - Credit 6/2 $1,000; Assets: Accounts Receivable: Debit 6/2 $1,000 - Credit.

Fixing the Books: Once in a while, we make a mistake. Here’s a tip for hunting down that lost entry. Grab a scratch pad and start making T accounts for the ledgers that don’t balance or the entry that is partly missing. Make each one carefully.As you work it through, you will see the entry that got missed. Debit: A reduction in the amount of money in an account. It shows up on the left side of a T account. Credit: An increase in the amount of money in an account. It shows up on the right side of a T account.

What do these two diagrams mean? The first one says that on June 2 the company received $1,000 in income. How is this possible, if you haven’t gotten a check yet? Because in accounting, we count the money as coming in when we bill it. Why? Because the money we are owed is an asset and we want to keep track of it. It is of value to our company. We could go to a bank and

borrow against the money our customers are due to pay us. So, the value of the company has increased, from an accountant’s perspective. The company is worth $1,000 more than the day before, because income has come in. So we have a credit to income—money coming in. The balancing T account is a debit to assets. But if our assets have increased, why do we debit them? This is one odd aspect of accounting. Asset accounts are debit accounts. So a debit to an asset is an increase of money in the company. Later on, we’ll see how this keeps the books in balance.But, in double-entry bookkeeping, all transac- tions are entered twice, so that all accounts are balanced. That is a fundamental rule of accounting. If the income account goes up (is credited) by $1,000, then a debit for $1,000 must show up somewhere else. It shows up in Assets—Accounts Receivable, as we see in the second T account diagram. Accounts receivable is a single account that shows all of the money that you are owed by everyone. Accounts receivable is an asset account. That is, it is one of the accounts that show how much money is in the company. The next day, you receive a bill in the mail from your subcontractor. This is another transaction. You enter the bill in your accounting ledger or system to show that you owe her the money. The T accounts look like this: Expenses: Subcontractor: Debit 6/3 $200Credit. Liabilities: Accounts Payable: Debit

Credit 6/3 $200. Together, these two T accounts say that your company has a $200 expense and owes a subcontractor $200. Even though you haven’t paid her bill yet, your company owes the money, so the value of the company is $200 less than it was. At the end of the week, you receive a $1,000 check from your customer and deposit it into the corporate checking account. Again, two T accounts record this in your accounting system. These two diagrams may seem backwards. But

remember: all asset accounts are debit accounts, so an entry in the debit column is an increase to the account and an entry to the credit column is a decrease. Assets: Accounts Receivable Debit Credit6/4 $1000. Assets: Corporate Checking Debit6/4 $1,000 Credit.

Now you feel like your business is up and running. You feel so good that you want to pay your subcontractor’s bill. Only you can’t—the check from the customer hasn’t had time to clear the bank. While you’re waiting for the check to clear, you ask those three basic questions all managers want to know: • How much money came in? • Where did the money go? • How much money is left? Since you’ve entered every transaction, your accounting system should be able to answer those

questions. The questions are answered in reports called financial statements. The two most

important financial statements are the income and expense statement and the balance sheet.

Income and expense statement: A document that shows all of the gozinta and gozouta for a business during a particular period of time. Sometimes it is just called an income statement.

Revenue is a synonym for income, so this can also be called a statement of revenue. Balance sheet: A financial statement that shows the financial position—that is, the assets, liabilities, and value—of a company on a particular day.

If you’re using a computerized accounting pack age, you simply go to the reports menu, select the report you want, select the start and end dates, and print it out. But, rather than relying on the magic

of a computer program, let’s walk through the process of building our financial statements, so that you can see how accounting moves from the recording of each transaction to the presentation of useful reports. Automagic Accounting: Even though all accounting systems are double entry, on many computerized accounting systems we enter each number only once. How does it do that? The computer maintains a chart of accounts.The bookkeeper enters the transaction in one account (say, the bank’s checkbook) and then selects another account (perhaps a particular type of expense).When the bookkeeper clicks OK, the transaction is recorded in both accounts.The computer automagically takes care of the second entry, keeping the books in balance. Program

instructions also block transactions that do not fit the accounting equation.Try paying your rent out of your insurance account. It won’t work. There are two big advantages of computerized accounting systems.One is that they make it hard to make errors.The other is that you enter the information once, and then see it in several different ways: as data entry screens, account ledgers, and reports. Chart of accounts :A list of all the accounts in the accounting system. Some of them may be used every day, such as Cash, and some rarely or even never.

Bookkeeping and Accounting: Many people confuse bookkeeping and accounting. They think

that bookkeeping is accounting. Bookkeeping is the act of recording transactions in the accounting system in accordance with the principles discussed in Chapter 2. Accounting is the way we set up the system, the principles behind it, and the ways we check the system to make sure that it is working properly. Accounting ensures that bookkeeping is honest and accurate and, through financial accounting and management accounting, it provides people outside and inside the business the picture they need of where the company’s money is. Accountants developed bookkeeping procedures as a way to organize records, to classify the many transactions that take

place. Bookkeeping puts related transactions together into groups so that their impact on the accounting equation can be recorded and analyzed. When we put several transactions together into one account, we’re creating a ledger. Each account has a ledger that lists all its transactions. Every

transaction is entered twice, in two ledgers, once as a credit and once as a debit. The individual lines in a ledger are called entries. In a manual system, each entry is first put on a master page called the journal, or book of first entry, and then copied to the appropriate individual account pages. As a result, the books stay in balance; the total of all credits equals the total of all debits. Right from the Start: If you are a sole proprietor, you may be doing much of your bookkeeping yourself. If so, you might consider taking a bookkeeping course If someone else is doing it, either

inhouse or outside, recognize that it’s critical that the initial entries go in correctly. Running down bookkeeping entry mistakes is a tedious task, especially if they happen regularly. Ledger The record of all transactions in a particular account.The detail generally includes the date the transac-

tion took place, the amount, whether it was a debit or a credit, and a short memo, if necessary.

Entry An individual line in a ledger. Journal Where a transaction is first entered. It’s also called the book of first entry.While the ledger shows all the action in a particular account, the journal shows the original transaction and all the accounts affected by it.A $1,000 dollar payment could be $250 of fuel, $75 of oil, and $675 of maintenance.The date, the accounts debited and credited, and the memo are also recorded.

Before we overload you with more accounting terminology, let’s use the example of our new service business to show how all this works. As a result of the three transactions we’ve entered, here are the ledgers for five accounts: Income: Consulting Services: Debit Credit 6/2 $1000 ($1,000) Notes Invoice for consulting services (Total). .... • Income: Consulting Services • Assets: Accounts Receivable • Assets: Corporate Checking • Liabilities: Accounts Payable • Expenses: Subcontractor With these five account ledgers laid out, we can trace the transactions related to that one day of work. For example, we can see that accounts receivable increased by $1,000 when we sent the invoice, then decreased back to zero when we received the invoice and deposited the check.

Take a moment to trace all the entries from the previous pages in these ledgers. In fact, take more than a moment. Visualize the action that was taken related to each transaction. See yourself first writing an invoice, then receiving and entering a bill, and finally receiving and depositing a check. Find the two entries related to each of these actions. When it’s all clear in your mind, you’re ready for the big leap—from bookkeeping to accounting.