Accounting

Accounting Plus

Accounting Basics
 Accounting Basics
Like all small business owners, you went into business with a dream: to sell your unique product or services
and make a living for you, your family, and your employees. As your business grows ‘beyond the chequebook’
your record keeping and reporting and compliance needs also increase. Now you have customers to track,
suppliers to pay, sales to record, and a full set of accounts to maintain. You probably also have an accountant
who is preparing your taxes for you and your growing business.

But now you find yourself spending more time keeping your books than keeping your customers happy. You
understand the importance of having accurate books, but you have a lot of demands on your time, so
accounting never seems to get the time it requires. Further, you willingly skipped all those school and college
accounting courses, thinking you weren’t “going to be an accountant anyway”. Well, surprise! Not only are you
an accountant, you are a lawyer, a shipping clerk, a customer service rep and more – all in the pursuit of your
dream.

So what can you do to make this work? The first step is to understand what all those accounting terms mean
and how they all fit together. At the end of this booklet is a glossary of all the relevant accounting terms that
will help you understand the science of accounting. Much like computers, understanding the terminology will
help you understand their meaning and their relevance to you and, more importantly, help you analyse and
run your small business.

Before we go any further, keep this in mind: you don’t have to be an accountant to run MYOB. All too
often small business owners use this line to shun doing any type of record keeping, to their own detriment.
The reality is, I’m not a mechanic, but I can drive my car. I’m also not a plumber, but I can fix an overflowing
toilet and I’m certainly not a doctor, but I can put a plaster on my kid’s bumps and bruises. All it takes is the
will to succeed and the desire to run a successful operation. Will it be easy? I wish I could say yes. Will it be
frustrating? I wish I could say no. Will it be invaluable to your business and your long-term success?
Certainly! While our goal here is to help you understand the basic concepts of accounting, one of the great
things about MYOB is that it does all the debits and credits for you.

J Your Daily Lives

First, lets start with an overview of how accounting fits into your daily life. Quite simply, every transaction
you make results in an entry into your “books”. Whether it is a receipt of cash, a sale, a cheque you’ve
written or a deposit from a customer – every transaction gets recorded in your books at some point. The
timeliness and accuracy of when and how you record your transaction directly affects your ability to manage
your business and your cash flow.

If you think your business is “chequebook-centric”, remember that there are plenty of transactions that do not
involve cash that should be recorded in your books. Anything that affects the things you own (assets) like
repairs or purchases, all require a transaction. Anything that affects what you owe (liabilities) like VAT or
payroll taxes requires a transaction to be recorded. Anything that affects sales (revenue), like an invoice or a
product return needs to be recorded. And, as you no doubt already know, all your supplier invoices
(expenses) are recorded when paid. Just because cash is not exchanged does not mean there are no entries
to record. For example, you probably sell items or services on credit. In this simple example, you record the
sales when your invoice is issued, and then subsequently record the cash receipt when your customer pays
you.

J The Golden Rules of Accounting

Lets discuss the Golden Rules of Accounting. They are:

1.) Debits ALWAYS EQUAL Credits

2.) Increases DO NOT NECESSARILY EQUAL Decreases
3.) Assets - Liabilities = Owner’s Capital (The accounting equation!)

Don’t let the words Debits and Credits scare you. They simply refer to the Left side and Right side of a
‘T Account’, a graphical representation of the amounts recorded into an account (see the examples below).
Every transaction recorded into MYOB is posted to your accounts as a combination of debits and credits, we do
all the work for you. For an individual transaction, total debits always equal total credits. A cheque written to
pay rent is an increase to Rent Expense (a debit) and a decrease to Cash (a credit).

J Chart of Accounts
The chart of accounts, or simply accounts, is a list of categories into which all your accounting transactions will
be recorded. In MYOB they are defined by a five digit number and account name: A one digit prefix
designates what type of account it is (and where it will be displayed on your financial statements), followed by
a four digit main account number. With MYOB, you have complete control over your account numbers and
their names.

Here is a table that will help you understand what this means and how it applies to your business.

ACCOUNT ACCOUNT
INCREASE DECREASE
NUMBER TYPE
1-xxxx Assets DEBIT CREDIT
Balance Sheet 2-xxxx Liabilities CREDIT DEBIT
(As of a ‘point of time’)
3-xxxx Owner’s Capital CREDIT DEBIT
4-xxxx Revenue CREDIT DEBIT
Profit and Loss 5-xxxx Cost of Goods Sold DEBIT CREDIT
(For a ‘period of time’)
6-xxxx Expenses DEBIT CREDIT
The exceptions are contra accounts, which are accounts that are offset against another account.
Examples include: Accumulated Depreciation, Sales Discounts, and Sales Returns and Allowances.

Let’s drill down on how each account type actually relates to your business.

J Assets
An asset is anything you own in your business. They are the things in your office, your computers,
your vehicles, the amounts owed by customers and your cash on hand. Everything you own is considered an
asset of the business. Assets are used to generate revenue and purchase other assets. For example, when
you buy a new computer, you use one asset (cash) in exchange for another asset (equipment).

J Liabilities
Your liabilities are the things you owe, like VAT collected on sales but not yet paid to Customs & Excise, or
loans payable to your bank. Another example are your credit cards, unless you pay your balance off every
month, the money you owe to your credit card company is considered a liability on your books. Liabilities
represent claims against your assets.

J Owner’s Capital
The difference between the value of your assets and the total of your liabilities is the value of your company.
As the Accounting Equation states: Assets - Liabilities = Owner’s Capital. Depending on the type of taxable
entity you created when you first formed your company, the Owner’s Capital section of your Chart of Accounts
and Balance Sheet may have another name.
J Revenue
The revenue of your company is the total amount of proceeds generated for providing goods and services to
your customers. This is typically the total amount of the invoices you generated for your customers.

J Cost of Sales
Cost of Sales refers to the total value of the goods and services that were sold to your customers. Typically,
this refers to items based businesses that buy stock for resale or a manufacturer who builds items for resale.
Total revenue less cost of goods sold equals your gross profit.

J Expenses
Expenses are the costs you incur to run your business, whether they are fixed costs (independent of how
much business activity you have, like rent) or variable costs (directly related to how much business activity
you have, like carriage).

J T Accounts and Double-Entry Accounting

T accounts are a graphical representation of debits (left side) and credits (right side) in a specific Nominal
Ledger account. Double-entry accounting means that every transaction has at least one debit and one
corresponding credit. The total debits always equal the total credits

Account Name (x-xxxx)

debits credits
debits credits
debits credits

Below is a series of typical accounting transactions and their affect on the appropriate Nominal Ledger accounts. The next
page shows the financial statements resulting from these entries. These examples ignore VAT.

J Examples:
NOTE: When your bank says that they
1.) You buy a desk and pay £250 cash
are crediting your account, they are
2.) You buy computer supplies for £100 with your company credit card*
referring to an entry on THEIR books.
3.) You buy 10 Widgets for stock at £150 each and pay on COD
4.) You sell 4 Widgets from stock for £250 each on Net 30 terms
Your money in the bank is a liability to
5.) You pay your monthly rent of £800
the bank; therefore when they credit
6.) You pay your credit card company for your computer supplies
your account, they are increasing their
7.) Your customer pays for the Widgets they purchased liability to you on their books.
8.) You sell 3 Widgets for £300 each, cash
9.) You buy 10 Widgets for stock at £150 each and pay on COD
10.) You sell 3 widgets for £350 each and take a £500 deposit

Cash (1-xxxx) Sales (4-xxxx)

7.) £1,000 1.) £250 4.) £1,000
8.) £900 3.) £1,500 8.) £900
10.) £500 5.) £800 10.) £1,050
6.) £100
9.) £1,500
COGS (5-xxxx)
4.) £600
Debtors (1-xxxx) 8.) £450
4.) £1,000 7.) £1,000 10.) £450
10.) £550

Office Expense (6-xxxx)

Stock (1-xxxx) 1.) £250
3.) £1,500 4.) £600 6.) £100
9.) £1,500 8.) £450
10.) £450
Rent (6-xxxx)
5.) £800
J Financial Statements
The primary financial statements of any business include the Balance Sheet and the Profit and Loss.
Together, they represent the total financial picture of your business. They must be reviewed as a set
because collectively they tell you about your business, both in the short term and the long term.

J The Balance Sheet

The Balance Sheet, one of the primary financial statements, is a reflection of your total assets, less total
liabilities and the difference, or owner’s capital. The balance sheet reflects a ‘point in time’; for example, you
could produce a Balance Sheet as at 31 December 2002 that would reflect all the account balances “as at”
that date, or as at a point in time. For example, you would see the balance of your assets, liabilities and
owner’s capital accounts on 31 December.

J The Profit and Loss Statement (or Income Statement)

The Profit and Loss, also one of the primary financial statements, is a reflection of your total revenue
generated, less the cost of items sold (which equals your Gross Profit), less your operating expenses (which
equals your Net Income or Loss). The profit and loss reflects results for a ‘period of time’: the net income or
loss for a specific period of time, for example, 1 January 2002 to 31 December 2002.

These are the financial statements that result from the example transactions above. In our example below,
the owner also invested £5,000 cash into the business at the start of the year to fund its operations.

ABC Ltd.
Balance Sheet ABC Ltd.
31 December 2002 Profit and Loss Statement
1 January 2002 to 31 December 2002
Assets
Cash £3,250 Revenue
Trade Debtors £550 Sales £2,950
Stock £1,500 COGS (£1,500)
Total Assets £5,300 Gross Profit £1,450

Liabilities £ 0 Expenses
Office Expense £350
Capital Rent £800
Owners Investment £5,000 Total Expenses £1,150
Current Year Earnings £300
Total Capital £5,300 Net Income/(Loss) £300

Total Liabilities and Capital £5,300

The Capital section of your Balance Sheet includes an account called “Current Year Earnings” which
represents the year to date net income or loss of your business. The life to date history of profit and losses
for your business is recorded into the Retained Earnings account. At the close of every year, the Current
Year Earnings account is rolled (closed) into the Retained Earnings account. In our example above, our
business is brand new, so the profit for the year is presented on the Balance Sheet as an increase of Capital
in the Current Year Earnings account. If the next financial year produces a £2000 profit, the Retained
Earnings account will reflect the balance of £2,300 (a £300 profit plus a £2,000 profit), the cumulative
balance. Each year, your Profit and Loss information is closed into your Retained Earnings account, that is
how the Balance Sheet and the Profit and Loss report are tied together.

Again, it is important to remember, that a Balance Sheet represents a point in time (as at 31st December),
while a Profit and Loss represents a period of time (1st January to 31st December).
J Terminology

Accrued Liabilities: Represents expenses that are incurred prior to being paid. For example, salaries
earned by your employees and paid in a subsequent month are accrued as a liability until they are paid.

Asset: The things a company owns, seen on the Balance Sheet and represented as 1-xxxx accounts in your
Chart of Accounts.

Balance Sheet: The primary financial statement that shows detailed assets, liabilities and capital at a point
in time.

Capital (Equity): The owner’s interest in the business, which is the total assets minus the total liabilities of
a company, seen on the balance sheet and represented in the 3-xxxx accounts in your Chart of Accounts.

Chart of Accounts: A list of categories or accounts where transactions are recorded.

Cost of Goods Sold (COGS): Represents the cost of items or services sold to customers. These costs are
kept in the Stock asset account (1-xxxx) until they are sold. Then they are passed over to the COGS (5-xxxx)
account.

Credit: A credit is the right hand side of an account, represented in T-Account format on the previous page.

Current Year Earnings: This account represents year to date earnings, not yet recorded into the Retained
Earnings account.

Debit: A debit is the left hand side of an account, represented in T-Account format on the previous page.

Deferred Revenue: Represents income received, but not yet earned. This is typically a liability account.

Double Entry Accounting: MYOB products follow the convention of Double Entry Accounting. Every
accounting transaction is comprised of debits that equal credits.

Expenses: Costs incurred in the business, seen on the Profit and Loss report and represented in your Chart
of Accounts as 6-xxxx accounts.

Gross Profit: Represents your revenue from sales of stock or services, less Cost of Goods Sold, before
overhead expenses.

Journals: Account ledgers where entries are recorded. MYOB products have Nominal, Disbursements,
Receipts, Sales, Purchases, and Purchases journals. Every transaction creates a corresponding set of debit
and credit entries in a specific journal.

Liability: The things a company owes in cash or other resources, represented as 2-xxxx in your Chart of
Accounts. These are claims against assets.

Net Profit/Loss: Total Income minus Total Expenses. The bottom line!

Nominal Ledger: An accounting record where all of your accounts are maintained. In MYOB products, when
you enter any transaction, the Nominal Ledger accounts are automatically updated.

Operating Profit: Profit before Other Income is added and Other Expenses are subtracted.

Overhead Expenses: Represents the expenses of a business independent of how much revenue is
generated. Can also be considered Fixed Costs, things like rent, salaries, and utilities.

Profit and Loss Statement (or Income Statement): The primary financial statement that shows detailed
revenues and expenses for a period of time.

Prepaid Expenses: Represents expenses that are paid in advance of incurring them. For example, you
might pay a year’s worth of insurance but only 1/12 of it relates to the current month. The balance will be
shown as a prepaid expense. This is typically an asset account.
Retained Earnings: Represents the cumulative net income or loss of a business since its inception. When
you Start a New Year in MYOB products, the program automatically transfers your year-end income (Current
Year’s Earnings) or loss to this account. This is called the closing entry.

Start a New Year: The process in MYOB products that closes a financial year, transfers your Current Years
Earnings to Retained Earnings and prepares the accounts for a new financial year. All Income and Expense
accounts are reduced to zero to start the new year.

Subsidiary Ledgers: Customer and supplier balances that equal the amount of the Trade Debtors and Trade
Creditors Nominal Ledger accounts.

Trade Creditors: Money or other obligations owed to creditors for services and materials, a Liability on the
Balance Sheet.

Trade Debtors: Money or other obligations due for services rendered or items sold on terms, an Asset on
the Balance Sheet.

Trial Balance: A list of all your Nominal Ledger accounts and their current balances.

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