Accounting 101 - Part 1

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Each Tuesday, our new series ‘Accounting Tips Tuesday’, brought to you by Zoho Books, will present articles that fit into one of two categories.

First, the theory behind basic, and even not so basic, accounting concepts with practical applications including the old ‘debits and credits’ appropriate to the situation. Second, we will go beyond the practical theory and actually cover fundamental software use in the proper recording of these types of transactions using Zoho Books.

Today's article begins a new mini-series on basic accounting. While we will focus on use of Zoho Books, the concepts within this article apply regardless of the accounting software you are using.

A “Journal” is a chronological accounting record of a business’s financial transactions. Journals provide the fundamental details of each accounting transaction including the transaction amount, the accounts impacted, and details like the various ‘parties’ (vendors, customer, employee, etc.) associated with the transaction.

Back in the days before computers, business owners had to find a way of keeping their records accurate, it was out of this need that double-entry bookkeeping was conceived. The earliest records of such a system appear near the end of the thirteenth century.  The term ‘double entry’ is a literal description of the requirement that clerks would enter the number for every transaction in two accounts, once as a debit and once as a credit, they would then sum the total of their debits and credits to insure they matched, and in so doing insure that the businesses accounts were in balance.

The fundamental accounting equation,

lies at the foundation of double-entry accounting.  In simplest terms, the value of the business equals the sum total of what has been put into the business plus whatever debts the business has incurred.  The Chart of Accounts of a business essentially represents an expansion of the fundamental accounting equation in an effort to provide greater detail regarding the various amounts associated with each of the three components of the equation.

In the days when everyone kept ‘manual books’, the Journal allowed clerks to record each financial transaction’s details and perform the related calculations on paper before ultimately transferring the associated debits and credits as journal entries to the General Ledger.  Since most accounting today is performed using software, like Zoho Books, the way in which financial transactions are recorded into the software may vary, but ‘behind the scenes’ the software is designed to still ‘keep the books using debits and credits’ in exactly the same double-entry fashion that manual books were kept.

Let’s assume you manufacture ‘dongles’ (don’t ask me what a ‘dongle’ is, I just like the sound of it.) You decide to go into business by opening a checking account with $1000.00 in cash from your personal savings.  You now purchase one dongle-maker at a cost of $1000.00, but you don’t want to use all of your cash, so you pay for half of the dongle-maker, and the maker of the dongle-maker gives you an interest-free loan for the remaining $500.00.  You also spend $250.00 on the materials you need to manufacture your first run of dongles. At the end of the first month you actually have sold $2500.00 worth of dongles and so your bank balance has $2750.00 in it. Since you haven’t made another payment on the dongle-maker at month’s close, your liabilities are $500.00, and your Owner’s Equity is $1000.00. Your total equity also includes the value or your revenue $2500.00, less the expenses (your costs of materials) of $250.00.

So it is easy to see where the numbers come from, and perhaps even to see where the numbers fit in the accounting equation.  But that doesn’t mean that the actual double-entry accounting is easy, now does it?  This is especially true since the terms ‘debit’ and ‘credit’ are often misunderstood, and even mistakenly instructed.

In order to understand these two terms, we have to return to the concept of double-entry accounting.  In our accounting framework two columns are used for recording transaction values.  Debits are recorded in the left column and credits are recorded in the right-hand column.  In fact, the two words actually mean left and right (debit = left, credit = right); so if you have these terms confused with positive and negative, or plus and minus, you are probably in for a rude awakening.

Despite the fact that modern accounting software tends to be transaction driven, allowing you to record different types of transactions in familiar forms such as checks or deposits or invoices or purchases from vendors, the debits and credits are being recorded within the various registers, journals and general ledger as debits and credits.  Ultimately you can’t just rely on transactional accounting, you finally need to develop an understanding of the debits, credits and principles of double-entry accounting if you are going to accurately keep the financial records of a client’s business, or even your own.

With this in mind, let’s return to our example and see how some of the numbers fit into double-entry accounting. 

When we started our business we took $1000.00 of our own money and put it in a new bank account for the business.  That bank account is an Asset because it represents ‘cash’.  It has value. At the same time our investment in the business represents Equity called Owner’s Equity.  To increase the value of an asset we Debit the account, and to increase the value of an Equity account we must Credit the account, so our Debits and Credits for the initial bank deposit representing Owner’s Equity are:

Wow, everything is in balance, our first ‘Journal Entry’ is a success; we are actually doing ‘double-entry’ accounting the old fashioned way, and even more importantly, we are understanding how it works.

As we learned at the beginning of this article, journals are used by accountants to work directly with the general ledger to create debit and credit entries for financial transactions. Typically, the specialty journals are Sales Journals, Purchase Journals, the Cash Disbursement Journal, and the Cash Receipt Journal.

While Zoho Books will perform most of the behind-the-scenes accounting as you enter normal day-to-day transactions, there may come a time where you need to make manual entries to record unique financial transactions which cannot be recorded using normal transactions. These transactions might include “depreciation of fixed assets”, or "opening balances", so you would make a manual journal entry for the particular period. Here is the ‘New Journal’ entry screen you will be using to post these special transactions:

Let’s assume you are the newly hired accountant for our ‘scenario business’.  At the end of the first month they come to you asking for help in setting-up their Zoho Books, and so you decide that the simplest method is to just journalize the few transactions (we have already discussed for the first month), beginning with the owner’s initial deposit of capital into the bank. Let’s look at the 10-steps you will be using to make your entry:

  1. Enter the Date on which the adjustment needs to be made by creating a journal.
  2. Enter a Reference Number with which the journal will be associated.
  3. Enter a Note about why you are making the journal entry. Notes are a mandatory field for a journal to be recorded.
  4. Check the box Cash based Journal if you want this journal entry to show-up ONLY in reports that reflect cash-basis transactions; if you leave this box un-checked, the journal entry will show up in reports that reflect either cash-basis or accrual-basis transactions.
  5. Select the Account to be Debited and the amount of the debit.
  6. Select the Account to be Credited and the amount of the credit.
  7. You can only choose to make a journal entry Taxable or Non-Taxable for Income accounts. The selection you make on the first transactional line will apply to all subsequent lines.
  8. Click the + Add another line if you need to make additional postings.
  9. Verify that the amount debited amounts equal the amounts credited. Also, you can only choose to make a journal entry Taxable or Non-Taxable for Income accounts.
  10. Save the journal entry.

Now that we are clear on the entry and the process, we can record the journal transaction that corresponds to the manual journal entry (shown in the above 'table') we posted the old fashion way. Just follow the 10-steps.

In seconds, everything is posted correctly, and it is also in balance, just like in our manual journal entry.  We have mastered both ‘the old fashion way’ and ‘the Zoho Books’ way of making journal entries.

Unfortunately, the accounting for that first month is just getting started, next time in Accounting 101 – Part 2, we will look at the rest of the ‘debits’ and ‘credits’ associated with your first month of business, and post those into Zoho Books as well.  Until then, may all your Debits and Credits be in Balance.