Accounting 101 - Part 3

by

Introduction:

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 is Part 3 in our mini-series on basic accounting. This Accounting 101 series is intended to cover the fundamentals of transactional posting impacting the financial statements.

While we will focus on use of Zoho Books, the concepts within this article apply regardless of the accounting software you may be using.  After presenting a brief review of the content covered in Parts 1 and 2, this article will examine part of the transactions impacting our Profit and Loss statement from our scenario upon which this series is based.

So that you don’t need to look back at Part 1 or Part 2, I will briefly summarize both our ‘scenario’ as well as the prior content covering basic accounting principles. In Part 1 of this mini-series we looked at the fundamental equation:

and applied it to the following simulated scenario: 

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.

We then identified how the various numbers within the scenario fit into the accounting equation.

After reviewing the meanings of debit (left) and credit (right), we applied the principles of double-entry accounting and recorded our first transaction in Zoho Books to match the beginning bank account and owner's equity. The old fashioned journal would have been recorded as:

but in Zoho Books we posted the transaction like this:

As important as it was to post this journal entry into our new Zoho Books account, we also learned the principles of debits, credits and journal entries associated with double-entry accounting.

In Part 2 of this mini-series we learned the fundamental differences between Assets and Liabilities; we learned that Debits increase Assets, and Credits decrease Assets; on the other hand, we learned that Debits decrease Liabilities and Credits increase Liabilities. And we confirmed that the Balance Sheet should ALWAYS be in balance and conform to our fundamental accounting equation.  In so doing we learned two different ways to post transactions (like the one below) impacting Balance Sheet accounts like Fixed Assets, Loans (secured against those Fixed Assets) and Cash.

One method involved posting the transaction to Zoho Books using a General Journal Entry, and the other involved using a Vendor Bill associated with the purchase of the Fixed Asset (as well as posting the opening loan balance payable to the same vendor), along with the Payment to the Vendor for the portion of the purchase not pledged against the loan. We then learned how to produce a ‘Balance Sheet’ to confirm that our accounting was completely ‘in balance.’

In today’s Part 3 we are going to look at one of the transactions associated with our scenario that impacts the Profit & Loss statement, as well as the Balance Sheet. Our scenario specified, “You also spent $250.00 on the materials you needed to manufacture your first run of dongles.” We have a couple of critical pieces of accounting that we must ‘assume’ because the scenario description was incomplete. (My Bad)  First we will assume that ‘the materials’ specified will be accounted for as ‘Cost of Goods Sold (COGS) – Raw Materials’. COGS can be defined as any cost of goods made by the business including materials, labor, and allocated overhead related thereto. In some instances, you might have other materials that are an integral part of the process of production and not directly attributable to COGS, but in this case we will make the assumption that the entire $250.00 represents COGS we needed to produce our first production run that was sold prior to the month's end. (Note: later in this Accounting 101 series we will examine how the 'carrying of inventory' impacts Cost-of-goods Sold, using different 'cost-basis'.)

For our initial ‘entry’ we are going to assume that the total $250.00 was paid by cash from our bank account. So let’s post our journal entry the ‘old fashioned way’.

Our expenditure is in balance; we are paying out $250.00 from our bank account in order to purchase $250.00 in materials used for production (COGS).  We are reducing the balance of our bank account by posting a credit, and we are increasing the value of the COGS account by posting a debit. Here is the Expense entry (rather than a journal entry) in Zoho Books:

To create an expense paid from a bank account in Zoho Books (like the one shown above):

  1. Go to the ‘Purchases’ tab on the Zoho Books home page,
  2. Select ‘Expenses’,
  3. Click on the ‘+ New’ button,
  4. Select ‘Record Expense’ to create a new expense.
  5. Enter the expense details (the fields with ‘red’ titles are required) such as an account to track it, payment method and the amount. [Note: In our example above, we recorded the account as our Cost of Goods Sold-Materials account; we entered $250.00 as the amount, and we entered Bank as our Paid through account.
  6. Save the expense.
  7. Optional: You can attach a receipt – Zoho Books allows you to upload a picture of the receipt and attach it to the corresponding expense instantly. This can be done both while recording a new expense or by opening an already existing expense and clicking on Attach Receipt.

So now let’s take a look at the impact of this transaction on our Profit & Loss report. Remember, this transaction posted to COGS on the P&L, and to our Bank Account (an Asset) on the Balance Sheet.  Here is our Zoho Books' Profit and Loss Report:

At present our Profit and Loss report shows we have a $250.00 Net Loss for this year-to-date; but remember, we still haven’t posted our sales (income) for our start-up month (we will do that in Part 4, next time). 

Steps to run a Zoho Books' Profit & Loss report:

  1. Click the Reports module from the navigation panel (illustrated below).
  2. Select the Profit and Loss report from the left pane (illustrated below).
  3. Choose your preferred Date Range (illustrated below).
  4. Click the Run Report button (illustrated below).
  5. Print or export the report as PDF.

As I mentioned a couple of paragraphs back, we will look at posting income in Part 4 of this mini-series.  "Until then, may all your accounting transactions be in balance."