Accounting Basics

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Accounting Basics
Important Disclaimer
Important Note: The text in this chapter is intended to clarify
business-related concepts. It is not intended nor can it replace
formal legal advice. Before taking any actions relating to your
business, always consult your accountant or a business law/tax
attorney.

The Need for Accounting
Every organization needs to maintain good records to track how
much money they have, where it came from, and how they spend it.
These records are maintained by using an accounting system.
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These records are essential because they can answer such important
questions as:
• Am I making or losing money from my business?
• How much am I worth?
• Should I put more money in my business or sell it and go into
another business?
• How much is owed to me, and how much do I owe?
• How can I change the way I operate to make more profit?
Even if you do not own or run a business, as an accountant you will
be asked to provide the valuable information needed to assist
management in the decision making process. In addition, these
records are invaluable for filing your organization’s tax returns.
The modern method of accounting is based on the system created by
an Italian monk Fra Luca Pacioli. He developed this system over
500 years ago. This great and scientific system was so well designed
that even modern accounting principles are based on it.
In the past, many businesses maintained their records manually in
books – hence the term “bookkeeping” came about. This method of
keeping manual records was cumbersome, slow, and prone to human
errors of translation.
A faster, more organized, and easier method of maintaining books is
using Computerized Accounting Programs. With the decrease in the
price of computers and accounting programs, this method of keeping
books has become very popular.
Accounting and Business
Accounting is the system a company uses to measure its financial
performance by noting and classifying all the transactions like sales,
purchases, assets, and liabilities in a manner that adheres to certain
accepted standard formats. It helps to evaluate a Company’s past
performance, present condition, and future prospects.
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A more formal definition of accounting is the art of recording,
classifying, and summarizing in a significant manner and in terms
of money, transactions and events which are, in part at least, of a
financial character and interpreting the results thereof
.
What Accountants Do
We have said that accounting consists of these functions:
• Recording
• Classifying
• Summarizing
• Reporting and evaluating the financial activities of a business
Before any recording can take place, there must be something to
record. In accounting, the something consists of a transaction or
event that has affected the business. Evidence of the transaction is
called a document.
For example:
• A sale is made, evidenced by a sales slip.
• A purchase is made, as evidenced by a check and other
documents such as an invoice and a purchase order.
• Wages are paid to employees with the checks and payroll records
as support.
• Accountants do not record a conversation or an idea. They must
first have a document.
In almost any business, these documents are numerous and their
recording requires some sort of logical system. Recording is first
carried out in a book of original entry called the journal. A journal is
a record, listing transactions in a chronological order.
At this point, we have a record of a great volume of data. How can
this data best be used? Aside from writing down what has occurred
for later reference, what has been accomplished? The answer is, of
course, that the accountant has only started on his task. This great
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volume of data in detailed listings must be summarized in a
meaningful way.
When asked, the accountant must turn to these summaries to answer
questions like:
• What were total sales this month?
• What were the total expenses and what were the types and
amounts of each expense?
• How much cash is on hand?
• How much does the business owe?
• How much are the accounts receivable?
The next task after recording and classifying is summarizing the data
in a significant fashion.
The records kept by the accountant are of little value until the
information contained in the records is reported to the owner(s) or
manager(s) of the business. These records are reported to the owners
by preparing a wide variety of financial statements.
The accountant records, classifies, summarizes, and reports
transactions that are mainly financial in nature and affect the
business. The reporting, of course, involves placing his interpretation
on the summarized data by the way he arranges his reports.
Every business has a unique method of maintaining its accounting
books. However, all accounting systems are similar in the following
manner:
• Business documents representing transactions that have taken
place. (A business transaction occurs when goods are sold, a
contract is signed, merchandise is purchased, or some similar
financial transaction has occurred).
• Various journals where the documents are recorded in detail and
classified
• Various ledgers where the details recorded in the journals are
summarized
• Financial reports where the summarized information is presented
Where variations exist, they have to do with the way the business
transaction is assembled, processed, and recorded.
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These methods are partly arbitrary. First, you must understand
certain simple principles of accounting. When you have a firm grasp
of the fundamentals you can deal with any kind of accounting
problem.
Advantages of Computerized Accounting
Some of the advantages of using a computerized accounting system
are:
• The arithmetic of adding up debits and credits columns is done
automatically and with total accuracy by the computer.
• Audit trails or details are automatically maintained for you.
• Produce financial statements simply by selecting the appropriate
menu item.
• A computerized system lets you retrieve the latest accounting
data quickly, such as today’s inventory, the status of a client’s
payment, or sales figures to date.
• Data can be kept confidential by taking advantage of the security
password systems that most accounting programs provide.
Computerized accounting programs usually consist of several
modules.
The principal modules commonly used are:
• General Ledger
• Inventory
• Order Entry
• Accounts Receivable
• Accounts Payable
• Bank Manager
• Payroll
In a good accounting system, the modules are fully integrated. When
the system is integrated, the modules share common data. For
example, a client sales transaction can be entered in as an invoice,
which automatically posts to the General Ledger module without re-
entering any data. This is one of the greatest advantages of a
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computerized accounting system – you need to enter the information
only once. As a result of this:
• Data entry takes less time.
• There is less chance that errors will occur.
• You do not have to re-enter data for posting.
Types of Business Organizations
Three principal types of organizations have developed as ways of
owning and operating business enterprise.
In general, business entity or organizations are:
• Sole proprietorship
• Partnerships
• Corporations
Let us discuss these concepts starting with the simplest form of
business organization, the single or sole proprietorship.
Sole Proprietorship
A sole proprietorship is a business wholly owned by a single
individual. It is the easiest and the least expensive way to start a
business and is often associated with small storekeepers, service
shops, and professional people such as doctors, lawyers, or
accountants. The sole proprietorship is the most common form of
business organization and is relatively free from legal complexities.
One major disadvantage of sole proprietorship is unlimited liability
since the owner and the business are regarded as the same, from a
legal standpoint.
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Partnerships
A partnership is a legal association of two or more individuals called
partners and who are co-owners of a business for profit. Like
proprietorships, they are easy to form. This type of business
organization is based upon a written agreement that details the
various interests and right of the partners and it is advisable to get
legal advice and document each person’s rights and responsibilities.
There are three main kinds of partnerships
• General partnership
• Limited partnership
• Master limited partnership
General Partnership
A business that is owned and operated by 2 or more persons where
each individual has a right as a co-owner and is liable for the
business’s debts. Each partner reports his share of the partnership
profits or losses on his individual tax return. The partnership itself is
not responsible for any tax liabilities.
A partnership must secure a Federal Employee Identification
number from the Internal Revenue Service (IRS) using special
forms.
Each partner reports his share of partnership profits or losses on his
individual tax return and pays the tax on those profits. The
partnership itself does not pay any taxes on its tax return.
Limited Partnership
In a Limited Partnership, one or more partners run the business as
General Partners and the remaining partners are passive investors
who become limited partners and are personally liable only for the
amount of their investments. They are called limited partners
because they cannot be sued for more money than they have invested
in the business.
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Limited Partnerships are commonly used for real-estate
syndication.
Master Limited Partnership
Master Limited Partnerships are similar to Corporations trading
partnership units on listed stock exchanges. They have many
advantages that are similar to Corporations e.g. Limited liability,
unlimited life, and transferable ownership. In addition, they have the
added advantage if 90% of their income is from passive sources (e.g.
rental income), then they pay no corporate taxes since the profits are
paid to the stockholders who are taxed at individual rates.
Corporations
The Corporation is the most dominant form of business
organization in our society. A Corporation is a legally chartered
enterprise with most legal rights of a person including the right to
conduct business, own, sell and transfer property, make contracts,
borrow money, sue and be sued, and pay taxes. Since the
Corporation exists as a separate entity apart from an individual, it is
legally responsible for its actions and debts.
The modern Corporation evolved in the beginning of this century
when large sums of money were required to build railroads and steel
mills and the like and no one individual or partnership could hope to
raise. The solution was to sell shares to numerous investors
(shareholders) who in turn would get a cut of the profits in exchange
for their money. To protect these investors associated with such large
undertakings, their liability was limited to the amount of their
investment.
Since this seemed to be such a good solution, Corporations became a
vibrant part of our nation’s economy. As rules and regulations
evolved as to what a Corporation could or could not do, Corporations
acquired most of the legal rights as those of people in that it could
receive, own sell and transfer property, make contracts, borrow
money, sue and be sued and pay taxes.
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The strength of a Corporation is that its ownership and management
are separate. In theory, the owners may get rid of the Managers if
they vote to do so. Conversely, because the shares of the company
known as stock can sold to someone else, the Company’s ownership
can change drastically, while the management stays the same. The
Corporation’s unlimited life span coupled with its ability to raise
money gives it the potential for significant growth.
A Company does not have to be large to incorporate. In fact, most
corporations, like most businesses, are relatively small, and most
small corporations are privately held.
Some of the disadvantages of Corporations are that incorporated
businesses suffer from higher taxes than unincorporated businesses.
In addition, shareholders must pay income tax on their share of the
Company’s profit that they receive as dividends. This means that
corporate profits are taxed twice.
There are several different types of Corporation based on various
distinctions, the first of which is to determine if it is a public, quasi-
public or Private Corporation. Federal or state governments form
Public Corporations
for a specific public purpose such as making
student loans, building dams, running local school districts etc.
Quasi-public Corporations are public utilities, local phones, water,
and natural gas. Private Corporations are companies owned by
individuals or other companies and their investors buy stock in the
open market. This gives private corporations access to large amounts
of capital.
Public and private corporations can be for-profit or non-profit
corporations. For-profit corporations are formed to earn money for
their owners. Non-profit Corporations have other goals such as
those targeted by charitable, educational, or fraternal organizations.
No stockholder shares in the profits or losses and they are exempt
from corporate income taxes.
Professional Corporations are set up by businesses whose
shareholders offer professional services (legal, medical, engineering,
etc.) and can set up beneficial pension and insurance packages.
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Limited Liability Companies (LLCs as they are called) combine
the advantages of S Corporations and limited partnerships, without
having to abide by the restrictions of either. LLCs allow companies
to pay taxes like partnerships and have the advantage of protection
from liabilities beyond their investments. Moreover, LLCs can have
over 35 investors or shareholders (with a minimum of 2
shareholders). Participation in management is not restricted, but its
life span is limited to 30 years.
Subchapter S Corporation
Subchapter S Corporation, also known as an S Corporation is a cross
between a partnership and a corporation. However, many states do
not recognize a Subchapter S selection for state tax purposes and will
tax the corporation as a regular corporation.
The flexibility of these corporations makes them popular with small-
and medium-sized businesses. Subchapter S allows profits or losses
to travel directly through the corporation to you and to the
shareholders. If you earn other income during the first year and the
corporation has a loss, you may deduct against the other income,
possibly wiping out your tax liability completely subject to the
limitations of Internal Revenue Service tax regulations.
Subchapter S corporations elect not to be taxed as corporations;
instead, the shareholders of a Subchapter S corporation include their
proportionate shares of the corporate profits and losses in their
individual gross incomes. Subchapter S corporations are excellent
devices to allow small businesses to avoid double taxation. If your
company does produce a substantial profit, forming a Subchapter S
Corporation would be wise, because the profits will be added to your
personal income and taxed at an individual rate. These taxes may be
lower than the regular corporate rate on that income.
To qualify under Subchapter S, the corporation must be a domestic
corporation and must not be a member of an affiliated group. Some
of the other restrictions include that it must not have more than 35
shareholders – all of who are either individuals or estates. Subchapter
S corporations can have an unlimited amount of passive income from
rents, royalties, and interest. For more information on the rules that
apply to a Subchapter S corporation, contact your local IRS office.
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