The above scenario describes the traditional practices under manually maintained accounts. In that scenario, the bookkeeper enters transactions into day books in a chronological order. Cash transactions, credit sales, credit purchases and merchandise returns (incoming and outgoing) are thus recorded in separate day books. The bookkeeper then transcribed the details in the day books to relevant accounts maintained in ledgers, suppliers ledger, customers ledger and general ledger. Finally, balances of each account in the ledgers were extracted and listed in a Trial Balance.
Computerized Accounting
When computers and accounting applications appeared on the scene, the above scenario changed dramatically. The bookkeeper entered transaction details into data entry screens on the computer. The accounting application will then produce all the "reports" – the day books, ledgers, trial balance, income statement and balance sheet, in addition to any custom reports that have been provided for.
In a computerized system, the accountant can create the chart of accounts and ask for any of the reports, specifying the dates range that the report should cover.
Double Entry Bookkeeping
The scenarios discussed above generally assumes a system of double entry bookkeeping, a set of practices described in the 15th century by the Italian Luca Pacioli. Under this system, every transaction is recorded by debiting one or more accounts and crediting one or more other accounts. The total of the debits should invariably equal the total of credits. The principle underlying the practice is that every business transaction involves receiving a value and giving an equal amount of value.
The double entry system helped prove the accuracy of bookkeeping. However, this can be a misleading accuracy if the debits and credits are made to wrong accounts. The accountant (and auditor) reviews this aspect and ensures that the correct accounts have been debited and credited for each transaction.
In a trial balance prepared under double entry system, the total of debit balances in accounts will be equal to the total of all credit account balances.
Single Entry Bookkeeping
Smaller businesses with no expert accountants often maintained accounts in a simpler fashion. They simply recorded all cash transactions, credit sales and credit purchases. By summarizing these transactions in an ad hoc manner, they could compute the cash, debtors and creditors balances. Knowing these things, they could continue running the business.
However, it will be difficult to find out exactly what is happening in the business, such as whether a profit has been made and if so, how much. Additionally, with no accounts of assets (other than cash) pilferages will not be easily detected.
Single entry is not a formalized system and different businesses might practice it in different ways. For example, one business might summarize the expenses and revenues also and compute the profits. The problem is that these will have to be done in an ad hoc manner instead of being automatically generated by the accounting records.
Types of Accounts
Accounts are generally classified into three broad categories, Real, Personal and Nominal:
- Real accounts are generally accounts of tangible assets used in the business, such as land, buildings, plant, furniture and vehicles. It can also include some intangible assets such as goodwill, patents and copyrights.
- Personal accounts are accounts with individuals and other business entities such as partnership firms and companies, typically receivables and payables.
- Nominal accounts are accounts of income and expense, such as sales, purchases and traveling expenses. These are balanced out once a year and the balance carried to the capital account (personal account).
Accounts can also be classified as Income (short term inflow), Expense (short term outflow), Asset (long term inflow) and Liability (long term outflow).
Double entry accounting rules can be simplified as follows:
- Credit an increase income or decrease in expense
- Debit an increase in expense or decrease in income
- Debit an increase in asset or decrease in liability
- Credit an increase in liability or decrease in asset
Bookkeeping and accounting, though a mundane activity, provides information about what is going on in a business and provides control over the business to its managers.
