Welcome to Week 2

Week 1: Tasks 1 and 2 answer: There is no definitive answer as accounts can be named anything you like and can be placed anywhere you like within the simple structure of Assets and Liabilities. This is because any account can have a positive or a negative balance.

So, to recap, assets are things the business owns and liabilities are things the business owes. Lets take a bank account. Whilst it has a positive balance, it is an asset. However, if it should go into the red (it becomes overdrawn) then it is a liability!

So, what to do! Some accounts are simple to place. For example a loan such as a mortgage. We can say with 99% certainty that this is a liability (although if you were to pay off more than you owe, then it becomes an asset!).

What about a building? Now that is for sure an asset. So, common sense is required to decide whether an account is more likely to have a positive balance than a negative one.

Lets take a look at a simple list of accounts split into assets and liabilities:

• Assets
  • Bank
  • Cash
  • Deposit/Savings
  • Business Premises
  • Equipment Used In Business
  • Stock Bought For Resale
  • Unpaid Invoices
• Liabilities
  • Mortgage
  • Loan
  • Credit Card
  • Unpaid Bills

Notice one thing that is missing from these accounts? Yes, sales and expenses. The whole point of the business. Sales and expense accounts are part of what determines your interest in the business. And that is what the Equity section we briefly mentioned earlier is for.

Equity

There are 3 important ingredients of the equity group:

• Profit and Loss Account
• Retained Earnings
• Capital Introduced

At this point we are only interested in the Profit and Loss Account. An interesting thing to note, even at this early stage of this course, is that the Profit and Loss is just another account. It is a long standing misconception that it is some kind of ‘report’. Yes, you can make a lovely looking report from the balances that make up your profit and loss account, and charge for that process, but to really understand accounting, you need to realise that, as said right at the start ‘Everything is an Account’.

The Profit and Loss Account is usually made up from the balances of other accounts. This is where the idea that it is a report comes from. But lets take a look at this in detail. Here’s the rule: Any account can contain other accounts. To make the distinction between a single account and one that contains other accounts, we will call the latter an Account Group, or Group for short.

As you have seen, Assets and Liabilities are both groups. Equity is also a group. Profit and Loss (aka P&L) is a group. And in turn, the P&L also can contain groups. And that is where we are going right now. The heart of the business. The single most important part of your chart of accounts is the P&L.

Sales and Expense Accounts

Every business needs to analyse its sales. You can do that with a single Sales Account, or you can break that analysis down into as many sales accounts as you need. If you have different segments within your business, you can set up sales groups that contain individual sales accounts.

The exact same applies to expenses. You could have just a single expense account to cover everything, or break expenses into many different accounts (and account groups).

So, what’s the point of bookkeeping and why do we need to use accounts and account groups? There are only 2 reasons:

1. Keeping the Inland Revenue Service happy
2. Managing your business

The Inland Revenue is only interested in your sales (and the tax you will pay on them) and how much you are trying to reduce that tax by submitting expenses. Although in some tax regimes, tax returns contain boxes for different types of expense, all that matters to the revenue is ‘are those expenses real expenses?’. So, the most basic of accounts can contain a single Sales Account and a single Expense Account.

However, the second reason for bookkeeping is by far the most important. Managing your business. You need to breakdown your accounts in as much detail as possible. That way you can track exactly which aspects of your business make money, and which aspects cost you the most. From there you can make the right management decisions that will make your business more profitable.

So lets take a look at the P&L account group and the accounts it could contain:

• Equity
  • Profit and Loss Account Group
    • Sales Account Group
      • General Sales Account
      • Consultancy Sales Account
      • Other Income Account
    • Expense Account Group
      • General Expense Account Group
      • Rent and Rates
      • Stationery
      • Utility Expense Account Group
      • Mortgage Interest
      • Telephone
      • Internet
      • Gas and Electricity
      • Rent and Rates
      • Water
      • Other Expense Account

This is a very general breakdown. You may want to breakdown your sales and expenses in far more detail. The more detail you have the more you will be in control of, and understand, your business.

The Accounting Equation

Assets = Liabilities + Equity

We are moving rapidly into tricky territory here, but stick with it. It is worth it. The point of the double-entry system is that things must balance. What comes in must balance with what goes out. It is all about the flow of money. If you add an asset, then there must be a liability. Hence the accounting equation. Equity is also a liability. Why? because it is what the business owes the owners of that business. The money generated in a business comes from sales. And sales are held in the P&L account. The P&L account is held in Equity. Hopefully that makes sense. You help your business generate sales, therefore the business owes you!

Remember:

• Assets are what the business owns (not you, but the business)
• Liabilities are what the business owes to third parties (eg. suppliers, Inland Revenue etc.)
• Equity is what the business owes its owners (eg. you)

To help you remember this all important equation. Change it to the acronym ALE. Whenever you think of bookkeeping, think of sipping a cold beverage on a hot summers day. Ah, bliss!

The way to really get to grips with this, however, is to move on to the other main ingredient in a set of books: Transactions. But that is for the next instalment.

Task

Task 1: This task is slightly tougher (the answer is in the next instalment). You have just started a business and you have injected some money into it. You have deposited the money into the business bank account. So, we know where the money went to (the bank), the question is, where did it come from? Your task is to name that account, then place it in one of the main account groups (assets, liabilities or equity). Remember: accounting is all about the flow of money, where it came from and where it went to.

Next Week

• Your first transaction
• Exactly what are debits and credits?
• Learn the one simple rule that simplifies everything