Friday, August 17, 2007

What's it all mean?

Okay, we've debited and we've credited, but what does it all mean?

Let's look at each in turn.

What are debits?

A debit is either an expense or an asset.

In the basis of book keeping, we learnt that debits are the receiving aspect. A debit will therefore be the representation of a value received.

So if you bought a car, the value of the car would be represented by a debit entry in the Motor Vehicle account, and it is an asset.

If you paid for utilities, the value of the services rendered by the utility company is represented by a debit entry in the Utility account, which is an expense.

What's the diff?

The difference is in the lifetime value.

A car's value is over several years, whereas the value of services rendered by a utility company is month to month. A car is an asset whose value to the business extends beyond one year. So, although buying a car is an expense, it is categorized as an asset because it's value to the business extends beyond a year.

When you make calls on your telephone in September, the value of those calls have been expended in that month and does not carry through to October. The benefit of services rendered by utility companies is only for that particular month. It is therefore an expense.

What are credits?

A credit can be interpreted as capital, liability or an income.

Capital is the amount of money put into the business by the owner of the business. In book keeping, we regard the owner as an entity separate from the business. With that in mind, whatever the owner puts in is considered as owing by the business to the owner.

A liability is a debt owed to another business or person. So if you buy a car on hire purchase, you create an asset by acquiring the car and you also create a liability in the amount you owe to the hire purchase company. The entry would be to debit the motor vehicle account and credit the hire purchase company account.

Income on the other hand represents revenue earned. A service or product is the giving aspect and the income gained from that is the receiving aspect. An income is, like with expenses, earned in that particular month only.

Summing up
Okay, so step 1 was to understand the basis of accounting, which is debit and credit. Step 2 was to understand what a debit and credit represented.

In a future post, we will get into a bit more detail and look at the long and short term interpretations of it.

Stock transactions

There are two ways to handle stock transations.

The first is to debit all trade purchases into the Purchases account, and maintain a separate (perhaps manual) stock account.

In this method, to calculate your cost of sales, you would:

1. Add opening stock balance
2. Add Purchases
3. Deduct Closing stock

Your Profit & Loss account would look like this:


Less: Cost of sales

Opening stock 35,000.00

Purchases 75,000.00


Less: Closing stock 30,000.00


Gross profit

You would have to do a stock take to ascertain the value of your closing stock as at any point in time, and pass a journal entry into the system so that Gross Profit can be calculated.

The alternative is to maintain a perpetual stock system.

With this method, purchases are debited to a stock account and, as stocks are sold, the cost is deducted from it.

At any point in time, the amount reflected in the stock account would therefore be the value of stocks on hand.

In this scenario, the Profit & Loss Account would look like this:


Less: Cost of sales

Gross profit

The real impact on the bottom line is the same. I say real because with the previous system the closing stock value would, at best, be an estimate as you would first have to do a stock take, and then value the stock. This would be time consuming, and, except at the financial year end, most businesses would just take an estimated value and plug it in.

To maintain such a system manually would be too tedious, but the good news is that most, if not all, modern day accounting systems cater for this.

There are primarily three advantages to using this system.

The first is that you can ascertain the gross margin on each sale, as well as ascertain your profits at any given time.

Secondly you know the exact value of your stock in hand, as well as what is in stock and what needs re-ordering.

Thirdly, you can easily do a month to month comparative of your monthly income, because the actual cost is recorded at the time of recording the sale.

Note that although you do not have to perform stock takes just to ascertain the value of your stocks, you would still need to do one at the end of each financial year for audit purposes.

It's also a good idea to do selective stock takes to ensure that the balances in your system tally with that of the physical stock. This will also discourage pilferage.

Tuesday, August 14, 2007

The basis of book keeping

To start with, I am never sure if it's bookkeeping, book keeping or book-keeping. A quick search on Wikipedia seems to confirm this confusion is not confined to me as all three are deemed acceptable.

And that, to me is the only confusing part. Once you get past that, everything else is, as we are so fond of saying here in Malaysia, kacang putih (peanuts)!

Most are daunted by it, but it is actually very simple and precise. Bookkeeping is simply the act of recording a business transaction. That's it, nothing more, nothing less.

Double entry concept
Business transactions have two aspects, the giving aspect and the receiving aspect. Think of it as when someone gives, another receives. These two aspects are named Debit (the receiving aspect) and Credit (the giving aspect).

So in recording a transaction, you need to ask yourself who is giving and who is receiving. For instance, if you pay salary to your employee, the bank is the giving aspect, and the employee is the receiving aspect. Easy huh?

The bank gives and the employee receives.

Debit aspects are recorded on the left and credit on the right.

Most business transactions can be grouped together. For instance when you pay an employee, or your utility bill or your creditor, the common giving aspect here is the bank (assuming you make all these payments by cheque).

For transactions that occur regularly, we create an account so that we can group or categorise them. An account is essentially a name that describes the transaction, for example, we would name banking transactions with the name of the bank that we maintain an account with. (See some similarity here? Banks create an account with our name when we when we open an account with them.) So if your bankers were XYZ Bankers Ltd, you would name the account "XYZ Bank" or to that effect.

Grouping of transactions is relatively straight forward, and depends on the depth of information you require about your business. For instance, you pay for electricity, water and telephone. If you absolutely need to know what the business expended on each, you would create an account for each. In practical terms it would be more prudent to group all 3 under an account called "Utilities" or simply "Electricity, water and telephone".

On the same note, payment of salaries can be grouped under one account rather than in separate accounts for each employee.

Why group transactions?
We group transactions so that we can obtain information about the business. Transactions, if not grouped, do not offer information. It's nothing more than a list of transactions that need to be analysed further if any sort of meaningful information is to be gleaned from it.

If we grouped them however, we would be able to extract meaningful information such as how much was expended on rental or what was the total sales this month.

If you look back at the figure above, at a glance you can ascertain that RM1,000.00 was paid out in salaries.

Is that it?
Well, yes and no. There is much more to bookkeeping than just debits and credits, but this is the basis of everything else.