Accounting
Basics
for Lawyers
As a legal professional your
clients and staff expect you
to have a solid understanding
of accounting.
But do you?
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Introduction
Accounting can seem scary at first; the domain of
bookkeepers and accountants using complex terminology
like ‘aged receivables’, ‘journals’, ‘depreciation’, ‘ledgers’,
and ‘accruals’.
This arcane terminology has arisen from the quill and ink
days where numbers were entered into journals
(notebooks) by different people in different places.
For example, a fish merchant might have the sales person
on the beach meeting the incoming boats and recording
sales into the sales journal. Back at the office the
receivables clerk will be recording payments into the
receipts journal. Every month these various journals need
to be combined, and entries matched from each journal
until the ‘books are balanced’. With computer-based
accounting, much of this old terminology is unnecessary.
The basic principles of accounting are very easily
understood. If you have a personal bank account and
household expenses then you are probably already using
them.
In this document we de-mystify accounting with simple
examples to provide you with a clear understanding of
how it all fits together.
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General Ledger and the Chart of Accounts
At the heart of all accounting systems is the General Ledger (often
called the ‘GL’ for short). The General Ledger is the place where all
account entries are kept. To help you organize the account entries,
the General Ledger is divided up into several ‘Accounts’ . Each
Account holds similar types of entries e.g. bank account, rent
expenses, salary income, etc. The list of all of the accounts making
up the general ledger is called the ‘Chart of Accounts’ .
In practical terms, (although not 100% technically accurate) you can
refer to the General Ledger and Chart of Accounts interchangeably,
and people will understand what you mean.
The General Ledger holds all the account entries.
The Chart of Accounts lists all the Accounts in the general ledger.
Primary Sections
The Chart of Accounts is organized into five primary sections:
1.
2.
3.
4.
5.
Assets
Liabilities
Equity
Income
Expenses
Technically speaking, you could get away with running your
accounting system using only these five Accounts. The problem
with that approach is that it would be difficult to find specific
transactions and run meaningful reports. So in practice, you will
create several Accounts under each primary section to organize the
entries. In basic terms, these five primary sections can be described
as follows:
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Assets
Things of commercial value (cash, property, furniture, equipment,
etc.)
Liabilities
Money you owe (mortgages, unpaid bills, etc.).
Equity
How much you (or the business) is currently worth (i.e. assets less
liabilities)
Equity = Assets – Liabilities
Income
Money coming in (proceeds from sales, interest income, etc.)
Expenses
Money going out (bill payments, staff salaries, etc.)
Profit/Loss = Income – Expenses
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Debits and Credits
Debits and Credits are at the heart of double-entry accounting
principles, and are also the cause of much confusion and anguish to
people who are new to accounting. The confusion is understandable
for a number of reasons:
•
debits and credits mean different things depending on
whether you’ re looking at them from a business’ s perspective
or from a bank’ s perspective;
•
a debit to one account will increase the balance, whereas in
another account it will decrease the balance;
•
a ‘debt’ may sound like a kind of debit, but it’ s not really;
•
an Account can be said to be in ‘credit’ but that is a different
thing to a ‘credit entry’ in the Account;
•
banks issue ‘debit cards’ and ‘credit cards’ , but these have
little to do with debits and credits posted to the Accounts.
To keep it simple, we are going to ignore all the other uses of the
words ‘debit’ and ‘credit’ , focussing only on entries into an Account
in the General Ledger.
Each entry of an amount into an Account in the General Ledger must
be identified as either a ‘debit’ or a ‘credit’ ; this governs what effect
the entry will have on the balance of the Account.
The effect of a debit or credit will depend on which primary section the
Account is located under.
It may not seem logical, but it is simply something that you have to
remember.
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A debit (of a positive amount) to an asset Account will increase the balance.
This is probably the most helpful rule for understanding debits and credits, so
find a way to get this permanently etched into your brain!
Using the above rule, you can usually figure out what effect the other
side of the transaction will have.
So for example, if you are going to pay a bill then the bank account
is going to decrease (credit). Hence, the other side of the
transaction will be a debit. Since the bill is an expense, the
transaction will look like this:
Bank
Expenses
$100
$100
Credit
Debit
You can even use this rule if no asset Account is involved in the
transaction. Let’ s say you purchased something via a loan. You
would record this as an entry to ‘Liabilities’ and as an entry to
‘Expenses’ .
So how do you figure out which is the debit and which is the credit?
Knowing we want to increase the balance of the liabilities Account
(because we will end up owing more), think about what bank
transaction would cause a liability Account to increase. If we took
out a loan and added the money to a bank account, then we would
be increasing liabilities (that’ s our aim), and increasing the bank
balance (by depositing the loan funds into the bank). If you increase
the bank balance, then it must be a debit (according to the above
rule), so the liabilities entry must be a credit.
Back to our example: we now know that we need to credit liabilities,
and therefore we must debit expenses.
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Double Entry Accounting
Another fundamental concept of the accounting framework is that
every accounting transaction must be composed of an equal and
opposite set of debit and credit entries.
Transactions vs. Entries
A balanced set of debit and credit ‘entries’ are linked together as a
single ‘transaction’ . The transaction is saved (posted) to the General
Ledger as a whole. If any entry fails to save, then the whole
transaction is aborted.
Every transaction must consist of an equal and opposite set of debit and
credit entries.
A DEBIT to Accounts in the five primary sections has the following
effect on the account balances:
•
Assets
(increase)
•
Liabilities
(decrease)
•
Equity
(decrease)
•
Income
(decrease)
•
Expenses
(increase)
A CREDIT to accounts in the five primary sections has the following
effect on the account balances:
•
Assets
(decrease)
•
Liabilities
(increase)
•
Equity
(increase)
•
Income
(increase)
•
Expenses
(decrease)
This is probably best illustrated by an example.
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Example 1: Receive Money
Let’ s say you wish to record the receipt of your monthly salary in
your personal accounting system. This will affect your bank balance
and your income account.
Your bank account is an asset account so remember the rule ‘a
debit to an asset account increases the balance’ . This means
that you will debit the bank account and then to balance out the
transaction, you will need to credit the income account.
•
Debit Bank $5,000 (increase balance)
•
Credit Income $5,000 (increase balance)
Example 2: Mortgage Payment
When you make a mortgage payment, part of the payment goes to
interest and the other part to reducing the principal. Money will be
leaving your bank account so using the rule ‘a debit to an asset
account increases the balance’ you must be crediting the bank
account because you are decreasing the balance. This transaction
consists of one credit and two debit entries:
•
Credit Bank $2,000 (decrease balance)
•
Debit Interest Expense $1,700 (increase balance)
•
Debit Mortgage Liability $300 (decrease balance)
The credits and the debits match, so the transaction is balanced!
General Journals
Most transactions are posted to the General Ledger from the
appropriate screens in the computer application (e.g. ‘Sales’ ,
Purchases’ , ‘Banking’ , etc.). These areas are sometimes referred to
as ‘source journals’ .
However, occasionally you, or more commonly your accountant, will
need to make some correcting entries that are not directly related to
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a source journal. These transactions are known as ‘General Journal’
transactions (or simply ‘GJs’ ).
An example of a GJ is the recording of a depreciation expense of an
asset.
Financial Statements
Of the wide variety of reports and statements that you can generate
from an accounting system, there are two key reports that underpin
the accounting framework; the ‘Balance Sheet’ and the ‘Income
Statement’ .
Balance Sheet (Statement of Financial Position)
The Balance Sheet provides a summary of your financial position at a
single point in time. It does this using the balances in the first
three primary sections; Assets, Liabilities, and Equity.
The ‘balance’ part of Balance Sheet comes from comparing Assets
to comparing the difference between Assets and Liabilities. These
two amounts should always be in balance.
Equity = Assets – Liabilities
Example:
Assets
Liabilities
Equity
Assets – Liabilities
$10,000
$3,000
$7,000
$7,000
The last two figures match, so the Balance Sheet is balanced.
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Income Statement (Statement of Financial Performance)
The Income Statement compares income (revenue) with expenses
over a certain period of time. The difference between Income
and Expenses is the net profit or loss for the period.
Profit/Loss = Income – Expenses
Example:
Income
Expenses
$12,000
$9,000
Profit
$3,000
The Balance Sheet and Income Statement are
Linked
Once you understand this point then you will understand one of the central
points of accounting.
Looking at the sample Balance Sheet above, let’ s say that you now
pay a bill for $1,000. This will decrease your bank balance and
consequently your total Assets. So your Balance Sheet will look
something like the following:
Assets
Liabilities
Equity
Assets – Liabilities
$9,000
$3,000
$7,000
$6,000
This Balance Sheet is out of balance because Equity does not
equal Assets minus Liabilities. So what’ s the problem? It is that the
other side of the bill payment went to Expenses (which is on the
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Income Statement) and reduced the net profit by $1,000. To fix this,
we move the net profit (or loss) from the Income Statement and add
it under Equity in an account called “Current Year Earnings”. Once
we do this, the equity will change to $6,000 and the Balance Sheet
will balance again.
Examples
Example 1
Let’ s start with a simple household example.
List all the things you own under Assets and any loans under
Liabilities. If you subtract the two then you have a snapshot of your
net worth (‘equity’ in business-speak) at that point in time ($112,000
in this example). This is essentially your personal Balance Sheet.
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Example 2
Continuing with the household example, list all sources of income
and expenditure in a typical month.
In this example we are assuming that the household has two salary
earners.
What you see below is essentially your personal Income Statement
for the month. You have earned $570 more than you spent during
the month, so this can be retained as savings (‘profit’ in businessspeak).
Example 3
Let’ s now take a look at how the individual debits and credits are
entered to make up the Balance Sheet and Income Statement. To
make things easier to understand, we are going to start with a blank
slate and assume that you have just received an inheritance
(wouldn’ t that be nice!). You have decided to start recording your
personal finances from this point forward.
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According to the ‘double-entry’ principle, we need to enter a debit
and a credit to record the receipt of the inheritance. So in this case
we debit the bank account (debits increase Asset accounts) and
credit the inheritance account under Equity (credits increase Equity
accounts).
There are no liabilities so Equity = Assets – Liabilities; everything is
balanced.
Example 4
Now that the money is in the bank, what should we do with all this
new wealth? Let’ s put down a $100,000 deposit and buy a house!
Normally you would record all the entries in a single transaction, but
for clarity, let’ s do this is two stages. Firstly, let’ s record the
purchase of the house with the full mortgage as a Liability.
We haven’ t paid the deposit yet so all we are doing is creating a
new asset (debit house $400,000) and an equal offsetting liability
(credit mortgage $400,000).
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Equity = Assets – Liabilities, so we’ re still all balanced.
Now let’ s pay the deposit. Credit bank $100,000 (credit to an Asset
account decreases the balance), and debit the mortgage $100,000
(debit to Liability account decreases the balance).
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Equity = Assets – Liabilities, so we’ re still all balanced.
Example 4
Now let’ s record your salaries for the first month and make your first
mortgage payment. For simplicity, we will assume that this is an
interest-only payment.
Debit the bank $8,000 for the salaries.
Credit the bank $2,000 for the mortgage payment.
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Oops, the Balance Sheet no longer balances! The reason for this is
that the other side of the previous two entries were recorded under
Income and Expenses, which are not Balance Sheet accounts.
This is where we connect the Income Statement and the Balance
Sheet. In order to get everything to balance, you must move the net
result of the monthly change in Income and Expenses to the Balance
Sheet.
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In this case we have mode a “profit” of $6,000 for the month, so our
net worth (or Equity) has increased by $6,000 from where we
started. Therefore move this to the Balance Sheet under the Equity
section. This is normally entered under an account called ‘Current
Year Earnings’ .
Equity = Assets – Liabilities, so we’ re still all balanced again.
NOTE: In reality, mortgage payments are normally a combination of
interest and capital and so you would record it as follows:
Bank (Asset)
$2,000
Credit (decrease balance)
Interest Paid (Expense)
$1,800
Debit (increase balance)
$200
Debit (decrease balance)
Mortgage (Liability)
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Receivables and Payables
In most businesses, the process of buying and selling is
accomplished through the exchange of ‘invoices’ . An invoice lists
the items, the price, tax component, and payment due date.
Payment is not normally required immediately and ‘credit terms’ are
extended to the purchaser, giving them a certain amount of time to
pay (2 weeks, 1 month, etc.).
When the invoice is created, the sale (or purchase) is recorded in the
accounting system. However, since no money is actually received or
paid, at that point you cannot record the entry in the bank account.
To deal with this, special Asset and Liability accounts are created to
record these anticipated payments. These are called ‘Accounts
Receivable’ (asset account) and ‘Accounts Payable’ (liability
account).
To record a sales invoice, the entries would be as follows:
Accounts Receivable (Asset)
$249.99
Debit (increase balance)
Product Sales (Income)
$249.99
Credit (increase balance)
When you receive a payment, the income remains unchanged since
the sale has already been recorded, and you simply record the
payment to the bank account, and remove the amount from
Accounts Receivable.
To record a sales invoice payment, the entries would be as follows:
Bank (Asset)
$249.99
Debit (increase balance)
Accounts Receivable (Asset)
$249.99
Credit (decrease balance)
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The same process would occur for purchases, except that you would
use the Accounts Payable account instead (and the debits and
credits would be swapped).
“Aged” Receivables/Payables
At any point in time, the current balance of the Accounts Receivable
or Accounts Payable show you the net amount of money owing to
you by customers (or how much you owe to suppliers). Because
each invoice has a due date, it is important to know which of these
amounts are overdue and require attention.
The Aged Receivables and Payables reports will list all unpaid
invoices, with columns grouping overdue payments by how much
they are overdue (30-days, 60-days, 90-days, etc.)
Debtors and Creditors
Traditionally customers who owe you money are called ‘Debtors’
and suppliers to whom you owe money are called ‘Creditors’ .
Cash vs. Accrual Methods
‘Cash’ versus ‘Accrual’ accounting methods are simply a means of
dealing with sales and purchases for tax purposes. The issue arises
from the difference in time between recording the invoice in the
accounting system and receiving the payment.
Using the cash method tax is only assessed when payment is
made/received.
Using the accrual method tax is assessed on the invoice date.
The choice of cash versus accrual method is most often left for the
company to decide; for large corporations accrual is sometimes the
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only option. The reason for choosing one method over the other can
be quite complex, but generally has to do with optimising cash-flow,
or making sure that profits are recorded in the correct periods.
Some companies may elect to use one method for tax purposes, but
may still run financial reports in both methods to compare their cash
position with their financial position.
Sales Tax (a.k.a. GST, VAT)
In some jurisdictions, businesses are required to collect sales tax on
the goods and services that they sell and pay this through to the
government. The amount of sales tax the business owes to the
government is reduced by the amount of sales tax it pays to its
suppliers.
In cases where business buy more goods than they sell in a certain
period, the government will pay the business a cash refund. The
timing of the sales tax payments to/from the government will
depend on whether the business has elected to report on a cash or
accrual basis.
Sales tax is sometimes called ‘Goods and Services Tax’ (GST) or
‘Value-Added Tax’ (VAT).
When you record a sale with a sales tax component, only the taxexclusive portion is recorded under income, and the sales tax
component is recorded as a liability (since you owe this to the
government).
The transaction would look something like (assuming 10% sales tax):
Accounts Receivable (Asset)
$110.00
Debit (increase balance)
Product Sales (Income)
$100.00
Credit (increase balance)
$10.00
Credit (increase balance)
Sales Tax Payable (Liability)
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Capital vs. Revenue Expenses
Normally when you buy something for the business, you will be
exchanging cash for something of equal value, so there should be no
change to the Balance Sheet after the purchase. Essentially all you
would be doing was moving the amount between Asset Accounts.
For example, if you buy a new computer:
Bank (Asset)
$2,500
Credit (decrease balance)
Computer Equipment (Asset)
$2,500
Debit (increase balance)
The total Assets remain the same and so the Balance Sheet is
unchanged.
This works for large items of tangible value, however if you are
buying smaller items (e.g. paper clips and pens) you would not want
to go through all of the trouble of recording these as Assets; they
only have a limited lifespan and would be difficult to re-sell to
recover the cash. For these items, it is more convenient to treat
them as an Expense. The transaction would look like this:
Bank (Asset)
$15.23
Credit (decrease balance)
Office Supplier (Expense)
$15.23
Debit (increase balance)
(The slight decrease in profit for that month as a result of this
expense would be included in “Current Year Earnings” to balance
the Balance Sheet).
So obviously, some line needs to drawn in the sand to decide
whether an item should be recorded as a Capital Expense (and
recorded as an Asset), or as a Revenue expense (and recorded as an
Expense). The local tax jurisdiction will define these limits and you
need to be aware of them in order to code your entries correctly.
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Depreciation
The computer that was purchased for $2,500 in the above example
will not hold that value forever. After a year or two, you would
probably only be able to sell it for about $1,000. However, as it is
still listed under Assets for $2,500, your Balance Sheet would not be
giving you a true snapshot of your business value at that time.
What you need to do is to periodically ‘depreciate’ your assets. This
means that you need to remove part of the value under Assets, and
push this through to Expenses. Let’ s say that at the end of the first
year you decide that the computer is only now worth $1,800. You
could then enter the following transaction to correct the Balance
Sheet:
Computer Equipment (Asset)
$700
Credit (decrease balance)
Depreciation
$700
Debit (increase balance)
(Expense)
In practice, the tax authorities set the amounts you can depreciate
your assets by over time. Some of the more common methods you
might hear about are “straight-line method”, “declining-value
method”, etc.
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Terminology
Account
A names section of the General Ledger that
holds similar entries
Account Entry
(Entry)
A single amount entered into an Account. Each
entry is either a debit or a credit.
Debtor
A customer with unpaid invoices. These invoices
are known as ‘receivables’.
Creditor
A supplier that you need to pay. These invoices
are known as ‘payables.
Current Year
Earnings
Profit/Loss from the current financial year
recorded on the Balance Sheet
Financial Year
The 12 months period used for financial and tax
reporting purposes. The financial year-end date
may be different to the calendar year end.
Retained Earnings
Profit/Loss from the prior financial year
recorded on the balance sheet
Transaction
A container for the two, or more, related
account entries making up a balanced set of
debits and credits.
Trust Accounting
Special accounting procedures governing the
management of funds and assets you hold on
behalf of your clients
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