The Source Document

The Source Document

When a business transaction occurs, a document known as the source document captures the key data of the transaction. The source document describes the basic facts of the transaction such as its date, purpose, and amount.
Some examples of source documents:

• cash receipt
• cancelled check
• invoice sent or received
• credit memo for a customer refund
• employee time sheet

The source document is the initial input to the accounting process and serves as objective evidence of the transaction, serving as part of the audit trail should the firm need to prove that a transaction occurred.
To facilitate referencing, each source document should have a unique identifier, usually a number or alphanumeric code. Prenumbering of commonly-used forms helps to enforce numbering, to classify transactions, and to identify and locate missing source documents. A well-designed source document form can minimize errors and improve the efficiency of transaction recording.
The source document may be created in either paper or electronic format. For example, automated accounting systems may generate the source document electronically or allow paper source documents to be scanned and converted into electronic images. Accounting software often provides on-screen entry forms for different types of transactions to capture the data and generate the source document.
The source document is an early document in the accounting cycle. It provides the information required to analyze and classify the transaction and to create the journal entries.

Recommended Reading
Schaum's Outline of Bookkeeping and Accounting

The General Ledger

The General Ledger

While the journal lists transactions in chronological order, its format does not faciliate the tracking of individual account balances. The general ledger is used for this purpose.
The general ledger is a collection of T-accounts to which debits and credits are transferred. The action of recording a debit or credit in the general ledger is referred to as posting. The posting of a journal entry to the general ledger accounts is a purely mechanical process using information already in the journal entry and requiring no additional analysis.
To understand the posting process, consider a journal entry in the following format:

General Journal Entry

Date	Accounts	Debit	Credit
mm/dd	Account 1	xxxx.xx
	Account 2		xxxx.xx

There are two ledger accounts affected by the above journal entry (Account 1 and Account 2). Each of these accounts is represented by a T-account in the general ledger. To post the entry to the ledger, simply transfer the information to the T-accounts:

Ledger Accounts

Account 1 mm/dd xxxx.xx                                                       Bal. xxxx.xx

Account 2                            mm/dd xxxx.xx                                    Bal. xxxx.xx

Note that the debit portion of the journal entry is posted to the left side of its associated T-account, and the credit portion is posted to the right side of its T-account. The date helps to identify the transactions with the journal entries. Additionally, a reference number may be added to further facilitate cross-referencing.

Because the general ledger is organized by account, it allows one to view the activity and balance of any account at a glance.

Recommended Reading

Schaum's Outline of Bookkeeping and Accounting

Closing Entries

Closing Entries

Revenue, expense, and capital withdrawal (dividend) accounts are temporary accounts that are reset at the end of the accounting period so that they will have zero balances at the start of the next period. Closing entries are the journal entries used to transfer the balances of these temporary accounts to permanent accounts.
After the closing entries have been made, the temporary account balances will be reflected in the Retained Earnings (a capital account). However, an intermediate account called Income Summary usually is created. Revenues and expenses are transferred to the Income Summary account, the balance of which clearly shows the firm's income for the period. Then, Income Summary is closed to Retained Earnings.
The sequence of the closing process is as follows:

1. Close the revenue accounts to Income Summary.
2. Close the expense accounts to Income Summary.
3. Close Income Summary to Retained Earnings.
4. Close Dividends to Retained Earnings.

The closing journal entries associated with these steps are demonstrated below. The closing entries may be in the form of a compound journal entry if there are several accounts to close. For example, there may be dozens or more of expense accounts to close to Income Summary.

1.  Close Revenue to Income Summary

The balance of the revenue account is the total revenue for the accounting period. Since revenue is one of the components of the income calculation (the other component being expenses), in the last day of the accounting period it is closed to the Income Summary account as follows:

Closing Entry :  Revenue to Income Summary

Date	Accounts	Debit	Credit
mm/dd	Revenue	xxxx.xx
	Income Summary		xxxx.xx

Once this closing entry is made, the revenue account balance will be zero and the account will be ready to accumulate revenue at the beginning of the next accounting period.

2. Close Expenses to Income Summary

Expenses are the other component of the income calculation and like revenue, are closed to the Income Summary account:

Closing Entry :  Expenses to Income Summary

Date	Accounts	Debit	Credit
mm/dd	Income Summary	xxxx.xx
	Expenses		xxxx.xx

After closing, the balance of Expenses will be zero and the account will be ready for the expenses of the next accounting period. At this point, the credit column of the Income Summary represents the firm's revenue, the debit column represents the expenses, and balance represents the firm's income for the period.

3. Close Income Summary to Retained Earnings

The income or loss for the period ultimately adds to or subtracts from the firm's capital. The Retained Earnings account is a capital account that accumulates the income from each accounting period. The Income Summary account is closed to Retained Earnings as follows:

Closing Entry :  Income Summary to Retained Earnings

Date	Accounts	Debit	Credit
mm/dd	Income Summary	xxxx.xx
	Retained Earnings		xxxx.xx

4. Close Dividends to Retained Earnings

Any capital withdrawals (e.g. dividends paid) during the period will reduce the capital account balance, so the withdrawal is closed to Retained Earnings:

Closing Entry :  Dividends to Retained Earnings

Date	Accounts	Debit	Credit
mm/dd	Retained Earnings	xxxx.xx
	Dividends		xxxx.xx

After closing, the dividend account will have a zero balance and be ready for the next period's dividend payments.

Posting of the Closing Entries

As with other journal entries, the closing entries are posted to the appropriate general ledger accounts. After the closing entries have been posted, only the permanent accounts in the ledger will have non-zero balances.

Post-Closing Trial Balance

Once the closing entries have been posted, the trial balance calculation is performed to help detect any errors that may have occurred in the closing process.

Recommended Reading

Schaum's Outline of Bookkeeping and Accounting

The Balanced Scorecard

The Balanced Scorecard

Traditional financial reporting systems provide an indication of how a firm has performed in the past, but offer little information about how it might perform in the future. For example, a firm might reduce its level of customer service in order to boost current earnings, but then future earnings might be negatively impacted due to reduced customer satisfaction.

To deal with this problem, Robert Kaplan and David Norton developed the Balanced Scorecard, a performance measurement system that considers not only financial measures, but also customer, business process, and learning measures. The Balanced Scorecard framework is depicted in the following diagram:

Diagram of the Balanced Scorecard

Diagram of the Balanced Scorecard

		Financial
Customer		Strategy		Business   Processes
		Learning   & Growth

The balanced scorecard translates the organization's strategy into four perspectives, with a balance between the following:

between internal and external measures
between objective measures and subjective measures
between performance results and the drivers of future results


Beyond the Financial Perspective

In the industrial age, most of the assets of a firm were in property, plant, and equipment, and the financial accounting system performed an adequate job of valuing those assets. In the information age, much of the value of the firm is embedded in innovative processes, customer relationships, and human resources. The financial accounting system is not so good at valuing such assets.

The Balanced Scorecard goes beyond standard financial measures to include the following additional perspectives: the customer perspective, the internal process perspective, and the learning and growth perspective.

Financial perspective - includes measures such as operating income, return on capital employed, and economic value added.

Customer perspective - includes measures such as customer satisfaction, customer retention, and market share in target segments.

Business process perspective - includes measures such as cost, throughput, and quality. These are for business processes such as procurement, production, and order fulfillment.

Learning & growth perspective - includes measures such as employee satisfaction, employee retention, skill sets, etc.

These four realms are not simply a collection of independent perspectives. Rather, there is a logical connection between them - learning and growth lead to better business processes, which in turn lead to increased value to the customer, which finally leads to improved financial performance.

Objectives, Measures, Targets, and Initiatives

Each perspective of the Balanced Scorecard includes objectives, measures of those objectives, target values of those measures, and initiatives, defined as follows:

Objectives - major objectives to be achieved, for example, profitable growth.

Measures - the observable parameters that will be used to measure progress toward reaching the objective. For example, the objective of profitable growth might be measured by growth in net margin.

Targets - the specific target values for the measures, for example, +2% growth in net margin.

Initiatives - action programs to be initiated in order to meet the objective.

These can be organized for each perspective in a table as shown below.
Balanced Scorecard as a Strategic Management System

The Balanced Scorecard originally was conceived as an improved performance measurement system. However, it soon became evident that it could be used as a management system to implement strategy at all levels of the organization by facilitating the following functions:

Clarifying strategy - the translation of strategic objectives into quantifiable measures clarifies the management team's understanding of the strategy and helps to develop a coherent consensus.

	Objectives	Measures	Targets	Initiatives
Financial
Customer
Process
Learning

Communicating strategic objectives - the Balanced Scorecard can serve to translate high level objectives into operational objectives and communicate the strategy effectively throughout the organization.

Planning, setting targets, and aligning strategic initiatives - ambitious but achievable targets are set for each perspective and initiatives are developed to align efforts to reach the targets.

Strategic feedback and learning - executives receive feedback on whether the strategy implementation is proceeding according to plan and on whether the strategy itself is successful ("double-loop learning").

These functions have made the Balanced Scorecard an effective management system for the implementation of strategy. The Balanced Scorecard has been applied successfully to private sector companies, non-profit organizations, and government agencies.


Recommended Reading

Robert S. Kaplan and David P. Norton, The Balanced Scorecard : Translating Strategy into Action

In The Balanced Scorecard, the original architects of the system introduce the framework assuming no prior knowledge by the reader. Kaplan and Norton discuss the need for the Balanced Scorecard, provide examples of metrics in the four perspectives, and explain how the system can be used to implement and manage business strategy.

Accounting Concepts

Accounting Concepts

Underlying Assumptions, Principles, and Conventions

Financial accounting relies on several underlying concepts that have a significant impact on the practice of accounting.

Assumptions

The following are basic financial accounting assumptions:

Separate entity assumption - the business is an entity that is separate and distinct from its owners, so that the finances of the firm are not co-mingled with the finances of the owners.

Going concern assumption - the business is going to be operating for the foreseeable future.

Stable monetary unit assumption - e.g. the U.S. dollar

Fixed time period assumption - info prepared and reported periodically (quarterly, annually, etc.)

Principles

The basic assumptions of accounting result in the following accounting principles:

Historical cost principle - assets are reported and presented at their original cost and no adjustment is made for changes in market value. One never writes up the cost of an asset. Accountants are very conservative in this sense. Sometimes costs are written down, for example, for some short-term investments and marketable securities, but costs never are written up.

Matching principle - matching of revenues and expenses in the period earned and incurred.

Revenue recognition principle - revenue is realized (reported on the books as earned) when everything that is necessary to earn the revenue has been completed.

Full disclosure principle - all of the information about the business entity that is needed by users is disclosed in understandable form.

Modifying Conventions

Due to practical constraints and industry practice, GAAP principles are not always applied strictly but are modified as necessary. The following are some commonly observed modifying conventions:

Materiality convention - a modifying convention that relaxes certain GAAP requirements if the impact is not large enough to influence decisions. Users of the information should not be overburdened with information overload.

Cost-benefit convention - a modifying convention that relaxes GAAP requirements if the expected cost of reporting something exceeds the benefits of reporting it.

Conservatism convention - when there is a choice of equally acceptable accounting methods, the firm should use the one that is least likely to overstate income or assets.

Industry practices convention - accepted industry practices should be followed even if they differ from GAAP.


Recommended Reading

Accounting (Barron's Business Review Series)

Trial Balance

Trial Balance


A basic rule of double-entry accounting is that for every credit there must be an equal debit amount. From this concept, one can say that the sum of all debits must equal the sum of all credits in the accounting system. If debits do not equal credits, then an error has been made. The trial balance is a tool for detecting such errors.

The trial balance is calculated by summing the balances of all the ledger accounts. The account balances are used because the balance summarizes the net effect of all of the debits and credits in an account. To calculate the trial balance, construct a table in the following format:
Trial Balance Calculation

Account         Debits         Credits     Account 1 xxxx.xx Account 2 xxxx.xx Account 3 xxxx.xx . . . Account 4 xxxx.xx Account 5 xxxx.xx Account 6 xxxx.xx . . . ________ ________ Totals:  xxxx.xx  xxxx.xx

In the above trial balance, the balances of Accounts 1, 2, and 3 are net debits, and the balances of Accounts 4, 5, and 6 are net credits. The totals of the debits and credits should be equal; if they are not, then an error was made somewhere in the accounting process. Some common errors include the following:

Error in totaling the columns - make sure that the trial balance columns were summed properly.

Error in transferring account balances to proper trial balance columns - make sure that debit and credit account balances are in the appropriate debit and credit columns of the trial balance calculation. Check for reversed digits and misplaced decimal points.

Omission of an account - an account may be missing in the trial balance calculation.

Error in account balance - an error may have been made in the calculation of a ledger account balance.

Error in posting a journal entry - a journal entry may not have been posted properly to the general ledger.

Error in recording a transaction in the journal - for example, making an error in a debit or credit, or failing to enter a debit or credit.

In general, the most effective way to isolate an error is to work backward from the trial balance itself to the initial journal entry, as outlined in the above list.

Note that a balanced trial balance does not guarantee that there are no errors. An error of omission could have been made in which a transaction was not recorded, a journal entry could have been posted to the wrong ledger account, or a debit and credit could have been transposed. Such errors are not caught by the trial balance.

Recommended Reading

Schaum's Outline of Bookkeeping and Accounting

Financial Accounting Standards

Financial Accounting Standards

Accounting standards are needed so that financial statements will fairly and consistently describe financial performance. Without standards, users of financial statements would need to learn the accounting rules of each company, and comparisons between companies would be difficult.
Accounting standards used today are referred to as Generally Accepted Accounting Principles (GAAP). These principles are "generally accepted" because an authoritative body has set them or the accounting profession widely accepts them as appropriate.

Securities and Exchange Commission (SEC) The Securities and Exchange Commission is a U.S. regulatory agency that has the authority to establish accounting standards for publicly traded companies. The Securities Act of 1933 and the Securities Exchange Act of 1934 require certain reports to be filed with the SEC. For example, Forms 10-Q and 10-K must be filed quarterly and annually, respectively. The head of the SEC is appointed by the President of the United States.
When the SEC was formed there was no standards-issuing body. However, rather than set standards, the SEC encouraged the private sector to set them. The SEC has stated that FASB standards are considered to have authoritative support.


Committee on Accounting Procedure (CAP)
In 1939, encouraged by the SEC, the American Institute of Certified Public Accountants (AICPA) formed the Committee on Accounting Procedure (CAP). From 1939 to 1959, CAP issued 51 Accounting Research Bulletins that dealt with issues as they arose. CAP had only limited success because it did not develop an overall accounting framework, but rather, acted upon specific problems as they arose.



Accounting Principles Board (APB)
In 1959, the AICPA replaced CAP with the Accounting Principles Board (APB), which issued 31 opinions and 4 statements until it was dissolved in 1973. GAAP essentially arose from the opinions of the APB.
The APB was criticized for its structure and for several of its positions on controversial topics. In 1971 the Wheat Committee (chaired by Francis Wheat) was formed to evaluate the APB and propose changes.

Financial Accounting Standards Board (FASB)
The Wheat Committee recommended the replacement of the Accounting Principles Board with a new standards-setting structure. This new structure was implemented in 1973 and was made up of three organizations:

• Financial Accounting Foundation (FAF)
• Financial Accounting Standards Board (FASB)
• Financial Accounting Standards Advisory Council (FASAC).

Of these organizations, FASB (pronounced "FAS-B") is the primary operating organization.
Unlike the APB, FASB was designed to be an independent board comprised of members who have severed their ties with their employers and private firms. FASB issues statements of financial accounting standards, which define GAAP. The AICPA issues audit guides. When a conflict occurs, FASB rules.



International Accounting Standards Committee (IASC)
The International Accounting Standards Committee (IASC) was formed in 1973 to encourage international cooperation in developing consistent worldwide accounting principles. In 2001, the IASC was succeeded by the International Accounting Standards Board (IASB), an independent private sector body that is structured similar to FASB.

Governmental Accounting Standards Board (GASB)
The financial reports of state and local goverment entities are not directly comparable to those of businesses. In 1984, the Governmental Accounting Standards Board (GASB) was formed to set standards for the financial reports of state and local government. GASB was modeled after FASB.

Recommended Reading
Tracy, John A., How to Read a Financial Report: Wringing Vital Signs Out of the Numbers

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