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Accounting Savvy for Business Owners
By Philip B. Goodman
CPA911 Publishing, LLCCopyright © 2010 CPA911 Publishing, LLC
All rights reserved.
Basic Accounting Rules
Business accounting is based on a double entry system of bookkeeping. This means that for every entry you make there must be an equal and opposite entry. Opposite refers to the other side of the ledger.
The ledger sides are labeled DEBIT (always on the left) and CREDIT (always on the right), and you must make sure that every transaction has equal entries posted to both sides of the ledger.
If you do your bookkeeping manually, or in a spreadsheet program, you must enter both sides of the ledger. If you use checkwriting software (such as Quicken) you should move those transactions into a manual system or a spreadsheet program in order to enter transactions to both sides of the ledger accurately (or, even better, invest in real accounting software).
If you use accounting software, you usually have to enter only one side of the transaction because your setup and configuration of the software pre-determines the postings. For most transactions the software takes care of the "other side" of the entry for you automatically, so you don't even have to think about it. (The exception is a journal entry which is generally used to adjust existing figures in the ledger.) However, you do have to assign the appropriate account to a transaction, which means you have to understand the way accounting transactions work in order to set up your software properly.
Every transaction falls into a category that has a default or "natural" side of the ledger, as seen in Table 1-1. These categories are explained in this chapter.
The information in Table 1-1 is the basis for all accounting whether your business is a multi-national corporation or an ice cream stand on the beach. All accounting processes follow the rules inherent in this chart, although large companies have many subcategories to refine and narrow the postings made in their accounting system.
When a category increases as a result of a transaction, the amount is posted to its assigned (default) side of the ledger; when it decreases as a result of a transaction, the amount is posted to the opposite side of the ledger.
For example, when you enter a transaction that adds an amount to your bank account, the increase in your bank balance is posted to the Debit side of the ledger (because your bank account is an asset and the Debit side is the default side for assets).
The offsetting entry is the "reason" for the transaction, which in this case is usually the receipt of business income (notice that income is on the Credit side of the ledger, and because income is increased, it is posted to its default side of the ledger).
On the other hand, when you remove money from your bank, that transaction decreases the value of that asset, so the amount is posted to the "other" (in this case, Credit) side of the ledger. The equal and opposite entry is the "reason" for the decrease, such as payment of an expense (notice that expenses are on the Debit side of the ledger, and since expenses have been increased by the transaction, you use the default side for that category).
Making Sense of the Debit and Credit Labels
The labels Debit and Credit can be confusing because they don't follow the logic of your generally accepted definitions for those words. How can an asset be a debit, isn't debit a negative word?
These terms are used all over the world, and date back to the 1400's; so it's too late to try to change them. Just live with them. The solution is to ignore your vocabulary skills (and your logic) and just memorize the rules and definitions. You'll be amazed at how fast you absorb the concepts once you've begun entering, or examining, business transactions. There are only two rules you have to memorize:
Debits on the left, Credits on the right.
Assets and expenses are debits by default; liabilities, equity, and income are credits by default.
Every transaction posts to both sides of the ledger, using at least one category on each side. Some of the category labels are rather broad, so in this section I'll define them more specifically.
Assets are things that belong to (are owned by) your business, and they are broken down into two main subcategories called Current Assets and Long Term Assets. In turn, each of those subcategories has additional subcategories. Chapter 5 teaches you when and how to use asset accounts in transactions.
Current assets are best described as those things that you expect to be able to convert to cash, or use as cash, within one year. These are the assets that are commonly used when you're posting transactions. The following are examples of common current assets:
Cash, which includes money in bank accounts, in the cash register, and in the petty cash box.
Accounts Receivable, which is the money currently owed to you by customers.
Inventory, which is the total value of the cost of products you purchased for resale or you purchased to create a product.
Loans you make to others.
Prepaid expenses, which are the monies you paid in advance of their actual use such as prepayments on insurance premiums, payment of business tax estimates for the current year's taxes, deposits on utility accounts, and other similar prepayments.
Long Term Assets
Long term assets are those possessions that you expect to remain in use, without converting them to cash, for more than a year. The following are common examples of long term assets:
Buildings (and accumulated depreciation)
Leasehold Improvements (and accumulated depreciation)
Equipment (and accumulated depreciation)
Vehicles (and accumulated depreciation)
Furniture and Fixtures (and accumulated depreciation)
Start Up Costs (and accumulated amortization)
Goodwill (and accumulated amortization)
Copyrights and Patents (and accumulated amortization)
You learn about tracking assets in Chapter 5, and Chapter 10 explains depreciation and amortization.
A liability is something that you may be holding, or have the use of, but does not belong to you. It is something you owe to someone else. Like assets, liabilities are subcategorized into two groups: Current Liabilities and Long Term Liabilities. Chapter 6 discusses the whens, hows, and whys of posting transactions to liability accounts.
Current liabilities are usually defined as debts due within a year. Following are the common current liabilities you track:
Accounts Payable, which is money you owe vendors.
Payroll Liabilities, which is money withheld from employees' pay, your business' share of taxes on that pay, and other payroll obligations due to government agencies, insurance companies, pension funds, etc.
Sales tax you have collected from customers and must turn over to the state tax authority.
Long Term Liabilities
Long term liabilities are debts that require more than a year to pay off. These are commonly loans such as mortgages, business loans, lines of credit, equipment loans, vehicle loans, etc.
Equity tracks the value of business ownership and the value of the business. The way you track equity, including the types of categories and ledger accounts you create, depends on the way your business is organized. Following are some of the common equity categories:
Stock in your company, if you are a corporation.
Capital invested by partners if you are a partnership, limited liability partnership (LLP), or limited liability company (LLC).
Capital invested by you if you are a proprietorship or single-member LLC.
Draws (withdrawals of funds) if you are not incorporated.
Retained earnings, which is the accumulated profit (or loss) since the business began. This is a calculated amount (income less expenses), not an account to which you normally post transactions.
Chapter 7 explains the various types of business organizations and explains when and how to post transactions to equity accounts.
Income is the revenue your business receives. You can separate your income into various subcategories in order to analyze the source of funds. For example, if you sell both products and services, you may want to track those monies separately. If you sell services only, you may want to subcategorize your revenue by service type.
In addition to the subcategories you set up to track specific revenue sources, it's common to create an Other Income subcategory to cover uncommon "miscellaneous" income receipts that aren't connected to your main source of revenue. For example, you may want to create a category for Interest Income or Finance Charges Collected.
In addition, you may want to track customer returns and refunds as its own category, instead of posting the amounts of those returns to the regular Income category (which produces a running total of the net sales). Chapter 3 discusses the ways to post income transactions.
Expenses are the monies you spend to run your business. Expenses are subcategorized for the purposes of meeting the reporting requirements on tax returns and for your own analysis.
Generally we think of expenses in two main categories - Cost of Goods Sold and General and Administrative Expenses.
Cost of Goods Sold
Sometimes called Cost of Sales, this is an expense category that usually tracks what you spend to create a product that you sell from inventory. Commonly, the following expenses are tracked as Cost of Goods Sold:
Cost of raw materials for manufacturing.
Cost of goods you purchase for resale.
Inbound shipping costs for raw materials or products for resale to your business.
Cost of labor to manufacture and assemble materials into products.
Other costs involved with creating an inventory item, such as packaging, crating, etc.
Sometimes businesses can track Cost of Goods even if they're not selling inventory items. Check with your accountant about the Cost of Goods subcategories that are appropriate for your business.
General and Administrative Expenses
The general expenses involved in running your business are tracked by category in order to calculate totals that are required for tax returns, and also to track specific types of expenses so you can analyze the way you're spending money to run your business. Some of the commonly used categories are the following:
Bank service charges
Dues and subscriptions
Entertainment (of customers, not your own fun)
Legal and accounting services
Employer payroll taxes
Postage and shipping
Web site expenses
You and your accountant can design the list of expenses you need to track your expenses intelligently, and to prepare tax returns easily.
In addition, it's common to have an expense category called Other Expenses, in which you track subcategories less commonly used in transactions. For example, you may want to track monies expended in the following subcategories as Other Expenses instead of putting these expenses in the general expense category list:
Fines and Penalties
For most businesses, the list of expense categories is quite long (and the more detail-oriented you want to be as you track and analyze where you spend money, the longer it gets). Some individual transactions cover multiple expense categories (think about entering the transaction that occurs when you write a check to your credit card company). Chapter 4 covers the ways in which you use these expense categories when you're entering transactions.
Cash Basis Vs. Accrual Basis Accounting
An accounting method is a set of rules used to determine when income and expenses are reported to the IRS. You can use either cash basis or accrual basis as your accounting method.
You don't really get to decide on an accounting method, because you can't flip a coin, nor can you decide based on what seems easier or more advantageous to your tax bill. There are rules about the accounting method you use and those rules are created and enforced by the IRS. If you do your own tax returns, you should consult an accountant before determining which accounting method to use.
You declare your accounting method when you file your first tax return for your business. If you want to change your accounting method after that you must apply to the IRS for permission to do so. The IRS provides forms for this purpose. (Sometimes, albeit rarely, the IRS contacts businesses and orders them to change their accounting method.)
You must use the same accounting method across the board, which means you can't opt to use the cash basis method for income and the accrual method for expenses (or the other way around).
In this section, I'll explain the differences between these two accounting methods, and then go over the guidelines for the types of businesses that must choose a specific accounting method.
Cash Basis Accounting
The cash basis accounting method is used by most small businesses. Cash basis accounting means you account for income when you receive it and you account for expenses when you pay them.
In cash basis accounting your income for the tax year includes all revenue you receive during that year, regardless of when you sold services or products and sent an invoice to the customer. It's the date on which you receive the money that determines the year in which you report it. The date on which you deposit the money doesn't count because you're not allowed to avoid increasing your revenue (and therefore not paying tax on it) by holding onto checks, cash, credit card sales slips, etc. and depositing them in the next year. The operative word for declaring revenue is "received", the customer's invoice date and the deposit date don't count.
For example, if you have a sale to a customer in November or December and create an invoice at that time, the amount of the invoice is not considered income if you use cash basis accounting. Instead, you recognize the income when you receive your customer's payment, which may not be until sometime in the next year.
If you collect sales tax your state's sales tax law determines when that sales tax is recorded. The state doesn't care which accounting method you use for reporting business income. Some states consider sales tax due when it's invoiced (accrual based accounting), and other states consider sales tax due when you receive payment from the customer (cash based accounting). Check the terms on your state sales tax license to learn how you should be tracking and remitting sales tax (and read Chapter 3 to learn how to enter those transactions).
Your business expenses are deducted in the year you pay them. It doesn't matter when the vendor sent a bill, you deduct the expense in the year you write the check (the date on your check is what counts) or hand over cash (don't forget to get a dated receipt when you use cash).
Accrual Basis Accounting
Accrual basis accounting is a more precise way of keeping books than cash basis accounting, because it takes into consideration every transaction and event as it occurs. When you view your records, or create reports, you see all the transactions you've created and posted, which makes it easier to analyze the health of your business.
In accrual basis accounting, your income is recorded when you earn it, either by performing a service or selling a product. When you create an invoice for a customer, you've earned the income and you report it in the year you earned it, even if the customer doesn't pay you until next year.
Your expenses are recorded when you become liable for them, regardless of when you actually pay them. When you receive a bill from a vendor, you're liable for the expense and you report the expense for the year in which you received the bill, based on the date of the bill, even if you don't pay the bill until the following year. The same is true for expenses for which you don't receive an invoice but you know your date of liability, such as rent, interest payments on a loan, etc.
Selecting an Accounting Method
Determining the accounting method is a matter of matching your business operations with the IRS rules. Some of the rules are clear; others may seem a bit confusing and hard to interpret. Most small businesses use cash basis accounting, but if you can't determine for sure which accounting method to use, consult an accountant.
Following is a very brief (and very oversimplified) summary of the scenarios in which the IRS insists on accrual basis accounting for calculating your tax liability. In actuality the rules are more complicated than set out here, and include exceptions for certain business types. You must get professional advice for this decision. If your business clearly doesn't fit into one of these descriptions, you can almost certainly keep books and file taxes using the cash basis accounting method.
Any corporation (other than an S corporation) that has average annual gross receipts exceeding $5 million must use the accrual basis accounting method.
Excerpted from Accounting Savvy for Business Owners by Philip B. Goodman. Copyright © 2010 CPA911 Publishing, LLC. Excerpted by permission of CPA911 Publishing, LLC.
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