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We often get questions about basic accounting principals. We will attempt to explain some of the basic principles in layman’s terms so that you can understand how your accounting system works and what the reports that you print out mean. In future issues we will attempt to explain a bit about debits and credits, what the balance sheet and income statement tell you, and other topics that come up frequently.
The terms “Cash Basis” and “Accrual Basis” have to do with the timing of recording income and expenses. With the cash basis method you would only record income if you actually received the cash from your customers. Expenses would only be recorded when you actually wrote the checks.
Benefits: Cash basis is the most simple method.
Drawbacks: Financial statements are not as meaningful, especially with seasonal businesses or if cash is tight.
With the accrual method you would record income at the time you make the sale to your customer (even if you didn’t get paid yet). This would create an account receivable from the customer. Likewise, you would record expenses when you received the bill from a vendor even if you haven’t paid it yet. This would create an account payable to the vendor.
Benefits: 1. Accrual accounting “matches” the income with the expenses. The financial statements will provide better information for determining if you are making money since it smoothes out the dips and peaks that happen with cash flow. 2. It provides better cash control because you can track who owes you money, who you need to pay and when. 3. Banks and other lenders prefer accrual based financial statements.
Draw backs: 1. The accrual method requires some additional accounting steps. 2. The books may have to be adjusted to cash basis for tax purposes. (This is not a problem if you have a CPA prepare your tax return).
The Chart of Accounts is the foundation of your accounting system. It is a list of classifications used to organize your financial transactions. The structure of the chart of accounts is built around the “accounting equation” which states that what you own minus what you owe equals your net worth. (Assets – Liabilities = Equity). The order of accounts within each classification is usually determined by how liquid they are – that is, how quickly they can be converted into cash or how soon they are due. There is no standard numbering system for the accounts – numbers are generally assigned after the accounts have been determined with enough room to add more in the future.
Assets - What you own
Current Assets - Generally include: Checking, Savings, etc.; Accounts Receivable – Amounts due from customers; Other Receivables such as employee advances; Inventory, Work-in-progress; Prepaid Expenses - expenses that are paid in advance for several months can be recorded as a prepaid expense and divided up over several months so that it doesn’t hit the income statement all at once.
Fixed Assets - Capital Equipment is usually divided into several accounts that track the kinds of equipment: Office Furniture, Computers, Vehicles, Machinery, etc. The amounts recorded here are for items that will last for several years and meet a dollar level set by the company. These assets are expected to help the company make money for several years so they are expensed/written off from income by “depreciating” them.
Accumulated Depreciation – The amounts that are expensed are accumulated in a separate account instead of being deducted from the fixed asset account that has the original cost of the items.
Other Assets - Items that will not be collected within the next year such as Notes/Contracts Receivable, Deposits/prepayments. Intangibles – assets that aren’t physical such as copyrights, goodwill, etc.
Liabilities - What you Owe
Current
Accounts Payable – This account records bills from vendors that will be paid at a later date.
Payroll Taxes Payable – These are employee withholdings and company expenses relating to payroll that will be paid at a later date.
Other Taxes Owed – This can be for sales taxes collected from customers (which are not income) or other business taxes that will be paid later.
Accrued Expenses – These accounts are similar to accounts payable. Some companies accrue expenses to get a better idea of their actual income and obligations. An example is accrued payroll.
Other Current Liabilities – These include obligations that will be due within a year. Such as: Bank Line of Credit and Customer Deposits.
Long-Term Liabilities
These are debts that are not expected to be paid within the next year.
Equity - Net Worth
By default it is the Assets minus the Liabilities (what you own minus what you owe). The types of accounts found in the Equity section depend on the type of ownership of the company.
All types - Retained Earnings (Owner’s Equity) is accumulated earnings of a business from day one. Each year the current year’s earnings are added to the Retained Earnings from the prior year. The Income Statement is the detail of how the Retained Earnings changed that year. Other equity accounts may include: Sole Proprietor - Owner’s Draws & Contributions for money deducted from or contributed to the business. Partnerships - similar to Sole Proprietors but with a Draw and Equity account for each partner. Corporations - Some additional equity accounts are: Capital Stock, Additional Paid in Capital and Dividends.
Income and Expense Accounts:
Most businesses pay lots of attention to the “bottom line”. Here is a look at some of the accounts that get you there. Hint: Don’t get too detailed. A good place to start is with an income tax form. At a minimum start with the categories listed on the return. Then add accounts for categories that fit your business. You can look at financial statements for other companies in your industry, use the samples from your software or ask your CPA. Remember you can always add new accounts as needed.
Income
Sales or revenue from everyday activities. You should not include sales tax which is money that belongs to the government. This belongs in a liability account. Adjustments to income, such as customer discounts, returns and allowances, are included here.
Cost of Goods Sold
Usually the cost of inventory sold. In an accrual system, the cost of inventory is held in the inventory asset account, when it is sold the cost is “moved” to the cost of goods sold account. Cost of Goods Sold is not limited to businesses with inventory. Service and other types of businesses use cost of sales for variable expenses that are a part of the service or sale, such as payroll and subcontracting.
Sales Expenses
Some businesses track other expenses related to generating income as a separate group called Sales Expenses. These are expenses that are directly related to generating sales but are not included in the product/service sold. They may include advertising, promotional materials and sales commissions.
Expenses
All other common business expenses are included here. They are called General and Administrative Expenses or Overhead Expenses. The list of possible expenses is too large to go into here. If you group accounts by related expenses such as office type expneses in one group, rent/utilities in another, you can summarize the detail more easily on the income statement.
Other Income/Expenses
Some income and expenses are not related to everyday operations. Examples include gains/losses on investments, gains/losses on sales of equipment and casualty losses.
Balance Sheet
The Balance Sheet is like a snap-shot of your Assets, Liabilities and Equity. You can learn more about how you are doing by looking at the change from one period to the next and studying simple ratios such as quick ratio, working capital ratio, debt to equity and others. All balance sheet accounts should be reconciled on a regular basis.
Income Statement
Also known as the P&L this statement will give you a look at how profitable the business is over time. If you are on accrual basis, you get a better picture of whether you are profitable. Try comparing current month to year-to-date, and last year. Setting up 12 months side by side will help you see trends in your business and see when something is unusual. Also try looking at budget and ratios to income. What it won’t tell you is how much cash you generated through your operations. That’s what the Statement of Cash Flows does:
Statement of Cash Flows
The Statement of Cash Flows ties the Income Statement and the Balance Sheet together by reporting how much cash was generated or used in three areas: Operations, Investing and Financing. The Net Income is adjusted by changes is accounts receivable, inventory, depreciation, accounts payable and other current assets and liabilities to give you how much cash was generated or used by operating the business. The next section shows how much money was spent to buy new equipment or other long-term investments. The last section shows money generated by loan advances or stock sales or paid out to loan principle. The total of all three areas tells the increase or decrease in cash.
Use Them All
Now that you know what each statement tells you, use them all to get the big picture on how your business is doing.
To gain an understanding of accounting, it helps to look at the foundation of accounting principles. Accounting is built on a basic mathematic equation: Assets - Liabilities = Equity. Or to say it another way, what you own minus what you owe equals your net worth. The balance sheet is just the accounting equation written another way: Assets = Liabilities and Equity. You can find previous articles explaining assets, liabilities and equity on our web-site.
Where do Income & Expenses fit?
Your income and expenses are actually the detail of how your net worth (equity) changes through operations.
Back to Algebra
Don’t panic now, we are going to be basic. An equal sign means the left side equals the right side. That is the basis of double entry bookkeeping: if you add something to an account that lives on the left side, you must add it to an account on the right (or subtract it from another account on the left).
For example: if you make a sale, you increase your cash (asset) and increase your net worth (through income).
Debits and Credits Revealed
Debits and credits seem to really confuse people. They are simply terms that stand for the left and right sides of the accounting equation. Most accounts on the left side of the balance sheet equation have ’debit’ balances. So a debit will increase the account and a credit will decrease the account.
Big Question Then: why does the bank credit your account when you make a deposit?... Your account is on the other side of their accounting equation! Your money is a liability to them - they owe it back to you.
Another reason debits and credits are confusing is a + sign is used to mean debit and a - sign to mean credit. When we report the income statement, we reverse these symbols! Remember, income increases equity (credit side), but people don’t want to see their income with a - sign in front of it.
Journal Entries Made Easy
Now that I have explained debits and credits, here is an easy hint if you have to make a journal entry. Enter the accounts you are affecting, guess at which amount is a debit and which is a credit. After you record your entry, check your account balance. If you guessed wrong, just change it! That is the beauty of QuickBooks and Peachtree.
