Accounts for the balance sheet

Here are a few terms you’ll want to know:

• Balance sheet: The financial statement that presents a snapshot of the company’s financial position (assets, liabilities, and equity) as of a particular date in time. It’s called a balance sheet because the things owned by the company (assets) must equal the claims against those assets (liabilities and equity).

  On an ideal balance sheet, the total assets should equal the total liabilities plus the total equity. If your numbers fit this formula, the company’s books are in balance. (Flip to Chapter 3 in Book 3 for more about the balance sheet.)

• Assets: All the things a company owns in order to successfully run its business, such as cash, buildings, land, tools, equipment, vehicles, and furniture.
• Liabilities: All the debts the company owes, such as bonds, loans, and unpaid bills.
• Equity: All the money invested in the company by its owners. In a small business owned by one person or a group of people, the owner’s equity is shown in a Capital account. In a larger business that’s incorporated, owner’s equity is shown in shares of stock. Another key Equity account is Retained Earnings, which tracks all company profits that have been reinvested in the company rather than paid out to the company’s owners. Small, unincorporated businesses track money paid out to owners in a Drawing account, whereas incorporated businesses dole out money to owners by paying dividends (a portion of the company’s profits paid by share of common stock for the quarter or year).

Accounts for the income statement

Here are a few terms related to the income statement that you’ll want to know:

• Income statement: The financial statement that presents a summary of the company’s financial activity over a certain period of time, such as a month, quarter, or year. The statement starts with Revenue earned, subtracts out the Costs of Goods Sold and the Expenses, and ends with the bottom line — Net Profit or Loss. (See Chapter 2 in Book 3 for more about the income statement.)
• Revenue: All money collected in the process of selling the company’s goods and services. Some companies also collect revenue through other means, such as selling assets the business no longer needs or earning interest by offering short-term loans to employees or other businesses.
• Costs of goods sold: All money spent to purchase or make the products or services a company plans to sell to its customers.
• Expenses: All money spent to operate the company that’s not directly related to the sale of individual goods or services.

Other common terms

Some other common terms include the following:

• Accounting period: The time for which financial information is being tracked. Most businesses track their financial results on a monthly basis, so each accounting period equals one month. Some businesses choose to do financial reports on a quarterly basis, so the accounting periods are 3 months. Other businesses only look at their results on a yearly basis, so their accounting periods are 12 months. Businesses that track their financial activities monthly usually also create quarterly and annual reports (a year-end summary of the company’s activities and financial results) based on the information they gather.
• Accounts Receivable: The account used to track all customer sales that are made by store credit. Store credit refers not to credit card sales but rather to sales in which the customer is given credit directly by the store and the store needs to collect payment from the customer at a later date.
• Accounts Payable: The account used to track all outstanding bills from vendors, contractors, consultants, and any other companies or individuals from whom the company buys goods or services.
• Depreciation: An accounting method used to track the aging and use of assets. For example, if you own a car, you know that each year you use the car its value is reduced (unless you own one of those classic cars that goes up in value). Every major asset a business owns ages and eventually needs replacement, including buildings, factories, equipment, and other key assets.
• General Ledger: Where all the company’s accounts are summarized. The General Ledger is the granddaddy of the bookkeeping system.
• Interest: The money a company needs to pay if it borrows money from a bank or other company. For example, when you buy a car using a car loan, you must pay not only the amount you borrowed but also additional money, or interest, based on a percent of the amount you borrowed.
• Inventory: The account that tracks all products that will be sold to customers.
• Journals: Where bookkeepers keep records (in chronological order) of daily company transactions. Each of the most active accounts, including cash, Accounts Payable, and Accounts Receivable, has its own journal.
• Payroll: The way a company pays its employees. Managing payroll is a key function of the bookkeeper and involves reporting many aspects of payroll to the government, including taxes to be paid on behalf of the employee, unemployment taxes, and workers’ compensation.
• Trial balance: How you test to be sure the books are in balance before pulling together information for the financial reports and closing the books for the accounting period.

Waiting for funds with cash-basis accounting

With cash-basis accounting, you record all transactions in the books when cash actually changes hands, meaning when cash payment is received by the company from customers or paid out by the company for purchases or other services. Cash receipt or payment can be in the form of cash, check, credit card, electronic transfer, or other means used to pay for an item.

Cash-basis accounting can’t be used if a store sells products on store credit and bills the customer at a later date. There is no provision to record and track money due from customers at some time in the future in the cash-basis accounting method. That’s also true for purchases. With the cash-basis accounting method, the owner only records the purchase of supplies or goods that will later be sold when he actually pays cash. If he buys goods on credit to be paid later, he doesn’t record the transaction until the cash is actually paid out.

Depending on the size of your business, you may want to start out with cash-basis accounting. Many small businesses run by a sole proprietor or a small group of partners use cash-basis accounting because it’s easy. But as the business grows, the business owners find it necessary to switch to accrual accounting (see the next section) in order to more accurately track revenues and expenses.

Cash-basis accounting does a good job of tracking cash flow, but it does a poor job of matching revenues earned with money laid out for expenses. This deficiency is a problem particularly when, as it often happens, a company buys products in one month and sells those products in the next month. For example, you buy products in June with the intent to sell them, and you pay $1,000 cash for those products. You don’t sell the products until July, and that’s when you receive cash for the sales. When you close the books at the end of June, you have to show the $1,000 expense with no revenue to offset it, meaning you have a loss that month. When you sell the products for $1,500 in July, you have a $1,500 profit. So, your monthly report for June shows a $1,000 loss, and your monthly report for July shows a $1,500 profit, when in actuality you had revenues of $500 over the two months.

This chapter concentrates on the accrual accounting method. If you choose to use cash-basis accounting, you’ll still find most of the bookkeeping information here useful, but you don’t need to maintain some of the accounts listed, such as Accounts Receivable and Accounts Payable, because you aren’t recording transactions until cash actually changes hands. If you’re using a cash-basis accounting system and sell things on credit, though, you had better have a way to track what people owe you.

Making the switch to accrual accounting

Changing between the cash-basis and accrual basis of accounting may not be simple, and you should check with your accountant to be sure you do it right. You may even need to get permission from the IRS, which tests whether you’re seeking an unfair tax advantage when making the switch. You might be required to complete and file the Application for Change in Accounting Method (Form 3115) in advance of the end of the year for which you make this change. In certain circumstances, IRS approval of change is automatic, but you should still file Form 3115 with the affected year’s tax return. For example, if you started as a service business and shifted to a business that carries inventory, permission for the accounting method change should be automatically granted.

Businesses that generally shouldn’t use cash-basis accounting include

• Businesses that carry an inventory if sales exceed $1 million per year.
• Businesses that incorporated as a C Corporation (more on incorporation in Chapter 6 of Book 2).
• Businesses with gross annual sales that exceed $5 million.

Recording right away with accrual accounting

With accrual accounting, you record all transactions in the books when they occur, even if no cash changes hands. For example, if you sell on store credit, you record the transaction immediately and enter it into an Accounts Receivable account until you receive payment. If you buy goods on credit, you immediately enter the transaction into an Accounts Payable account until you pay out cash.

Like cash-basis accounting, accrual accounting has its drawbacks. It does a good job of matching revenues and expenses, but it does a poor job of tracking cash. Because you record revenue when the transaction occurs and not when you collect the cash, your income statement can look great even if you don’t have cash in the bank. For example, suppose you’re running a contracting company and completing jobs on a daily basis. You can record the revenue upon completion of the job even if you haven’t yet collected the cash. If your customers are slow to pay, you may end up with lots of revenue but little cash.

Many companies that use the accrual accounting method also monitor cash flow on a weekly basis to be sure they have enough cash on hand to operate the business. If your business is seasonal, such as a landscaping business with little to do during the winter months, you can establish short-term lines of credit through your bank to maintain cash flow through the lean times.

Tackling assets

First on the chart are always the accounts that track what the company owns — its assets: current assets and long-term assets.

Laying out your liabilities

After you cover assets, the next stop on the bookkeeping highway is the accounts that track what your business owes to others. These “others” can include vendors from which you buy products or supplies, financial institutions from which you borrow money, and anyone else who lends money to your business. Like assets, liabilities are lumped into two types: current liabilities and long-term liabilities.

Eyeing the equity

Every business is owned by somebody. Equity accounts track owners’ contributions to the business as well as their share of ownership. For a corporation, ownership is tracked by the sale of individual shares of stock because each stockholder owns a portion of the business. In smaller companies that are owned by one person or a group of people, equity is tracked using Capital and Drawing Accounts. Here are the basic equity accounts that appear in the Chart of Accounts:

• Common Stock: This account reflects the value of outstanding shares of stock sold to investors. A company calculates this value by multiplying the number of shares issued by the value of each share of stock. Only corporations need to establish this account.
• Retained Earnings: This account tracks the profits or losses accumulated since a business was opened. At the end of each year, the profit or loss calculated on the income statement is used to adjust the value of this account. For example, if a company made a $100,000 profit in the past year, the Retained Earnings account would be increased by that amount; if the company lost $100,000, then that amount would be subtracted from this account.
• Capital: This account is only necessary for small, unincorporated businesses. The Capital account reflects the amount of initial money the business owner contributed to the company as well as owner contributions made after initial start-up. The value of this account is based on cash contributions and other assets contributed by the business owner, such as equipment, vehicles, or buildings. If a small company has several different partners, then each partner gets his or her own Capital account to track his or her contributions.
• Drawing: This account is only necessary for businesses that aren’t incorporated. It tracks any money that a business owner takes out of the business. If the business has several partners, each partner gets his or her own Drawing account to track what he or she takes out of the business.

Recording the money you make

First up in the income statement portion of the Chart of Accounts are accounts that track revenue coming into the business. If you choose to offer discounts or accept returns, that activity also falls within the revenue grouping. The most common income accounts are

• Sales of Goods or Services: This account, which appears at the top of every income statement, tracks all the money that the company earns selling its products, services, or both.
• Sales Discounts: Because most businesses offer discounts to encourage sales, this account tracks any reductions to the full price of merchandise.
• Sales Returns: This account tracks transactions related to returns, when a customer returns a product because he or she is unhappy with it for some reason.

When you examine an income statement from a company other than the one you own or are working for, you usually see the following accounts summarized as one line item called Revenue or Net Revenue. Because not all income is generated by sales of products or services, other income accounts that may appear on a Chart of Accounts include

• Other Income: If a company takes in income from a source other than its primary business activity, that income is recorded in this account. For example, a company that encourages recycling and earns income from the items recycled records that income in this account.
• Interest Income: This account tracks any income earned by collecting interest on a company’s savings accounts. If the company loans money to employees or to another company and earns interest on that money, that interest is recorded in this account as well.
• Sale of Fixed Assets: Any time a company sells a fixed asset, such as a car or furniture, any revenue from the sale is recorded in this account. A company should only record revenue remaining after subtracting the accumulated depreciation from the original cost of the asset.

Tracking the Cost of Goods Sold

Before you can sell a product, you must spend some money to either buy or make that product. The type of account used to track the money spent is called a Cost of Goods Sold account. The most common are:

• Purchases: Tracks the purchases of all items you plan to sell.
• Purchase Discount: Tracks the discounts you may receive from vendors if you pay for your purchase quickly. For example, a company may give you a 2 percent discount on your purchase if you pay the bill in 10 days rather than wait until the end of the 30-day payment allotment.
• Purchase Returns: If you’re unhappy with a product you’ve bought, record the value of any returns in this account.
• Freight Charges: Charges related to shipping items you purchase for later sale. You may or may not want to keep track of this detail.
• Other Sales Costs: This is a catchall account for anything that doesn’t fit into one of the other Cost of Goods Sold accounts.

Acknowledging the money you spend

Expense accounts take the cake for the longest list of individual accounts. Any money you spend on the business that can’t be tied directly to the sale of an individual product falls under the expense account category. For example, advertising a storewide sale isn’t directly tied to the sale of any one product, so the costs associated with advertising fall under this category.

The Chart of Accounts mirrors your business operations, so it’s up to you to decide how much detail you want to keep in your expense accounts. Most businesses have expenses that are unique to their operations, so your list will probably be longer than the one presented here. However, you also may find that you don’t need some of these accounts.

On your Chart of Accounts, the expense accounts don’t have to appear in any specific order. Here they’re listed alphabetically. The most common are as follows:

• Advertising: Tracks expenses involved in promoting a business or its products. Money spent on newspaper, television, magazine, and radio advertising is recorded here, as well as any money spent to print flyers and mailings to customers. For community events such as cancer walks or craft fairs, associated costs are tracked in this account as well.
• Bank Service Charges: This account tracks any charges made by a bank to service a company’s bank accounts.
• Dues and Subscriptions: This account tracks expenses related to business club membership or subscriptions to magazines.
• Equipment Rental: This account tracks expenses related to renting equipment for a short-term project. For example, a business that needs to rent a truck to pick up some new fixtures for its store records that truck rental in this account.
• Insurance: Tracks any money paid to buy insurance. Many businesses break this down into several accounts, such as Insurance – Employees Group, which tracks any expenses paid for employee insurance, or Insurance – Officers’ Life, which tracks money spent to buy insurance to protect the life of a key owner or officer of the company. Companies often insure their key owners and executives because an unexpected death, especially for a small company, may mean facing many unexpected expenses in order to keep the company’s doors open. In such a case, insurance proceeds can be used to cover those expenses.
• Legal and Accounting: This account tracks any money that’s paid for legal or accounting advice.
• Miscellaneous Expenses: This is a catchall account for expenses that don’t fit into one of a company’s established accounts. If certain miscellaneous expenses occur frequently, a company may choose to add an account to the Chart of Accounts and move related expenses into that new account by subtracting all related transactions from the Miscellaneous Expenses account and adding them to the new account. With this shuffle, it’s important to carefully balance out the adjusting transaction to avoid any errors or double counting.
• Office Expense: This account tracks any items purchased in order to run an office. For example, office supplies such as paper and pens or business cards fit in this account. As with miscellaneous expenses, a company may choose to track some office expense items in their own accounts. For example, if you find your office is using a lot of copy paper and you want to track that separately, you set up a Copy Paper expense account. Just be sure you really need the detail because the number of accounts can get unwieldy and hard to manage.
• Payroll Taxes: This account tracks any taxes paid related to employee payroll, such as the employer’s share of Social Security and Medicare, unemployment compensation, and workers’ compensation.
• Postage: Tracks money spent on stamps and shipping. If a company does a large amount of shipping through vendors such as UPS or FedEx, it may want to track that spending in separate accounts for each vendor. This option is particularly helpful for small companies that sell over the Internet or through catalog sales.
• Rent Expense: Tracks rental costs for a business’s office or retail space.
• Salaries and Wages: This account tracks any money paid to employees as salary or wages.
• Supplies: This account tracks any business supplies that don’t fit into the category of office supplies. For example, supplies needed for the operation of retail stores are tracked using this account.
• Travel and Entertainment: This account tracks money spent for business purposes on travel or entertainment. Some businesses separate these expenses into several accounts, such as Travel and Entertainment – Meals, Travel and Entertainment – Travel, and Travel and Entertainment – Entertainment, to keep a close watch.
• Telephone: This account tracks all business expenses related to the telephone and telephone calls.
• Utilities: Tracks money paid for utilities (electricity, gas, and water).
• Vehicles: Tracks expenses related to the operation of company vehicles.