Double Entry Book Keeping
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Double-Entry Book-Keeping System Organization & Preparation. The basic building block to good books is data entered in the right place. Bookkeeping is merely recording expenses and income. Whoever is entering the data needs to understand the true nature of each and every expense, and be able to put it in its right place. To begin with, you need a system to identify each purchase, and note its account number, or at least identify the category. This can be done by you, going through bills and marking each one with the right account name or number. The electric bill is easy - utilities, 5820. The hardware store might need a bit more thought if you want to separate small tools from supplies the drill you bought is 4809, the lumber you bought for packaging is 4550. The best trick is to identify the expense category when you make your purchases. How? When you sign the slip at the hardware store, you write right on it - drill: small tools. Lumber: supplies. That way, your bookkeeper can look up the number - you've passed on the wisdom of what category it goes to and you avoid the problem of..."now, what did I buy that for?" So, begin by figuring out who will identify which account number gets assigned to each item. Get your routine established, and stick to it. This is a critical step. If you don't pay attention, and set up a workable system, you will end up with meaningless information. The second step in getting your system organized is learning a little about the rules to follow when you are dealing with bookkeeping. A bit of time spent with your accountant is the first step toward saving yourself time and money. Large tools have to be depreciated. New terms here... so bear with me as we go through this section. All that means is that the total cost of the tool cannot be listed as an expense which you deduct from your taxes this year. The thought process is this: Say you purchase a $5,000 saw that will last you 5 years. Therefore, you may deduct $1,000 each year for each of five years. You need to work with your accountant to set up your depreciation schedules: one for your books, and one that recognizes the tax laws. But that's a one time simple project. Give your account information of what the item is (including the serial number), when you bought it, and for how much. Your accountant will return to you a depreciation schedule which that be updated each year with your taxes. You should always have a list of tools, the value (purchase price) of which exactly equals the item on your balance sheet labeled "equipment" likewise for office equipment and vehicles. Anything included in fixed assets should have a supporting list of what the items are. You will note an item on the asset page of your balance sheet that's called "accumulated depreciation" - that shows the amount by which the assets you are listing have been depreciated. If you take the asset value and subtract the accumulated depreciation, you will see what the book
value of your tools is. Eventually, they will be completely expensed and have no value at all. But the theory is by that time, you will have junked them and bought more. So, especially in any business that buy durable equipment, it may well be true that you have more value in tools than your books show, which is a point you can make in person with your banker. You can't change it in your books. The Double Entry System. Now for the fun stuff. You're ready to learn the "double-entry system." At first it might sound like twice as much work, but over time you'll learn to love and rely on the built-in checks and balances that help you keep accurate records. As you enter information in your books, you will always make two entries, which exactly balance one another. Each entry has a left side -- these are called debits, and a right side -- these are called credits. These two terms have mystified more people in the history of the world than any other. Just accept that they are part of the language of business and as you begin to use them the mystery will evaporate. So, I'll gratefully accept my chance to further confuse the issue and continue on. For each entry you must enter at least one debit and one credit, and the total of the amounts on the right must equal the total on the left. Another "rule" is that debits are positive and credits are negative and if you add them all together, the total is "zero." Really, it's just that simple. If you go to the store and buy a drill, you are decreasing your cash in the bank by $129.50. You are increasing your expenses by the same amount - and there you have your two entries. Cash gets the negative entry, or credit and small tools gets the positive entry, or debit. What puts a spin on this debit/credit thing is that most people think of credits as minus and debits as plus, but various account types are affected differently because you have debit and credit accounts. OK, I just lost you - but it's easier than it you think. First I'll provide a description of how each account type is affected by debits and credits, then conclude with a table that summarizes the "rules." All your asset accounts (1000 series) are debit accounts, which means they are positive numbers. Makes sense, so far? An asset is a positive number in the system. The liability accounts (2000 series) are all credit accounts and they are negative numbers, but generally when you look at them on the balance sheet, you don't show the minus sign. Accounts payable, for example, is listed at $1,235. To the computer, however, liabilities are actually negative numbers - because they need to be subtracted from the assets to come up with the total value of the company. It's not something you have, it's something you owe.
So stay with me - if you credit a liability account, you are actually adding a negative number to a negative number. That just makes a bigger negative number. Increasing your liability. Take the drill example above. If, instead of paying cash, you charged that drill. The expense entry stays the same - the expense is increased, or debited. You aren't touching your cash account this time - instead, you're increasing your accounts payable. So, to increase a liability account, you credit it, because to increase the liability, which is a negative number, you have to add a negative number, or a credit. And, there you have your balancing entry debit expense, credit accounts payable. Both times you had balancing entries, one debit, one credit - the credit just did different things each time. In the asset account, it decreased cash. In the liability account, it increased accounts payable. The 3000 series is just something you have to remember somehow- sales are considered a credit account. A friend had a memory trick for learning this concept: " making a sale is a credit to you." Another way to consider it is by thinking of the simplest sale, where you sell something and get some cash. Cash, as you know, is a debit account. Make a sale, and you better increase your cash debit cash. Positive entry. So the balancing entry has got to be a credit entry crediting sales increases the amount you are listing in sales, because sales is a negative number, (credit), and you are adding a negative number - another credit. The number gets bigger. The 4000 and 5000 series, the expense accounts, are all debit accounts. You enter an expense as a positive number (debit) to increase your record of what you've spent. Whenever you make a purchase of an item that goes to one of your expense accounts, you always increase your expense, which is a debit. The following chart shows how debits and credits effect the different types of accounts: Account Type ASSETS LIABILITIES EQUITY INCOME EXPENSES Debit Increases Decreases Decreases Decreases Increases Credit Decreases Increases Increases Increases Decreases
So, now that you've got the basics of the double entry system, the next step is simply a matter of beginning to enter the info. As you enter checks you've written, they will mostly be simple entries - debit (increase) the correct account number, and credit (decrease) cash. This is going to be the drill for the majority of your entries, when you have paid cash for an item. Even those things you charge, if you
are keeping your bills current, make your entry after you pay your bill, and the entry will always be credit cash, debit expense. To keep the process simple, when you receive a bill, go through it and total what part of the money due goes to which account, write it on the bill and use that when you make the entry into the system. Regular exceptions to this process will be: - When you buy a large tool or piece of equipment that needs to go on the asset page: credit cash and debit the proper asset account. As you make these entries, don't forget the information that you will need to set up your depreciation schedule. - When you pay an expense that has been listed as a liability, like a bank payment on a loan: credit cash, but debit two accounts, debit the liability account you're paying on for the amount of principal, and debit interest for the amount of interest expense. Doing this will decrease what you owe on the loan by the principal amount you have paid, and it will increase the record of what you have paid in interest expense. - When you make an addition to inventory: inventory is a cost you need to count as an expense only when you actually use it. Until then, it's an asset. So when you purchase inventory, credit cash and debit inventory - that will increase the value of your inventory. When you USE inventory, credit (reduce) inventory, and debit (increase) the appropriate expense account - materials, supplies, etc., or an inventory change account.
Expenses paid by check. Go through and enter all the other checks you have written by check number and to whom they were written. In general, all those entries will be credit cash; debit expense (decrease cash, increase expense). Make sure you put everything in the correct expense account. (And, since you have followed your "rule" about writing down the expense category right when you made the purchase you don't have any trouble remembering what this purchase was for, right?) The exceptions to this have been noted above: payments on loans, payments made on large equipment or fixtures, or additions to inventory. Expenses paid by cash. You may have paid for some things with cash. The entry here is exactly the same as if you paid with a check - it's just keeping track of these things that's different. You should have a file of receipts, and most of them will match a check (it will be easier to confirm if you've written the check number on the receipt). Any that were paid with cash should have that noted on them, along with what the item or account number was. Same entry - debit, expense, credit, and cash. If you have more than one cash account, have a separate account number for each bank account, and credit the account from which you are actually taking the money out of. If you move money from a savings to a checking account, the entry will be: credit (reduce) savings; and debit (increase) checking. Accounts Payable. At the end of any given month, you have things you have used or purchased, but have not paid for. These are listed as accounts payable. When you enter these bills, your entry is debit expense, credit accounts payable. Each month, you need to make and keep a list of items that were in accounts payable at the end of the month. When you are closing out our sample month, you will have paid these bills, which were in AP the previous month, reducing your cash. Using your list, identify the checks written for items that were listed in accounts payable the month before. You already listed the expenses the prior month - so you don't list them again. The entry to show on your books that you have paid your accounts payable is: debit accounts payable, credit cash. Reduce your cash; reduce your accounts payable. Assuming you pay all your bills each month, this step will bring your accounts payable to zero (and if not, the accounts payable balance per your books should equal all the outstanding bills). Later, you will rebuild a new AP list for the current month. Cash Discounts - purchases. In our sample chart of accounts we have set up account number 7100 for cash discounts on purchases. If you are paying a material order and get to deduct 2% for paying early, by all means, try to do so. This is where that amount goes: you debit the entire expense to the materials account as if you didn't take the discount, but credit the actual amount of your check to cash, and credit the remainder to the cash discounts account. This helps
you see the value of paying early, and if you're in a position to do this fairly regularly, it looks great to your banker - so take the time to book it correctly. Petty Cash. Petty cash is a handy item to have for small purchases, but it needs to be accounted for correctly. Do a one-time entry in your books to set up the petty cash account. If you want $300 in the account, credit the bank account you are taking the cash from, and debit your petty cash account. Then put that petty cash in a box. Every time you take some out to spend, keep track of what you've taken out, with a receipt, and at the end of the month you'll have a list that looks like this: Supplies (coffee, paper) Small tools Postage $25.00 $13.52 $22.30
Write a check to petty cash, which will be for the total of what you spent over the month, or $60.82. When you enter that check, credit cash and debit the three appropriate expense account numbers - supplies, small tools and postage. Cash the check, put the cash into the box, and start all over again. You can do this as many times over the month as you need to - every time you need to replenish the petty cash box, just write a check and make the balancing entries the same way. You never make the entries to Petty Cash itself after you initially set up the account, unless you want to make it larger or smaller at some point. Payroll. This one's a bit trickier...you've actually done a lot of things when you write that paycheck. If you have an accounting system and are using payroll, you should be in good shape - but even then, you may need some understanding of exactly what that system is doing for you. If you're doing payroll by hand, you will calculate and record the components described below. In Payroll you have:
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the wages themselves, the taxes the government makes you withhold, and taxes that you have to pay that you don't withhold.
Gross wages get debited to the wages expense account - divided properly between direct and indirect labor. (Recall that gross wages for people actually producing your goods or providing your services are direct expenses; gross wages for the office help and sales are indirect expenses.) Payroll taxes. Some of these come out of the employee's check - the federal withholding and the employee's share of FICA. Others come out of your pocket, like the employer portion of FICA, state and federal unemployment taxes. The ones that come out of your pocket require two entries: they get debited to payroll tax expense (either direct or indirect, depending on where the employee's wages
go), and credited to the proper liability account - either FICA payable, Fed payable, UI payable, FUTA payable or Workers Compensation payable. Determining tax liabilities. For each of these you have to figure the total due based on the gross wages for that period - these taxes are figured as a percent of gross. For example, when the FICA and Medicare tax is 7.65% of gross wages, you take the gross wage, multiply it by .0765, and that is what you owe for the employer portion of FICA. You can get a chart which shows the Federal and state taxes due for each employee, based on their W-4 status and earnings. Unemployment will be based partly on a state multiplier and partly on your company's unemployment history. Workers compensation will depend on the industry code your employees work under, as well as your company's performance. All the taxes that are withheld from the employee's check as well as those which come out of your pocket - are listed as liabilities, and are easier to deal with if you sort them out by what kind of tax they are. In the liability accounts, there is no need to separate direct from indirect numbers - it's just plain money you owe, and it doesn't matter whether it comes out of the employees check or out of you pocket. The FICA payable, for example, will contain all the FICA that was withheld from everyone's check, in addition to the amount that you are matching as the employer. Here's the picture of what you do with payroll, using a fictitious shop person who's going to have his salary listed under 4010, direct labor. In this payroll period, he made $700.00. His workers' compensation rate is 13.2 %. Debit 700.00 Credit 53.55 42.00 19.00 585.45
4010 Gross wages 2102 FICA withheld 2100 Fed withheld 2104 State tax withheld 1001 Cash (paycheck amount)
Up to this point, the entries balance, as they must. Now, to enter the employer's tax expenses: Debit 2102 FICA Payable 2103 FUTA Payable 2105 State Unemployment payable 5015 Payroll Tax Expense 2107 Workers Comp Payable 5023 Workers Comp Expense Credit 53.55 5.60 19.60 92.40 92.40
78.75
As a side note, here's a point you need to keep in mind: that person, who you thought was costing you $585.45, because that's what her paycheck says, or is costing you his gross wage of $700.00, is actually costing you $871.15 ($700 wages plus the payroll tax costs to you, which in this case total $171.15). If you're adding any benefits like insurance or retirement, put those on top. This is a prime example of the kind of overhead you need to make sure gets added into your pricing structure.
Sales & Customer Deposits. OK, now you've entered your accounts payable, your expenses, your payroll. Now for the good stuff - let's enter your sales. Remember: sales accounts are credit accounts. So when you want to increase the amount of sales. You have made, you make the entry as a credit entry. These entries are pretty easy, on the surface: you receive a check and put it in your account: debit cash. The sale, if it is an item you have on hand and give to the buyer, you enter as an immediate sale. Credit sales, the equal amount that you debited cash. HOWEVER, if you have just signed a contract, and have not actually done any work on that project this month, you have not yet earned that sale. You're just holding the person's money for them, keeping it safe. Right? So, it is not yet truly a sale - it's a customer deposit. The entry will be debit to cash (it's in the bank, either way) and credit customer deposit, which is a liability account (you would have to refund the money if you don't do the job). If you have a lot of jobs going at any one time, you'll make your job easier if you give each job its own number in customer deposits, so you can easily keep track of how much has been turned into sales, and how much remains to be earned. Customer deposits turn into cash as you earn them - through the purchase of materials or labor performed. It's a bit of a call, how you evaluate each month what part of each job is done, and this is beyond the scope of this walk-through guide. So if you need help with accounting for contractors, send us an email and we'll forward some information to you. Accounts Receivable- Accounts Receivables and sales operate much the same as Accounts Payables and your purchases. Under the accrual method, you'll be entering sales as you earn them and invoice your customers. Have a simple chart that shows who owes you money each month - have a beginning balance which equals last months' ending balance. Enter any payments they've made or new charges they've incurred, and come up with an ending balance. That must equal the amount you list as AR on your books - if it doesn't, your task is to figure out where the discrepancy is. Inventory. Inventory is a current asset account, which means it is something you have that can be turned into cash quickly. When you purchase inventory, you do
so out of cash, so one side of the entry is credit cash - the other side, to increase inventory, is debit inventory. Basically, by listing an inventory item, you're just saying, I bought it this month, but I plan to keep it - or at least part of it - around, so the entire cost should not show up this month. The trick with inventory is knowing how to book it when you use it. Some common inventory items are materials - which is simple. You have a value of raw material in inventory - which matches what you paid for it. (You cannot increase the value of your inventory as it sits in the yards, as prices go up. You make your gain when you use that cheaper material in a project where you're able to charge more for it than it cost you.) As you use your raw materials, you credit inventory, to reduce it, and debit the 4101 account, materials. Basically, think of it as buying the material from yourself, with no cash changing hands. Another way that inventory might come up is when you buy $5,000 worth of brochures. Put that as a lump sum in your books for any given month, and you'll be a sad business owner, you'll think you're losing money hand over fist. So, try this: decide how long those brochures will last you, say three years. Divide $5,000 over 36 months, and you'll find that each month you need to book $138.89 (Call it $140 and be done with it). The whole sequence will look First, you buy the brochures and put them in inventory: Debit 1001 Cash 1003 Inventory $5,000 like Credit $5,000 this:
Then, each month as you use the brochures, you will make an entry: Debit $140 Credit $140
5312 Advertising Expense 1003 Inventory
What you're saying is that each month, you have to cover $140 as the cost of your brochures. It'll show up on your income statement as an actual cost. Each month the value of that inventory will decrease by that amount, until it's all gone. Theoretically your brochures will be gone about the same time - or outdated. Deposits. Another item that has its own spot in your books is deposits you pay for various things, from workers compensations to the cleaning deposit on a rental, to a deposit with the post office for express mail. These are items that will be returned to you when you finish using the service - technically, it's your money that they're holding. These amounts all go into the account called deposits, in our system #1800, which is of course under the Asset section of your Balance Sheet.
Gain or Loss on Sale of Assets. This is where you account for assets you sell or dump. If you sell a vehicle, you have its value on that up to date list of assets you keep. You also have a record of how much it has been depreciated. You enter the cash you make off that sale in 1001, cash. Then you balance that entry with a credit to the asset account and a debit to the accumulated depreciation account, and whatever it takes to make those number balance is your gain, or loss, on that sale. Say you sold a truck which you bought for $6,780. It has depreciated by $3,200. You managed to get someone to pay you $5,400. The entry to record this sale would be as follows: Debit $5,400 $3,200 $1,820 Credit $6,780
1001 Cash 1300 Fixed Assets - truck 1301 Accum. Depreciation 7100 Gain (or loss) on the sale
If your balancing entry had been a debit, it would have meant you lost money on the sale. Here's how to think about it: You paid $6,780. On your books, its value had decreased by $3,200, meaning you had expensed out that amount of money over the period of time you had the truck. So, to you it's actually worth $3,580, and you sold it for $5,400, which was a gain of $1,820. Depreciation. This is an entry that you can make the call on whether you're going to deal with it monthly or annually. It's not a cash expense, in fact it's often sniffed at as a "paper expense" but if you have a pretty good sized company and you think you're making great money, don't count those chickens until you figure in your depreciation. It's real stuff, because things DO in fact wear out and have to be replaced, and this is where that process is built into your books. Basically, your accountant will give you a sheet listing your assets and the amount they will depreciate this year. You take those totals, and say, OK, my tools are going to depreciate a total of $890 this year. Take that number and divide by 12, and you have your monthly depreciation, which in this case is $74.17. So to give yourself a really good idea of where you are, each month make the entry of debit account 5341 (depreciation expense) $75, and credit 1601 (accumulated depreciation, tools) by the same amount. If you have office equipment, vehicles, buildings, all those will have their separate totals that you work with the same way. Most computer accounting systems have a setup where you can tell it to make those entries for you automatically each month, and you won't have to worry about it. Don't worry about being too exact - at the end of the year, you'll go through each of these numbers and adjust it so it's exactly in line with your depreciation schedule. Making the entries monthly saves you the shock when you
thought you'd made $20,000, and your depreciation expense at the end of the year cuts that in half. Suspense. Now I'm going to let you in on a secret if you promise not to take advantage of it. If you are making all these entries and they don't balance, do this: first, check the number they don't balance by - maybe you just left out an entry. Divide that number by two and see if anything becomes obvious. Divide it by nine and if it divides cleanly and evenly by nine, that means you have transposed an entry somewhere - maybe you said 765 instead of 756. (No, this is not an old wive's tail - but I do have some good hiccup cures for you after class). IF you have tried everything you can think of, and you have just got to turn your computer off and go home, put the remainder that won't balance in suspense. Then, while you're out of the system, look at all your entries, all your notes, and figure out the problem. Come back in, make the correcting entry, and take it back out of suspense by making the opposite entry you did before. If you had to credit suspense to make things balance, this time debit it - or you'll drive yourself even crazier. Suspense may end up with little bits and pieces of numbers - but it should never be allowed to get large. $1.31, you can let go. $500, and you'd better get serious about finding out what that is. Month End Adjustments. Now that you're sure you have the right amount of cash in your system, you're ready to check the rest of the books. How intense you get about this can well depend on what time of year it is - in a mid-year month, like March or July, you might be a little more lax about how closely you check every account, whereas at the end of the year you will want to tie every single account down exactly. Even those accounts you don't check over with a finetoothed comb should at least be glanced at, to make sure they make basic sense. If a $3,500 car liability all of sudden turns into a $15,293 item, you'll know something is entered in the wrong place. The process is this: go through your balance sheet, item by item. You've already done cash, and petty cash is a static account, so the next item is inventory. Check what your inventory was last month, total up what you know you've added to or deleted from it, and that should be your current total inventory. To make this easy, keep a list of what is in inventory: office supplies, raw materials, etc. Each item should have a beginning balance, an amount of current activity, and an ending balance. If inventory shows on your books as a higher number than you actually know you have, adjust that against the material expense. If you have $250 less value in actual office supplies than you show on the books, the adjustment will be to debit office supplies (account 5550) and credit inventory. That will reduce your inventory - which will, by the way, also reduce your profitability...sorry!
When you close your books for the end of the year, you need to take actual inventory - count it all up and make sure you've really got what you think you do. At other times of the year, whether or not you go through this step will depend on how much inventory you carry. Any materials you have a large value of on hand, it will pay you to take a physical inventory of more often. Failing to do that may result in a shock at the end of the year when it turns out you've been underestimating your use of material all year, giving your perceived profitability one more opportunity to fly out the window. It's amazing how that bird can get up and go at the smallest opportunity! This same process gets followed for each item on your balance sheet. If your books are computerized, you will find a good friend in your Detail Trial Balance and Detail Transaction Reports. These reports will show you the beginning balance for each account, what was added to or subtracted from that account over the month, and then an ending balance. This will be the easiest place for you to look for those items entered in the wrong account, items entered backwards (credit when you should debit, can you imagine?), items overlooked, or items that were transposed when they were entered, which are the top four ways to end up out of balance. The good news is that you don't have to do this to every expense account - just check out that your asset and liability accounts are correct. If you have large loans, make sure you're accounting for principal and interest correctly - putting interest in its own account, and taking principal against the liability account. The easiest way to do this is to call the loan officer and get an actual report (loan history) of how much you owe as of this date, and make sure your books reflect that. As with any of this work, if you're talking about a small loan it may not be worth adjusting every month - you may want to adjust those once a year. The items you adjust monthly are the ones that can throw off your books by a large enough amount that it's worth the time it will take to adjust for them. This process, completed through your entire balance sheet, will give you the assurance that your books are correct, and you can trust the bottom line on your income statement. This is actually about the first point in the process that I would actually look at the income statement - until you have adjusted your books to match physical reality, it can be relatively meaningless. Paper Trail. One last point: all these numbers that are going into your books need to be backed up by something that will give you a clue about them. You or someone else will at some point need to go back and recreate something you've entered, and you need a good clean system for keeping this information. Keep a list of everything you've done. Have a list and update it monthly, of what makes up Accounts Payable - and the total of that list needs to equal the AP entry on your balance sheet. Have a list of customer deposits, accounts receivable and a list of your assets. You need to be able to say what's in each number on your
balance sheet. It's not nearly as intimidating as it sounds, and it will save you hours of head scratching later. You will also need to keep good supporting documentation for your income and expenses. For more information on the types of records you need to keep, check out Documenting your journey. Congratulations! You've now got a real set of books that you can use to analyze your profitability and pricing, you can take to the bank or use to produce a tax return. Every month, you'll find this process easier to follow and less time consuming, and you'll understand the inner workings of your business in a way that will make you much more powerful and confident in your decision making. And, did you know that the word in the English language with the most consecutive double consonants is subbookkeeper? A heady responsibility, I'd say. Happy bookkeeping! And now you're ready to move on and learn to use your financial statements to manage by the numbers!
OWNERS' REVIEW CHECKLIST Even if you hire someone to do your accounting and bookkeeping, there are a number of items that that you as the business owner should do periodically. Many small businesses have suffered serious losses when the owner lost track of the numbers and the trusted bookkeeper "borrowed money" and left for an extended cruise. The following checklist will keep you in touch with your business, and perhaps even prevent you from serious losses. 1. Compare actual results to budget. Each and every month you need to compare your income and expenses to your budget. This review is perhaps one of the most important tools for a small business owner. It's a great way to learn what's working and what's not working with your business. The goal is not to have an accurate budget... but for you to have a thorough knowledge of what is happening and to know if anything unexpected is happening so that you can adjust your actions in a timely manner. What?? You don't have a budget? Stop right now and let's go over to the Budget Workshop! 2. Scan the check register. Periodically (say every 3-4 months) you should take a look at the check register just to make sure all the payees are familiar to you. Multiple checks written around the same time to the same vendor could be an indication that funds are being diverted. (You also might want to reduce the time spent writing and posting multiple checks.) 3. Review the bank reconciliation. This should be done on a monthly basis (or if you skip a month take a look at all the reconciliations since your last review.) This step is important, particularly if you have one person doing
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all the bookkeeping: writing checks, posting entries, preparing financials, etc. Look at any adjustments to the bank accounts, stale items, etc. Look at canceled checks. Occasionally (say 1-2 times a year) pull out a bank statement and flip through the canceled checks making sure that all those signatures are yours, that you recognize the vendors and scan the endorsements on the back. Obviously, this can't be done if you don't get your canceled checks back from the bank. In this case you might want to spend a little extra time with the check register. Review statements from vendors. Every now and then (say 3-4 times per year) take the time to open the mail and look at statements from vendors (many vendors have stopped sending statements, but they will send late notices). Here you want to make sure that your business is in good standing with vendors -- long overdue invoices might be an indication that a check you thought was going to a vendor actually went in someone else's pocket, or that an invoice has been overlooked. Review Payroll register and handout the paychecks. Now of course this isn't an issue for a business with only 1-2 employees. But "padding the payroll" is a common problem in some industries -- such as construction or cleaning services where it is common for the crew to go straight to the jobsite and perhaps not come into regular contact with the owner. Review your Accounts Receivable and aging. This needs to be done on a regular basis. Of course you need to know if you have any slow paying customers and a periodic review would also disclose any scheme of "misapplying" customer payments. Take a physical inventory. Many small businesses have very poor inventory records, so if you have a large amount of inventory or a high volume business, you probably will want to work with your accountant and get some type of perpetual inventory system set up. Again, there are some excellent software packages available for the small business that will make this process relatively painless. Once you have a system in place, you should take a physical inventory at least once a year and compare the actual goods on hand to the inventory records.
BALANCE SHEET The balance sheet is a snapshot of the company's financial standing at an instant in time. The balance sheet shows the company's financial position, what it owns (assets) and what it owes (liabilities and net worth). The "bottom line" of a balance sheet must always balance (i.e. assets = liabilities + net worth). The
individual elements of a balance sheet change from day to day and reflect the activities of the company. Analyzing how the balance sheet changes over time will reveal important information about the company's business trends. In this lesson we'll discover how you can monitor your ability to collect revenues, how well you manage your inventory, and even assess your ability to satisfy creditors and stockholders. The liabilities and net worth on the balance sheet represent the company's sources of funds. Liabilities and net worth are composed of creditors and investors who have provided cash or its equivalent to the company in the past. As a source of funds, they enable the company to continue in business or expand operations. If creditors and investors are unhappy and distrustful, the company's chances of survival are limited. Assets, on the other hand, represent the company's use of funds. The company uses cash or other funds provided by the creditor/investor to acquire assets. Assets include all the things of value that are owned or due to the business. Liabilities represents a company's obligations to creditors while net worth represents the owner's investment in the company. In reality, both creditors and owners are "investors" in the company with the only difference being the degree of nervousness and the timeframe in which they expect repayment. In this section, we will teach you about the elements of the Balance Sheet and how they either use or provide "funds". For example, when a supplier sends you inventory on credit, she in essence is providing "funds" that you may use to operate your business. Recall from the Basic Accounting lesson that you record both an asset (inventory) and a liability (accounts payable) when you purchase goods on credit. Of course, you must be able to pay your supplier in cash in a timely manner. Theoperating cycle, which is also known as the cash-to-cash cycle, is the process of using cash to purchase current assets that are to be sold at a profit and collected as cash. As an example, a company uses funds to purchase raw material inventory that is produced into finished goods inventory, sold at a profit to create a receivable and collected to become cash once again, then used to pay the supplier, with the profits left in the business. The Balance Sheet shows a "picture" of the assets, liabilities and equity (net worth) of a business as of a specific day. The Balance Sheet shows two "views" of the business -- what resources you own (Assets) and the creditor or owner/investor that made it possible to acquire these resources (Liabilites and Equity). Remember that Assets = Liabilites + Equity!
Assets - Liabilites = Equity What you own - what you owe = what the business is worth!
Sound financial management of a company involves matching the sources and uses of cash so that obligations come due as assets mature into cash. Take a moment to study the operating/cash cycle diagram. Throughout this lesson we'll refer back to the use of funds and cash in the business operation. After all... remember that the Balance Sheet is just a report card showing where the funds are, and who has helped you acquire them (and these folks expect repayment!). Now let's take a moment to look at a picture of a Balance Sheet. It is always shown in two parts to reflect the accounting equation (A=L+E). Individual items within each section are listed by how close they are to cash. Recall the cash-to-cash cycle, so cash and short term investments are shown first, then accounts receivable, then inventory, and so on. On the liability side, trade creditors will be paid regularly, then the short term bank loans, longer term loans and so forth. Now that you've got the "big picture", let's move on and discuss each component of the Balance Sheet and more importantly start discovering how you can use it as a tool to manage your business. Don't forget that you can click one of the red reference numbers anytime to view the sample Balance Sheet. ASSETS As noted previously, anything of value that is owned or due to the business is included under the Asset section of the Balance Sheet. Assets are shown at net book or net realizable value (more on this later), but appreciated values are not generally considered. Current Assets.
Current assets are those which mature in less than one year. They are the sum of the following categories:
o o o o o o
Cash Accounts Receivable (A/R) Inventory (Inv) Notes Receivable (N/R) Prepaid Expenses Other Current Assets
Cash. Cash is the only game in town. Cash pays bills and obligations. Inventory, receivables, land, building, machinery and equipment do not pay obligations even though they can be sold for cash and then used to pay bills. If cash is inadequate or improperly managed the company may become insolvent and be forced into bankruptcy. Include all checking, money market and short term savings accounts under Cash. For more on cash management, go to the lesson on cash management and cash flow projections. Accounts Receivable (A/R). Accounts receivable are dollars due from customers. They arise as a result of the process of selling inventory or services on terms that allow delivery prior to the collection of cash. Inventory is sold and shipped, an invoice is sent to the customer, and later cash is collected. The receivable exists for the time period between the selling of the inventory and the receipt of cash. For more on terms refer to the article on Aging Accounts Receivables. Receivables are proportional to sales. As sales rise, the investment you must make in receivables also rise. Example: Receivables vary with sales. The ABC Company gives Net 30 Day terms to its customers. Any sale made today will be collected one month from today. ABC's customers are prompt payers and all receivables are collected on the 30th day. On average, ABC will have one month's worth of sales always invested in receivables. In 19X1, sales are $1,200,000. Receivables, which are equal to one month's sales, total $100,000. In 19X2 sales rise to $2,400,000. Receivables which remain at one month's worth of sales, rise to $200,000. Due to the growth in sales, the company is forced to increase its investments in accounts receivable by $100,000. This investment in receivables is automatic and unavoidable. It does not indicate the company's terms have been lengthened or that management of collections has decayed.
Analyzing Receivables: Receivables increase for two reasons; 1) Growth in sales, and 2) Change in average collection period. Growth in sales is a healthy reason to increase receivables. Changing the collection period, however may not be so favorable, particularly if the reason is due to a collection problem with a customer. Here's an example of how analyzing your financial statements can help you spot unfavorable trends before they become a problem. To analyze the change in the collection period, some measure of the receivable's quality must be used. We do this by comparing the actual collection period to the stated payment terms. The actual collection period is known as Days In Receivables. To determine receivable quality, the company's terms of payment are compared to the actual collection period. The collection period and the terms should be about equal. If the calculated collection period is greater than the offered terms, then its time to dig deeper and see if some of your customers are lagging in paying their accounts. Look at your A/R Aging Report as a start. Allowance for doubtful accounts. At some point in time you may have customers that are unable to pay for the goods or services they received from you. When you determine that you will be unable to collect these accounts, you will write off the receivable and record a "charge off" loss. As your business matures, you will be able to estimate the amount of such losses. Many businesses calculate this expense on a monthly basis based on sales or a percentage of past due accounts. Your accountant can assist you with determining whether or not you should record an allowance for doubtful accounts. The allowance for doubtful accounts is subtracted from gross receivables on the Balance Sheet to show the net receivable balance. Inventory. Inventory consists of the goods and materials a company purchases to re-sell at a profit. In the process, sales and receivables are generated. The company purchases raw material inventory that is processed (aka work-in-process inventory) to be sold as finished goods inventory. For a company that sells a product, inventory is often the first use of cash. Purchasing inventory to be sold at a profit is the first step in the profit making cycle (operating cycle) as illustrated previously. Selling inventory does not bring cash back into the company -- it creates a receivable. Only after a time lag equal to the receivable's collection period will cash return to the company. Thus, it is very important that the level of inventory be well managed so that the business does not keep too much cash tied up in inventory as this will reduce profits. At the same time, a company must keep sufficient inventory on hand to prevent stockouts (having nothing to sell) because this too will erode profits and may result in the loss of customers.
The correct level of inventory is a function of the length of the company's inventory cycle and the company's sales level. A company's inventory cycle is divided into three phases:
1.the 2.the 3.the
ordering phase, production phase, and finished goods/delivery phase.
The ordering phase is the time it takes the a company to order and receive raw materials. The production phase is the time it takes to produce finished goods from raw materials. The finished goods/delivery phase is the amount of time finished goods remains in stock and the delivery time to a customer. The inventory cycle in days is determined as follows: Inventory Cycle In Days = Ordering Phase in Days + Production Phase in Days Finished Goods and + Delivery Phase in Days
Example: Inventory Cycle Now let's look at an example of how a small business might use this information to plan its purchases and manage inventories. The ABC Company is a producer of specialty pottery vases. The company imports clay from the Big Timber Landfill. Ordering and receipt of the clay generally takes 14 days. If the company orders clay today, it will receive the clay in 14 days. To prevent stockouts, the company reorders whenever clay inventories drop to 14 days. Once in the shop, the clay base is mixed with water and rests one day to set up to the proper texture. It takes one day to spin the vase, three days to dry, one day to paint and one more day to dry. The production cycle from wetting clay to drying the paint is seven days. Because it takes seven days to produce seven days worth of sales, the company never lets its stock of vases shrink to less than seven days worth of sales. The delivery phase is very short because most of the product will be delivered in the immediate area. Management estimates that delivery takes one day at most. The company's minimal inventory cycle is 22 days: Inventory Cycle In 14 days = Days ordering for + 7 days production for + 1 day delivery for
If clay is ordered today, a vase made of that clay can be delivered to a customer no sooner than 22 days from now. Now let's also assume that Company management likes to keep an additional five days of inventory on hand as a cushion to cover any delays in receipt of the clay and production of the vases.
Therefore, the company's total inventory cycle is 27 days. To keep the cycle running smoothly, the company must keep its investment in inventory equal to 27 days worth of sales. The company must keep an investment in inventory equal to its inventory cycle. If ABC keeps only 15 days' worth of investment in inventory, it eventually will run out of stock because clay ordered today cannot be delivered as a vase for 22 days. We have learned that this investment requires the use of cash. Thus in the above example, ABC must have sufficient cash to acquire at least 22 days of inventory, and that management operates more comfortably with 27 days' sales in inventory. Knowing this, we can estimate the dollar ($) amount of inventory as follows: Minimum Investment Inventory (in $'s) in = Inventory Cycle In Cost of a Day's Sales X Days (in $'s)
The investment in inventory will vary according to both the sales per day and the length of the inventory cycle in days. As sales rise, the amount of inventory sold daily rises and the investment in a day's worth of inventory must increase or stockouts will eventually occur. As the inventory cycle lengthens more inventory must be kept on hand to produce the same level of sales and the investment in inventory increases. Just as we measured the "quality" of accounts receivable, another ratio can be used as an indicator of the "quality" of inventory. We do this by comparing the actual inventory level to the inventory cycle. Insufficient inventory indicates potential stockouts, Excessive inventory may indicate, stale inventory, poor inventory controls, or fudging (miscounting). To measure quality, the actual number of days of inventory on hand is measured as follows: Days In Inventory = Actual Inventory Cost of Good Sold per year x 360
Ideally, inventory will be at a level slightly greater than the inventory cycle. Days In Inventory Inventory Cycle In Days
Notes Receivable (N/R) N/R is a receivable due the company, in the form of a promissory note, arising because the company made a loan. Making loans is the business of banks, not of operating business, and particularly not the business of a small company with limited financial resources. Notes receivable is probably a note due from one of three sources:
1. 2. 3.
Customers, Employee, or Officers of the company.
Customer notes receivable is when the customer who borrowed from the company probably borrowed because he could not meet the accounts receivable terms. When the customer failed to pay the invoice according to the agreed upon payment terms. The customer's obligation may have been converted to a promissory note. Employee notes receivable may be for legitimate reasons, such as a down payment on a home, but the company is neither a charity nor a bank. If the company wants to help the employee, it can co-sign on the loan advanced by a bank. An officer or owner borrowing from the company is the worst form of note receivable. If an officer takes money from the company, it should be declared as a dividend or withdrawal and reflected as a reduction in net worth. Treating it in any other way leads to possible manipulation of the company's stated net worth, and banks and other lending institutions frown greatly upon it. Other Current Assets. Other Current Assets consist of prepaid expenses and other miscellaneous and current assets. Prepaid expenses are the uses of cash to purchase in full a good or service, the benefit of which will be received within the next 12 months. Insurance is the most common form of prepaid expense. The premium is paid prior to the receipt of the benefit. Cash has been depleted by paying a bill before the benefit from the purchase has been received. Miscellaneous and other current assets generally consist of small deposits or receivables. Non-Current Assets. Non-current assets are defined as those that will not mature into cash within the next 12 months. They can consist of the following asset categories:
o o o o
Net Fixed Assets Investment into Subsidiaries Intangibles Other Assets
Fixed Assets. Fixed assets represent the use of cash to purchase physical assets whose life exceeds one year. They include assets such as:
o o o
Land Building Machinery and Equipment
o o
Furniture and Fixtures Leasehold Improvements
Calculating Net Fixed Assets. When a fixed asset is purchased for use in operations of the business it is recorded at cost. As the asset wears out, an amount is charged to expense and accumulated annually in a contra-account known as accumulated depreciation. Accumulated depreciation is the cumulative sum of all the years' worth of wearing out that has occurred in the asset. The gross fixed asset (purchase price) less the accumulated depreciation equals the Net Fixed Asset Value (also known as book value). Gross Fixed (Purchase Price) Assets Accumulated Depreciation = Net Fixed Assets (Book Value)
Intangibles. Intangibles represent the use of cash to purchase assets with an undetermined life and they may never mature into cash. For most analysis purposes, intangibles are ignored as assets and are deducted from net worth because their value is difficult to determine. Intangibles consist of assets such as:
o o o o o
Research and Development Patents Market Research Goodwill Organizational Expense
In several respects, intangibles are similar to prepaid expenses; the use of cash to purchase a benefit which will be expensed at a future date. Intangibles are recouped, like fixed assets, through incremental annual charges (amortization) against income. Standard accounting procedures require most intangibles to be expensed as purchased and never capitalized (put on the balance sheet). An exception to this is purchased patents that may be amortized over the life of the patent. Other assets. Other assets consist of miscellaneous accounts such as deposits and long-term notes receivable from third parties. They are turned into cash when the asset is sold or when the note is repaid. Total Assets is the sum of all the assets owned by or due to the business
value of your tools is. Eventually, they will be completely expensed and have no value at all. But the theory is by that time, you will have junked them and bought more. So, especially in any business that buy durable equipment, it may well be true that you have more value in tools than your books show, which is a point you can make in person with your banker. You can't change it in your books. The Double Entry System. Now for the fun stuff. You're ready to learn the "double-entry system." At first it might sound like twice as much work, but over time you'll learn to love and rely on the built-in checks and balances that help you keep accurate records. As you enter information in your books, you will always make two entries, which exactly balance one another. Each entry has a left side -- these are called debits, and a right side -- these are called credits. These two terms have mystified more people in the history of the world than any other. Just accept that they are part of the language of business and as you begin to use them the mystery will evaporate. So, I'll gratefully accept my chance to further confuse the issue and continue on. For each entry you must enter at least one debit and one credit, and the total of the amounts on the right must equal the total on the left. Another "rule" is that debits are positive and credits are negative and if you add them all together, the total is "zero." Really, it's just that simple. If you go to the store and buy a drill, you are decreasing your cash in the bank by $129.50. You are increasing your expenses by the same amount - and there you have your two entries. Cash gets the negative entry, or credit and small tools gets the positive entry, or debit. What puts a spin on this debit/credit thing is that most people think of credits as minus and debits as plus, but various account types are affected differently because you have debit and credit accounts. OK, I just lost you - but it's easier than it you think. First I'll provide a description of how each account type is affected by debits and credits, then conclude with a table that summarizes the "rules." All your asset accounts (1000 series) are debit accounts, which means they are positive numbers. Makes sense, so far? An asset is a positive number in the system. The liability accounts (2000 series) are all credit accounts and they are negative numbers, but generally when you look at them on the balance sheet, you don't show the minus sign. Accounts payable, for example, is listed at $1,235. To the computer, however, liabilities are actually negative numbers - because they need to be subtracted from the assets to come up with the total value of the company. It's not something you have, it's something you owe.
So stay with me - if you credit a liability account, you are actually adding a negative number to a negative number. That just makes a bigger negative number. Increasing your liability. Take the drill example above. If, instead of paying cash, you charged that drill. The expense entry stays the same - the expense is increased, or debited. You aren't touching your cash account this time - instead, you're increasing your accounts payable. So, to increase a liability account, you credit it, because to increase the liability, which is a negative number, you have to add a negative number, or a credit. And, there you have your balancing entry debit expense, credit accounts payable. Both times you had balancing entries, one debit, one credit - the credit just did different things each time. In the asset account, it decreased cash. In the liability account, it increased accounts payable. The 3000 series is just something you have to remember somehow- sales are considered a credit account. A friend had a memory trick for learning this concept: " making a sale is a credit to you." Another way to consider it is by thinking of the simplest sale, where you sell something and get some cash. Cash, as you know, is a debit account. Make a sale, and you better increase your cash debit cash. Positive entry. So the balancing entry has got to be a credit entry crediting sales increases the amount you are listing in sales, because sales is a negative number, (credit), and you are adding a negative number - another credit. The number gets bigger. The 4000 and 5000 series, the expense accounts, are all debit accounts. You enter an expense as a positive number (debit) to increase your record of what you've spent. Whenever you make a purchase of an item that goes to one of your expense accounts, you always increase your expense, which is a debit. The following chart shows how debits and credits effect the different types of accounts: Account Type ASSETS LIABILITIES EQUITY INCOME EXPENSES Debit Increases Decreases Decreases Decreases Increases Credit Decreases Increases Increases Increases Decreases
So, now that you've got the basics of the double entry system, the next step is simply a matter of beginning to enter the info. As you enter checks you've written, they will mostly be simple entries - debit (increase) the correct account number, and credit (decrease) cash. This is going to be the drill for the majority of your entries, when you have paid cash for an item. Even those things you charge, if you
are keeping your bills current, make your entry after you pay your bill, and the entry will always be credit cash, debit expense. To keep the process simple, when you receive a bill, go through it and total what part of the money due goes to which account, write it on the bill and use that when you make the entry into the system. Regular exceptions to this process will be: - When you buy a large tool or piece of equipment that needs to go on the asset page: credit cash and debit the proper asset account. As you make these entries, don't forget the information that you will need to set up your depreciation schedule. - When you pay an expense that has been listed as a liability, like a bank payment on a loan: credit cash, but debit two accounts, debit the liability account you're paying on for the amount of principal, and debit interest for the amount of interest expense. Doing this will decrease what you owe on the loan by the principal amount you have paid, and it will increase the record of what you have paid in interest expense. - When you make an addition to inventory: inventory is a cost you need to count as an expense only when you actually use it. Until then, it's an asset. So when you purchase inventory, credit cash and debit inventory - that will increase the value of your inventory. When you USE inventory, credit (reduce) inventory, and debit (increase) the appropriate expense account - materials, supplies, etc., or an inventory change account.
Expenses paid by check. Go through and enter all the other checks you have written by check number and to whom they were written. In general, all those entries will be credit cash; debit expense (decrease cash, increase expense). Make sure you put everything in the correct expense account. (And, since you have followed your "rule" about writing down the expense category right when you made the purchase you don't have any trouble remembering what this purchase was for, right?) The exceptions to this have been noted above: payments on loans, payments made on large equipment or fixtures, or additions to inventory. Expenses paid by cash. You may have paid for some things with cash. The entry here is exactly the same as if you paid with a check - it's just keeping track of these things that's different. You should have a file of receipts, and most of them will match a check (it will be easier to confirm if you've written the check number on the receipt). Any that were paid with cash should have that noted on them, along with what the item or account number was. Same entry - debit, expense, credit, and cash. If you have more than one cash account, have a separate account number for each bank account, and credit the account from which you are actually taking the money out of. If you move money from a savings to a checking account, the entry will be: credit (reduce) savings; and debit (increase) checking. Accounts Payable. At the end of any given month, you have things you have used or purchased, but have not paid for. These are listed as accounts payable. When you enter these bills, your entry is debit expense, credit accounts payable. Each month, you need to make and keep a list of items that were in accounts payable at the end of the month. When you are closing out our sample month, you will have paid these bills, which were in AP the previous month, reducing your cash. Using your list, identify the checks written for items that were listed in accounts payable the month before. You already listed the expenses the prior month - so you don't list them again. The entry to show on your books that you have paid your accounts payable is: debit accounts payable, credit cash. Reduce your cash; reduce your accounts payable. Assuming you pay all your bills each month, this step will bring your accounts payable to zero (and if not, the accounts payable balance per your books should equal all the outstanding bills). Later, you will rebuild a new AP list for the current month. Cash Discounts - purchases. In our sample chart of accounts we have set up account number 7100 for cash discounts on purchases. If you are paying a material order and get to deduct 2% for paying early, by all means, try to do so. This is where that amount goes: you debit the entire expense to the materials account as if you didn't take the discount, but credit the actual amount of your check to cash, and credit the remainder to the cash discounts account. This helps
you see the value of paying early, and if you're in a position to do this fairly regularly, it looks great to your banker - so take the time to book it correctly. Petty Cash. Petty cash is a handy item to have for small purchases, but it needs to be accounted for correctly. Do a one-time entry in your books to set up the petty cash account. If you want $300 in the account, credit the bank account you are taking the cash from, and debit your petty cash account. Then put that petty cash in a box. Every time you take some out to spend, keep track of what you've taken out, with a receipt, and at the end of the month you'll have a list that looks like this: Supplies (coffee, paper) Small tools Postage $25.00 $13.52 $22.30
Write a check to petty cash, which will be for the total of what you spent over the month, or $60.82. When you enter that check, credit cash and debit the three appropriate expense account numbers - supplies, small tools and postage. Cash the check, put the cash into the box, and start all over again. You can do this as many times over the month as you need to - every time you need to replenish the petty cash box, just write a check and make the balancing entries the same way. You never make the entries to Petty Cash itself after you initially set up the account, unless you want to make it larger or smaller at some point. Payroll. This one's a bit trickier...you've actually done a lot of things when you write that paycheck. If you have an accounting system and are using payroll, you should be in good shape - but even then, you may need some understanding of exactly what that system is doing for you. If you're doing payroll by hand, you will calculate and record the components described below. In Payroll you have:
o o o
the wages themselves, the taxes the government makes you withhold, and taxes that you have to pay that you don't withhold.
Gross wages get debited to the wages expense account - divided properly between direct and indirect labor. (Recall that gross wages for people actually producing your goods or providing your services are direct expenses; gross wages for the office help and sales are indirect expenses.) Payroll taxes. Some of these come out of the employee's check - the federal withholding and the employee's share of FICA. Others come out of your pocket, like the employer portion of FICA, state and federal unemployment taxes. The ones that come out of your pocket require two entries: they get debited to payroll tax expense (either direct or indirect, depending on where the employee's wages
go), and credited to the proper liability account - either FICA payable, Fed payable, UI payable, FUTA payable or Workers Compensation payable. Determining tax liabilities. For each of these you have to figure the total due based on the gross wages for that period - these taxes are figured as a percent of gross. For example, when the FICA and Medicare tax is 7.65% of gross wages, you take the gross wage, multiply it by .0765, and that is what you owe for the employer portion of FICA. You can get a chart which shows the Federal and state taxes due for each employee, based on their W-4 status and earnings. Unemployment will be based partly on a state multiplier and partly on your company's unemployment history. Workers compensation will depend on the industry code your employees work under, as well as your company's performance. All the taxes that are withheld from the employee's check as well as those which come out of your pocket - are listed as liabilities, and are easier to deal with if you sort them out by what kind of tax they are. In the liability accounts, there is no need to separate direct from indirect numbers - it's just plain money you owe, and it doesn't matter whether it comes out of the employees check or out of you pocket. The FICA payable, for example, will contain all the FICA that was withheld from everyone's check, in addition to the amount that you are matching as the employer. Here's the picture of what you do with payroll, using a fictitious shop person who's going to have his salary listed under 4010, direct labor. In this payroll period, he made $700.00. His workers' compensation rate is 13.2 %. Debit 700.00 Credit 53.55 42.00 19.00 585.45
4010 Gross wages 2102 FICA withheld 2100 Fed withheld 2104 State tax withheld 1001 Cash (paycheck amount)
Up to this point, the entries balance, as they must. Now, to enter the employer's tax expenses: Debit 2102 FICA Payable 2103 FUTA Payable 2105 State Unemployment payable 5015 Payroll Tax Expense 2107 Workers Comp Payable 5023 Workers Comp Expense Credit 53.55 5.60 19.60 92.40 92.40
78.75
As a side note, here's a point you need to keep in mind: that person, who you thought was costing you $585.45, because that's what her paycheck says, or is costing you his gross wage of $700.00, is actually costing you $871.15 ($700 wages plus the payroll tax costs to you, which in this case total $171.15). If you're adding any benefits like insurance or retirement, put those on top. This is a prime example of the kind of overhead you need to make sure gets added into your pricing structure.
Sales & Customer Deposits. OK, now you've entered your accounts payable, your expenses, your payroll. Now for the good stuff - let's enter your sales. Remember: sales accounts are credit accounts. So when you want to increase the amount of sales. You have made, you make the entry as a credit entry. These entries are pretty easy, on the surface: you receive a check and put it in your account: debit cash. The sale, if it is an item you have on hand and give to the buyer, you enter as an immediate sale. Credit sales, the equal amount that you debited cash. HOWEVER, if you have just signed a contract, and have not actually done any work on that project this month, you have not yet earned that sale. You're just holding the person's money for them, keeping it safe. Right? So, it is not yet truly a sale - it's a customer deposit. The entry will be debit to cash (it's in the bank, either way) and credit customer deposit, which is a liability account (you would have to refund the money if you don't do the job). If you have a lot of jobs going at any one time, you'll make your job easier if you give each job its own number in customer deposits, so you can easily keep track of how much has been turned into sales, and how much remains to be earned. Customer deposits turn into cash as you earn them - through the purchase of materials or labor performed. It's a bit of a call, how you evaluate each month what part of each job is done, and this is beyond the scope of this walk-through guide. So if you need help with accounting for contractors, send us an email and we'll forward some information to you. Accounts Receivable- Accounts Receivables and sales operate much the same as Accounts Payables and your purchases. Under the accrual method, you'll be entering sales as you earn them and invoice your customers. Have a simple chart that shows who owes you money each month - have a beginning balance which equals last months' ending balance. Enter any payments they've made or new charges they've incurred, and come up with an ending balance. That must equal the amount you list as AR on your books - if it doesn't, your task is to figure out where the discrepancy is. Inventory. Inventory is a current asset account, which means it is something you have that can be turned into cash quickly. When you purchase inventory, you do
so out of cash, so one side of the entry is credit cash - the other side, to increase inventory, is debit inventory. Basically, by listing an inventory item, you're just saying, I bought it this month, but I plan to keep it - or at least part of it - around, so the entire cost should not show up this month. The trick with inventory is knowing how to book it when you use it. Some common inventory items are materials - which is simple. You have a value of raw material in inventory - which matches what you paid for it. (You cannot increase the value of your inventory as it sits in the yards, as prices go up. You make your gain when you use that cheaper material in a project where you're able to charge more for it than it cost you.) As you use your raw materials, you credit inventory, to reduce it, and debit the 4101 account, materials. Basically, think of it as buying the material from yourself, with no cash changing hands. Another way that inventory might come up is when you buy $5,000 worth of brochures. Put that as a lump sum in your books for any given month, and you'll be a sad business owner, you'll think you're losing money hand over fist. So, try this: decide how long those brochures will last you, say three years. Divide $5,000 over 36 months, and you'll find that each month you need to book $138.89 (Call it $140 and be done with it). The whole sequence will look First, you buy the brochures and put them in inventory: Debit 1001 Cash 1003 Inventory $5,000 like Credit $5,000 this:
Then, each month as you use the brochures, you will make an entry: Debit $140 Credit $140
5312 Advertising Expense 1003 Inventory
What you're saying is that each month, you have to cover $140 as the cost of your brochures. It'll show up on your income statement as an actual cost. Each month the value of that inventory will decrease by that amount, until it's all gone. Theoretically your brochures will be gone about the same time - or outdated. Deposits. Another item that has its own spot in your books is deposits you pay for various things, from workers compensations to the cleaning deposit on a rental, to a deposit with the post office for express mail. These are items that will be returned to you when you finish using the service - technically, it's your money that they're holding. These amounts all go into the account called deposits, in our system #1800, which is of course under the Asset section of your Balance Sheet.
Gain or Loss on Sale of Assets. This is where you account for assets you sell or dump. If you sell a vehicle, you have its value on that up to date list of assets you keep. You also have a record of how much it has been depreciated. You enter the cash you make off that sale in 1001, cash. Then you balance that entry with a credit to the asset account and a debit to the accumulated depreciation account, and whatever it takes to make those number balance is your gain, or loss, on that sale. Say you sold a truck which you bought for $6,780. It has depreciated by $3,200. You managed to get someone to pay you $5,400. The entry to record this sale would be as follows: Debit $5,400 $3,200 $1,820 Credit $6,780
1001 Cash 1300 Fixed Assets - truck 1301 Accum. Depreciation 7100 Gain (or loss) on the sale
If your balancing entry had been a debit, it would have meant you lost money on the sale. Here's how to think about it: You paid $6,780. On your books, its value had decreased by $3,200, meaning you had expensed out that amount of money over the period of time you had the truck. So, to you it's actually worth $3,580, and you sold it for $5,400, which was a gain of $1,820. Depreciation. This is an entry that you can make the call on whether you're going to deal with it monthly or annually. It's not a cash expense, in fact it's often sniffed at as a "paper expense" but if you have a pretty good sized company and you think you're making great money, don't count those chickens until you figure in your depreciation. It's real stuff, because things DO in fact wear out and have to be replaced, and this is where that process is built into your books. Basically, your accountant will give you a sheet listing your assets and the amount they will depreciate this year. You take those totals, and say, OK, my tools are going to depreciate a total of $890 this year. Take that number and divide by 12, and you have your monthly depreciation, which in this case is $74.17. So to give yourself a really good idea of where you are, each month make the entry of debit account 5341 (depreciation expense) $75, and credit 1601 (accumulated depreciation, tools) by the same amount. If you have office equipment, vehicles, buildings, all those will have their separate totals that you work with the same way. Most computer accounting systems have a setup where you can tell it to make those entries for you automatically each month, and you won't have to worry about it. Don't worry about being too exact - at the end of the year, you'll go through each of these numbers and adjust it so it's exactly in line with your depreciation schedule. Making the entries monthly saves you the shock when you
thought you'd made $20,000, and your depreciation expense at the end of the year cuts that in half. Suspense. Now I'm going to let you in on a secret if you promise not to take advantage of it. If you are making all these entries and they don't balance, do this: first, check the number they don't balance by - maybe you just left out an entry. Divide that number by two and see if anything becomes obvious. Divide it by nine and if it divides cleanly and evenly by nine, that means you have transposed an entry somewhere - maybe you said 765 instead of 756. (No, this is not an old wive's tail - but I do have some good hiccup cures for you after class). IF you have tried everything you can think of, and you have just got to turn your computer off and go home, put the remainder that won't balance in suspense. Then, while you're out of the system, look at all your entries, all your notes, and figure out the problem. Come back in, make the correcting entry, and take it back out of suspense by making the opposite entry you did before. If you had to credit suspense to make things balance, this time debit it - or you'll drive yourself even crazier. Suspense may end up with little bits and pieces of numbers - but it should never be allowed to get large. $1.31, you can let go. $500, and you'd better get serious about finding out what that is. Month End Adjustments. Now that you're sure you have the right amount of cash in your system, you're ready to check the rest of the books. How intense you get about this can well depend on what time of year it is - in a mid-year month, like March or July, you might be a little more lax about how closely you check every account, whereas at the end of the year you will want to tie every single account down exactly. Even those accounts you don't check over with a finetoothed comb should at least be glanced at, to make sure they make basic sense. If a $3,500 car liability all of sudden turns into a $15,293 item, you'll know something is entered in the wrong place. The process is this: go through your balance sheet, item by item. You've already done cash, and petty cash is a static account, so the next item is inventory. Check what your inventory was last month, total up what you know you've added to or deleted from it, and that should be your current total inventory. To make this easy, keep a list of what is in inventory: office supplies, raw materials, etc. Each item should have a beginning balance, an amount of current activity, and an ending balance. If inventory shows on your books as a higher number than you actually know you have, adjust that against the material expense. If you have $250 less value in actual office supplies than you show on the books, the adjustment will be to debit office supplies (account 5550) and credit inventory. That will reduce your inventory - which will, by the way, also reduce your profitability...sorry!
When you close your books for the end of the year, you need to take actual inventory - count it all up and make sure you've really got what you think you do. At other times of the year, whether or not you go through this step will depend on how much inventory you carry. Any materials you have a large value of on hand, it will pay you to take a physical inventory of more often. Failing to do that may result in a shock at the end of the year when it turns out you've been underestimating your use of material all year, giving your perceived profitability one more opportunity to fly out the window. It's amazing how that bird can get up and go at the smallest opportunity! This same process gets followed for each item on your balance sheet. If your books are computerized, you will find a good friend in your Detail Trial Balance and Detail Transaction Reports. These reports will show you the beginning balance for each account, what was added to or subtracted from that account over the month, and then an ending balance. This will be the easiest place for you to look for those items entered in the wrong account, items entered backwards (credit when you should debit, can you imagine?), items overlooked, or items that were transposed when they were entered, which are the top four ways to end up out of balance. The good news is that you don't have to do this to every expense account - just check out that your asset and liability accounts are correct. If you have large loans, make sure you're accounting for principal and interest correctly - putting interest in its own account, and taking principal against the liability account. The easiest way to do this is to call the loan officer and get an actual report (loan history) of how much you owe as of this date, and make sure your books reflect that. As with any of this work, if you're talking about a small loan it may not be worth adjusting every month - you may want to adjust those once a year. The items you adjust monthly are the ones that can throw off your books by a large enough amount that it's worth the time it will take to adjust for them. This process, completed through your entire balance sheet, will give you the assurance that your books are correct, and you can trust the bottom line on your income statement. This is actually about the first point in the process that I would actually look at the income statement - until you have adjusted your books to match physical reality, it can be relatively meaningless. Paper Trail. One last point: all these numbers that are going into your books need to be backed up by something that will give you a clue about them. You or someone else will at some point need to go back and recreate something you've entered, and you need a good clean system for keeping this information. Keep a list of everything you've done. Have a list and update it monthly, of what makes up Accounts Payable - and the total of that list needs to equal the AP entry on your balance sheet. Have a list of customer deposits, accounts receivable and a list of your assets. You need to be able to say what's in each number on your
balance sheet. It's not nearly as intimidating as it sounds, and it will save you hours of head scratching later. You will also need to keep good supporting documentation for your income and expenses. For more information on the types of records you need to keep, check out Documenting your journey. Congratulations! You've now got a real set of books that you can use to analyze your profitability and pricing, you can take to the bank or use to produce a tax return. Every month, you'll find this process easier to follow and less time consuming, and you'll understand the inner workings of your business in a way that will make you much more powerful and confident in your decision making. And, did you know that the word in the English language with the most consecutive double consonants is subbookkeeper? A heady responsibility, I'd say. Happy bookkeeping! And now you're ready to move on and learn to use your financial statements to manage by the numbers!
OWNERS' REVIEW CHECKLIST Even if you hire someone to do your accounting and bookkeeping, there are a number of items that that you as the business owner should do periodically. Many small businesses have suffered serious losses when the owner lost track of the numbers and the trusted bookkeeper "borrowed money" and left for an extended cruise. The following checklist will keep you in touch with your business, and perhaps even prevent you from serious losses. 1. Compare actual results to budget. Each and every month you need to compare your income and expenses to your budget. This review is perhaps one of the most important tools for a small business owner. It's a great way to learn what's working and what's not working with your business. The goal is not to have an accurate budget... but for you to have a thorough knowledge of what is happening and to know if anything unexpected is happening so that you can adjust your actions in a timely manner. What?? You don't have a budget? Stop right now and let's go over to the Budget Workshop! 2. Scan the check register. Periodically (say every 3-4 months) you should take a look at the check register just to make sure all the payees are familiar to you. Multiple checks written around the same time to the same vendor could be an indication that funds are being diverted. (You also might want to reduce the time spent writing and posting multiple checks.) 3. Review the bank reconciliation. This should be done on a monthly basis (or if you skip a month take a look at all the reconciliations since your last review.) This step is important, particularly if you have one person doing
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5.
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all the bookkeeping: writing checks, posting entries, preparing financials, etc. Look at any adjustments to the bank accounts, stale items, etc. Look at canceled checks. Occasionally (say 1-2 times a year) pull out a bank statement and flip through the canceled checks making sure that all those signatures are yours, that you recognize the vendors and scan the endorsements on the back. Obviously, this can't be done if you don't get your canceled checks back from the bank. In this case you might want to spend a little extra time with the check register. Review statements from vendors. Every now and then (say 3-4 times per year) take the time to open the mail and look at statements from vendors (many vendors have stopped sending statements, but they will send late notices). Here you want to make sure that your business is in good standing with vendors -- long overdue invoices might be an indication that a check you thought was going to a vendor actually went in someone else's pocket, or that an invoice has been overlooked. Review Payroll register and handout the paychecks. Now of course this isn't an issue for a business with only 1-2 employees. But "padding the payroll" is a common problem in some industries -- such as construction or cleaning services where it is common for the crew to go straight to the jobsite and perhaps not come into regular contact with the owner. Review your Accounts Receivable and aging. This needs to be done on a regular basis. Of course you need to know if you have any slow paying customers and a periodic review would also disclose any scheme of "misapplying" customer payments. Take a physical inventory. Many small businesses have very poor inventory records, so if you have a large amount of inventory or a high volume business, you probably will want to work with your accountant and get some type of perpetual inventory system set up. Again, there are some excellent software packages available for the small business that will make this process relatively painless. Once you have a system in place, you should take a physical inventory at least once a year and compare the actual goods on hand to the inventory records.
BALANCE SHEET The balance sheet is a snapshot of the company's financial standing at an instant in time. The balance sheet shows the company's financial position, what it owns (assets) and what it owes (liabilities and net worth). The "bottom line" of a balance sheet must always balance (i.e. assets = liabilities + net worth). The
individual elements of a balance sheet change from day to day and reflect the activities of the company. Analyzing how the balance sheet changes over time will reveal important information about the company's business trends. In this lesson we'll discover how you can monitor your ability to collect revenues, how well you manage your inventory, and even assess your ability to satisfy creditors and stockholders. The liabilities and net worth on the balance sheet represent the company's sources of funds. Liabilities and net worth are composed of creditors and investors who have provided cash or its equivalent to the company in the past. As a source of funds, they enable the company to continue in business or expand operations. If creditors and investors are unhappy and distrustful, the company's chances of survival are limited. Assets, on the other hand, represent the company's use of funds. The company uses cash or other funds provided by the creditor/investor to acquire assets. Assets include all the things of value that are owned or due to the business. Liabilities represents a company's obligations to creditors while net worth represents the owner's investment in the company. In reality, both creditors and owners are "investors" in the company with the only difference being the degree of nervousness and the timeframe in which they expect repayment. In this section, we will teach you about the elements of the Balance Sheet and how they either use or provide "funds". For example, when a supplier sends you inventory on credit, she in essence is providing "funds" that you may use to operate your business. Recall from the Basic Accounting lesson that you record both an asset (inventory) and a liability (accounts payable) when you purchase goods on credit. Of course, you must be able to pay your supplier in cash in a timely manner. Theoperating cycle, which is also known as the cash-to-cash cycle, is the process of using cash to purchase current assets that are to be sold at a profit and collected as cash. As an example, a company uses funds to purchase raw material inventory that is produced into finished goods inventory, sold at a profit to create a receivable and collected to become cash once again, then used to pay the supplier, with the profits left in the business. The Balance Sheet shows a "picture" of the assets, liabilities and equity (net worth) of a business as of a specific day. The Balance Sheet shows two "views" of the business -- what resources you own (Assets) and the creditor or owner/investor that made it possible to acquire these resources (Liabilites and Equity). Remember that Assets = Liabilites + Equity!
Assets - Liabilites = Equity What you own - what you owe = what the business is worth!
Sound financial management of a company involves matching the sources and uses of cash so that obligations come due as assets mature into cash. Take a moment to study the operating/cash cycle diagram. Throughout this lesson we'll refer back to the use of funds and cash in the business operation. After all... remember that the Balance Sheet is just a report card showing where the funds are, and who has helped you acquire them (and these folks expect repayment!). Now let's take a moment to look at a picture of a Balance Sheet. It is always shown in two parts to reflect the accounting equation (A=L+E). Individual items within each section are listed by how close they are to cash. Recall the cash-to-cash cycle, so cash and short term investments are shown first, then accounts receivable, then inventory, and so on. On the liability side, trade creditors will be paid regularly, then the short term bank loans, longer term loans and so forth. Now that you've got the "big picture", let's move on and discuss each component of the Balance Sheet and more importantly start discovering how you can use it as a tool to manage your business. Don't forget that you can click one of the red reference numbers anytime to view the sample Balance Sheet. ASSETS As noted previously, anything of value that is owned or due to the business is included under the Asset section of the Balance Sheet. Assets are shown at net book or net realizable value (more on this later), but appreciated values are not generally considered. Current Assets.
Current assets are those which mature in less than one year. They are the sum of the following categories:
o o o o o o
Cash Accounts Receivable (A/R) Inventory (Inv) Notes Receivable (N/R) Prepaid Expenses Other Current Assets
Cash. Cash is the only game in town. Cash pays bills and obligations. Inventory, receivables, land, building, machinery and equipment do not pay obligations even though they can be sold for cash and then used to pay bills. If cash is inadequate or improperly managed the company may become insolvent and be forced into bankruptcy. Include all checking, money market and short term savings accounts under Cash. For more on cash management, go to the lesson on cash management and cash flow projections. Accounts Receivable (A/R). Accounts receivable are dollars due from customers. They arise as a result of the process of selling inventory or services on terms that allow delivery prior to the collection of cash. Inventory is sold and shipped, an invoice is sent to the customer, and later cash is collected. The receivable exists for the time period between the selling of the inventory and the receipt of cash. For more on terms refer to the article on Aging Accounts Receivables. Receivables are proportional to sales. As sales rise, the investment you must make in receivables also rise. Example: Receivables vary with sales. The ABC Company gives Net 30 Day terms to its customers. Any sale made today will be collected one month from today. ABC's customers are prompt payers and all receivables are collected on the 30th day. On average, ABC will have one month's worth of sales always invested in receivables. In 19X1, sales are $1,200,000. Receivables, which are equal to one month's sales, total $100,000. In 19X2 sales rise to $2,400,000. Receivables which remain at one month's worth of sales, rise to $200,000. Due to the growth in sales, the company is forced to increase its investments in accounts receivable by $100,000. This investment in receivables is automatic and unavoidable. It does not indicate the company's terms have been lengthened or that management of collections has decayed.
Analyzing Receivables: Receivables increase for two reasons; 1) Growth in sales, and 2) Change in average collection period. Growth in sales is a healthy reason to increase receivables. Changing the collection period, however may not be so favorable, particularly if the reason is due to a collection problem with a customer. Here's an example of how analyzing your financial statements can help you spot unfavorable trends before they become a problem. To analyze the change in the collection period, some measure of the receivable's quality must be used. We do this by comparing the actual collection period to the stated payment terms. The actual collection period is known as Days In Receivables. To determine receivable quality, the company's terms of payment are compared to the actual collection period. The collection period and the terms should be about equal. If the calculated collection period is greater than the offered terms, then its time to dig deeper and see if some of your customers are lagging in paying their accounts. Look at your A/R Aging Report as a start. Allowance for doubtful accounts. At some point in time you may have customers that are unable to pay for the goods or services they received from you. When you determine that you will be unable to collect these accounts, you will write off the receivable and record a "charge off" loss. As your business matures, you will be able to estimate the amount of such losses. Many businesses calculate this expense on a monthly basis based on sales or a percentage of past due accounts. Your accountant can assist you with determining whether or not you should record an allowance for doubtful accounts. The allowance for doubtful accounts is subtracted from gross receivables on the Balance Sheet to show the net receivable balance. Inventory. Inventory consists of the goods and materials a company purchases to re-sell at a profit. In the process, sales and receivables are generated. The company purchases raw material inventory that is processed (aka work-in-process inventory) to be sold as finished goods inventory. For a company that sells a product, inventory is often the first use of cash. Purchasing inventory to be sold at a profit is the first step in the profit making cycle (operating cycle) as illustrated previously. Selling inventory does not bring cash back into the company -- it creates a receivable. Only after a time lag equal to the receivable's collection period will cash return to the company. Thus, it is very important that the level of inventory be well managed so that the business does not keep too much cash tied up in inventory as this will reduce profits. At the same time, a company must keep sufficient inventory on hand to prevent stockouts (having nothing to sell) because this too will erode profits and may result in the loss of customers.
The correct level of inventory is a function of the length of the company's inventory cycle and the company's sales level. A company's inventory cycle is divided into three phases:
1.the 2.the 3.the
ordering phase, production phase, and finished goods/delivery phase.
The ordering phase is the time it takes the a company to order and receive raw materials. The production phase is the time it takes to produce finished goods from raw materials. The finished goods/delivery phase is the amount of time finished goods remains in stock and the delivery time to a customer. The inventory cycle in days is determined as follows: Inventory Cycle In Days = Ordering Phase in Days + Production Phase in Days Finished Goods and + Delivery Phase in Days
Example: Inventory Cycle Now let's look at an example of how a small business might use this information to plan its purchases and manage inventories. The ABC Company is a producer of specialty pottery vases. The company imports clay from the Big Timber Landfill. Ordering and receipt of the clay generally takes 14 days. If the company orders clay today, it will receive the clay in 14 days. To prevent stockouts, the company reorders whenever clay inventories drop to 14 days. Once in the shop, the clay base is mixed with water and rests one day to set up to the proper texture. It takes one day to spin the vase, three days to dry, one day to paint and one more day to dry. The production cycle from wetting clay to drying the paint is seven days. Because it takes seven days to produce seven days worth of sales, the company never lets its stock of vases shrink to less than seven days worth of sales. The delivery phase is very short because most of the product will be delivered in the immediate area. Management estimates that delivery takes one day at most. The company's minimal inventory cycle is 22 days: Inventory Cycle In 14 days = Days ordering for + 7 days production for + 1 day delivery for
If clay is ordered today, a vase made of that clay can be delivered to a customer no sooner than 22 days from now. Now let's also assume that Company management likes to keep an additional five days of inventory on hand as a cushion to cover any delays in receipt of the clay and production of the vases.
Therefore, the company's total inventory cycle is 27 days. To keep the cycle running smoothly, the company must keep its investment in inventory equal to 27 days worth of sales. The company must keep an investment in inventory equal to its inventory cycle. If ABC keeps only 15 days' worth of investment in inventory, it eventually will run out of stock because clay ordered today cannot be delivered as a vase for 22 days. We have learned that this investment requires the use of cash. Thus in the above example, ABC must have sufficient cash to acquire at least 22 days of inventory, and that management operates more comfortably with 27 days' sales in inventory. Knowing this, we can estimate the dollar ($) amount of inventory as follows: Minimum Investment Inventory (in $'s) in = Inventory Cycle In Cost of a Day's Sales X Days (in $'s)
The investment in inventory will vary according to both the sales per day and the length of the inventory cycle in days. As sales rise, the amount of inventory sold daily rises and the investment in a day's worth of inventory must increase or stockouts will eventually occur. As the inventory cycle lengthens more inventory must be kept on hand to produce the same level of sales and the investment in inventory increases. Just as we measured the "quality" of accounts receivable, another ratio can be used as an indicator of the "quality" of inventory. We do this by comparing the actual inventory level to the inventory cycle. Insufficient inventory indicates potential stockouts, Excessive inventory may indicate, stale inventory, poor inventory controls, or fudging (miscounting). To measure quality, the actual number of days of inventory on hand is measured as follows: Days In Inventory = Actual Inventory Cost of Good Sold per year x 360
Ideally, inventory will be at a level slightly greater than the inventory cycle. Days In Inventory Inventory Cycle In Days
Notes Receivable (N/R) N/R is a receivable due the company, in the form of a promissory note, arising because the company made a loan. Making loans is the business of banks, not of operating business, and particularly not the business of a small company with limited financial resources. Notes receivable is probably a note due from one of three sources:
1. 2. 3.
Customers, Employee, or Officers of the company.
Customer notes receivable is when the customer who borrowed from the company probably borrowed because he could not meet the accounts receivable terms. When the customer failed to pay the invoice according to the agreed upon payment terms. The customer's obligation may have been converted to a promissory note. Employee notes receivable may be for legitimate reasons, such as a down payment on a home, but the company is neither a charity nor a bank. If the company wants to help the employee, it can co-sign on the loan advanced by a bank. An officer or owner borrowing from the company is the worst form of note receivable. If an officer takes money from the company, it should be declared as a dividend or withdrawal and reflected as a reduction in net worth. Treating it in any other way leads to possible manipulation of the company's stated net worth, and banks and other lending institutions frown greatly upon it. Other Current Assets. Other Current Assets consist of prepaid expenses and other miscellaneous and current assets. Prepaid expenses are the uses of cash to purchase in full a good or service, the benefit of which will be received within the next 12 months. Insurance is the most common form of prepaid expense. The premium is paid prior to the receipt of the benefit. Cash has been depleted by paying a bill before the benefit from the purchase has been received. Miscellaneous and other current assets generally consist of small deposits or receivables. Non-Current Assets. Non-current assets are defined as those that will not mature into cash within the next 12 months. They can consist of the following asset categories:
o o o o
Net Fixed Assets Investment into Subsidiaries Intangibles Other Assets
Fixed Assets. Fixed assets represent the use of cash to purchase physical assets whose life exceeds one year. They include assets such as:
o o o
Land Building Machinery and Equipment
o o
Furniture and Fixtures Leasehold Improvements
Calculating Net Fixed Assets. When a fixed asset is purchased for use in operations of the business it is recorded at cost. As the asset wears out, an amount is charged to expense and accumulated annually in a contra-account known as accumulated depreciation. Accumulated depreciation is the cumulative sum of all the years' worth of wearing out that has occurred in the asset. The gross fixed asset (purchase price) less the accumulated depreciation equals the Net Fixed Asset Value (also known as book value). Gross Fixed (Purchase Price) Assets Accumulated Depreciation = Net Fixed Assets (Book Value)
Intangibles. Intangibles represent the use of cash to purchase assets with an undetermined life and they may never mature into cash. For most analysis purposes, intangibles are ignored as assets and are deducted from net worth because their value is difficult to determine. Intangibles consist of assets such as:
o o o o o
Research and Development Patents Market Research Goodwill Organizational Expense
In several respects, intangibles are similar to prepaid expenses; the use of cash to purchase a benefit which will be expensed at a future date. Intangibles are recouped, like fixed assets, through incremental annual charges (amortization) against income. Standard accounting procedures require most intangibles to be expensed as purchased and never capitalized (put on the balance sheet). An exception to this is purchased patents that may be amortized over the life of the patent. Other assets. Other assets consist of miscellaneous accounts such as deposits and long-term notes receivable from third parties. They are turned into cash when the asset is sold or when the note is repaid. Total Assets is the sum of all the assets owned by or due to the business
