Accounting and Bookkeeping

Transcription

1 Accounting and Bookkeeping Learn the basics of accounting and bookkeeping for your small business. Many new business owners are daunted by the mere idea of bookkeeping and accounting. But in reality, both are pretty simple. Keep in mind that bookkeeping and accounting share two basic goals: to keep track of your income and expenses, which improves your chances of making a profit, and to collect the financial information necessary for filing your various tax returns. There is no requirement that your records be kept in any particular way. As long as your records accurately reflect your business's income and expenses, the IRS will find them acceptable. (There is a requirement, however, that some businesses use a certain method of crediting their accounts: the cash method or accrual method. For more information, see Cash vs. Accrual Accounting. ) Depending on the size of your business and amount of sales, you can create your own ledgers and reports, or rely on accounting software. Three Steps to Keeping Your Books The actual process of keeping your books is easy to understand when broken down into three steps. 1. Keep receipts or other acceptable records of every payment to and every expenditure by your business. 2. Summarize your income and expenditure records on some periodic basis (daily, weekly, or monthly). 3. Use your summaries to create financial reports that will tell you specific information about your business, such as how much monthly profit you're making or how much your business is worth at a specific point in time. Whether you do your accounting by hand on ledger sheets or use accounting software, these principles are exactly the same. Step One: Keeping Your Receipts Each of your business's sales and purchases must be backed by some type of record containing the amount, the date, and other relevant information about that sale. You'll use these to create summaries of your transactions. From a legal point of view, your method of keeping receipts can range from slips kept in a cigar box to a sophisticated cash register hooked into a computer system. Practically, you'll want to choose a system that fits your business needs. For example, a small service business that handles only relatively few jobs may get by with a bare-bones approach. But the more sales and expenditures your business makes, the better your receipt filing system needs to be. 1

2 Step Two: Setting Up and Posting to Ledgers A completed ledger is really nothing more than a summary of revenues, expenditures, and whatever else you're keeping track of (entered from your receipts according to category and date). Later, you use these summaries to answer specific financial questions about your business, such as whether you're making a profit and, if so, how much. Post receipts on a regular basis. On some regular basis -- like every day, once a week, or at least once a month -- you should transfer the amounts from your receipts for sales and purchases into your ledger. This is called posting. How often you do this depends on how many sales and expenditures your business makes, and how detailed you want your books to be. Your posting schedule depends on your sales numbers. Generally speaking, the more sales you do, the more often you should post to your ledger. A retail store, for instance, that does hundreds of sales amounting to thousands of dollars every day should post daily. With that volume of sales, it's important to see what's happening every day and not to fall behind with the paperwork. To do this, the busy retailer should use a cash register that totals and posts the day's sales to a computerized bookkeeping system at the push of a button. A slower business, however, or one with just a few large transactions per month, such as a small website design shop, dog-sitting service, or swimming pool repair company, would probably be fine if it posted weekly or even monthly. If possible, use accounting software. You can purchase an accounting software program that will generate its own ledgers as you enter your information (and then automatically generate the necessary financial reports from the same information). All but the tiniest new business are well advised to use an accounting software package to help keep their books. Micro-businesses can get by with personal finance software such as Quicken. Step Three: Creating Basic Financial Reports Financial reports are important because they bring together several key pieces of financial information about your business. Think of it this way: while your income ledger may tell you that your business brought in a lot of money during the year, you won't know if you turned a profit without measuring your income against your total expenses. And even comparing your monthly totals of income and expenses won't tell you whether your credit customers are paying fast enough to keep adequate cash flowing through your business to pay your bills on time. That's why you need financial reports: to combine data from your ledgers and sculpt it into a shape that shows you the big picture of your business. The key reports you need to create regularly are a cash flow analysis, a profit and loss forecast, and a balance sheet. (Both QuickBooks and Quicken Home and Business, as well as other accounting software, can provide these regular reports.) If you are ready to start your own business, get all the information you need, including tips on accounting and bookkeeping with Nolo's Quicken Legal Business Pro -- a complete 2

3 business library on your desktop, featuring five Nolo business books, over 140 forms and a dozen 'how to' checklists. WHY KEEP GOOD RECORDS? Why bother? Most people view bookkeeping as an exercise that they go through for one reason only: the tax return. With this outlook, it's no wonder that no one wants to bother until the end of the year when it's that or go to jail. But it's also no wonder that businesses fail from surprises in their bank accounts - which shouldn't have been surprises at all. Here's the full story on why you have to keep accurate books, and you'll notice that tax reporting is so far to the bottom that it's really just there by default: a. Price your product accurately. b. Know if you're making or losing money - in general and on specific jobs. c. Know your cash flow - short and long term. d. Work with bankers. e. Let the tax agencies know how you're doing. Pricing your product is the first single most important thing you have to do in business. It's a simple equation, which says that you have to charge more than it costs you, right?? So tell me, what about paying back that loan that you opened last winter when you couldn't meet your workers compensation bill? What about the tools you put on your MasterCard for the last job? What about product liability insurance? There's a long list you're likely forgetting, or if not forgetting, discounting beyond reality. Nearly anyone can figure out the direct costs of their product or service - a good set of books will tell you just what ought to go into that equation for overhead, which is the difference between making a profit or loss. Are you making money? Well, even after you price your product, you have to know how your pricing compares with reality. If you are making some bad decisions with your pricing, and you wait until next April 14th to find out whether you've lost or made money, it may be too late to do anything about it. Running a business profitably is tough. It can take a long time for some of your decisions to prove right or wrong, even with good books. Give yourself a break and at least be paying attention so you see things happening soon enough to correct them. Cash Flow? What's that? Laugh all you want but learn from the mistakes of Paula and Shawn; they didn't know what cash flow was until it was almost too late. They had an incredible summer starting their contracting business. There was always money in the bank, thanks to customer deposits which seemingly never ended. When fall came, however, business began to slow down and Paula and Shawn took a look, in a sort of vague, starry-eyed way, at "the books." They congratulated themselves on having beaten the odds of making a business very profitable in its first year. A week later, they revised the profit estimate down... to account for a loan payment they had forgotten was still due. A month later, they had to revise it down again... when the quarterly payroll taxes came due that included a contribution to worker's compensation. Then there was the $2,500 check Paula had added to the checkbook by mistake, because she hit the wrong button on the calculator. It wasn't long before they were on their knees at the local bank, pleading for a loan to tide them over the winter, promising they could pay it back in three months. (You should have seen the party two years later when they actually did finally pay off that first loan!) One of the most important things you will learn from keeping your books is how to understand and manage Cash Flow. 3

4 The Banker. You may not work with a banker... yet. Paula and Shawn didn't, until, as you read above, they ran out of cash. They were lucky - they found a banker who would work with them, and help them learn about business while they were growing their business. As much as possible, have your numbers organized on a cash flow spreadsheet before you go to the bank. If you're already working with a bank, impress them with good numbers. I don't mean good in the sense of whitewashed, at all. I mean good in the sense of accurate. With good books, you will see problems coming before they happen. Go talk with your banker about them in advance, and you'll have a better chance of getting and keeping that person on your side. A side note about relationships - never go in thinking that your relationship with your banker is adversarial by definition. The opposite is true - that relationship has to be one of teamwork and understanding. To look at your banker as an adversary from whom you should hide bad information is a huge mistake. Find a banker you can talk to and work with, and keep him/her posted, good or bad. Develop those relationships, and they'll stick by you as long as they can. Finally, that tax return. Use books that you've prepared for your decision making, and maybe the results won't be a surprise. If your books are done and you know before the end of the year what taxes you have to pay, chances are you can save yourself money by paying ahead, or by buying tools that you know you'll need. At any rate, your tax accountant can help you do whatever planning you need to do, but you cannot do that in the absence of good information. WHERE'S THE STARTING LINE? How to begin? Now that you're so fired up by possibilities that we'll have to hold you back, where do you start? In the next section, we will cover: Financial Statements- Introducing your first business summary. Cash vs. Accrual Accounting - Understanding the difference. Chart of Accounts & Definitions - Organizing the categories. Before you begin, you might want to download our sample chart of accounts to use as a study aid. Financial Statements. To enjoy bookkeeping and accounting, you need to understand why you are doing what you're doing with these numbers, and what knowledge your work will give you. The result you are working toward is good information that which will be available to you from your financial statements. Financial statements come as a pair: a balance sheet and an income statement. These are really two ways of looking at generally the same information. The income statement (also called profit and loss statement) tells you how much money you've made (or lost!) in a period of time which you can specify. (This month, this quarter, this year). The balance sheet tells you where your business stands as of the date you specify. How much cash you have, the value of your tools, how much you owe, on a given day. Although there is an early tendency to want to see the income statement and ignore the balance sheet, you need to use both together to see all of the facts. Over time, you might even become a balance sheet fan, as you begin to understand what it's telling you. So don't ignore, your balance sheet. What makes accounting interesting is the relationship between the numbers on the financial statements, and the things you can learn when you understand them. I can almost promise you that the better you understand what knowledge can be extracted 4

5 from your financial statements, the better job you will do of keeping your books, which will start you on an upward spiral of great financial record keeping. Cash vs. Accrual Accounting. You have two choices of accounting method: cash and accrual. The cash method does not account for payments due or bills due - it says, when you write the check, you enter the expense, when you receive money, you enter the sale. The accrual method says that you keep track of what expenses actually apply to the current period...if you receive a $100,000 check for deposit on a house in December, and cut the frame in March, in the cash method you're going to be taxed one year on the money you've taken in, and the next year show a tremendous loss because of your expenses of cutting the frame. The accrual method, on the other hand, lets you put the money in the accounting period where it actually belongs - you pay the expenses the same month as you book the sale, so it all makes sense. All the instructions here are given for the accrual method of accounting. Chart of Accounts. To develop a set of financial statements, you have to start with an outline of how you will organize the information. This outline is called your chart of accounts, and it is the framework upon which the financial statements are built. In your business, you have expenses that are going directly into your product - labor, materials, freight...then there are the costs that are more supportive (and ongoing) in nature - the utilities and telephone, stationery and the cost of this bookkeeping. An easy way to think about them is that the direct expenses stop when you don't have work - those indirect, or overhead costs don't. A chart of accounts uses a numbering system to organize the data. All the data on all the reports you print comes out in numerical order. The first digit of each shows what sort of account it is, and the digits which follow put the accounts in order. As your system develops and you want to get more intricate, you can further refine this system - but the basic outline is as follows: Balance Sheet Accounts: Asset Accounts. What you own. Liability Accounts. What you owe. Preparation of a balance sheet in vertical format. Income Statement Accounts: Income Accounts. Sales. Everyone's favorite account. Direct Expense Accounts. Expenses that will quit if you're not working. Indirect Expense Accounts. Expenses they just keep going, whether you're working or not. Non-Operating Accounts. Numbers whose meanings are pretty obvious (interest income, income tax, etc.), but which are kept at the bottom of the page separate from normal operating expenses or incomes. Within this outline, you have a variety of subheadings, that further organize your data, as follows: 1000 Asset Accounts, what your own, comes in two forms. Current assets are cash or things you can convert to cash readily, like inventory that could be sold, accounts receivable which you've billed for and should be in the mail, etc. All of that gets an early number and gets put at the top of the page on your balance sheet under Current 5

6 Assets. You need to make sure that you have enough current assets on hand to cover current bills. Fixed Assets are the ones that are bolted to the shop or office floor...the big tools, the computers, the vehicles, land, the shop itself, etc. Here is where you put the value of those items, generally expressed as the purchase price. Sorry, you don't get to put in new values as your classic vehicles become more and more valuable, or your land doubles in assessed value, or your tools take on the value of antiquity. No choices here; it's in the book. But then again, give yourself a break and put in the entire purchase price, not just what you've paid to date. You'll have a chance later on to admit how much you still owe on all those great tools. Liability Accounts. These, like assets, come in two types - current and long term. There's a pretty easy definition of which goes where - if it's due within the year, put it in the current category. If you have a loan you get to pay out over time, you can put it under long term, with the one small caveat that you have to take one year's worth of principal on each loan and put that part up under current liabilities- because you do, in fact, owe that within a year. One thing you're going to find under liabilities, and under current liabilities no less, is customer deposits. I can hear my phone ringing already. OK,you say, that's really cash in hand, a serious asset, jobs sold, lucrative profits, trips to the Caribbean...sure! I'm in, and I'll go along with that thought...after you earn it. Until that product is made or service rendered, you are holding money that belongs to someone else, and even if you have spent money on contracts which claim it's non refundable, it still isn't earned. This is really protection for you - you have a long list of expenses to work your way through before you make that trip to the Caribbean. List this as a liability, and earn it. You will have a chance to earn it a bit at a time, reducing the liability as you go - but that's for a later chapter. These numbers up until now are all what you call balance sheet accounts. The information here will show up only on your balance sheet. They all have a serious and intimate relationship with the numbers on your income statement, but the next discussion topics will actually make your income statement. The 3000 series...sales. This is where you enter the value of any sales you make Direct Expenses. Here is where you enter the expenses that will stop when you are not working. The costs that go directly into the product you are making...labor, materials, etc Indirect Expenses. This is the area of overhead. Those expenses which never go away. Keeping the Direct Expenses separate from Indirect Expenses is very important. You'll need to know what your overhead (indirect expense) is when you price your work. You'll want to know what your gross profit is when you start analyzing your numbers (more later). Those sorts of things you will only know if, as you go along, you make a concerted effort to separate your direct from your indirect expenses. On the other hand, don't get too nit-picky about it. Just follow the simple rule -- costs that go into making your product or expenses related to your services are considered "direct". 6

7 As far as the people in your organization go: overhead is the support staff - office and sales, primarily. Shop and design is direct, the staff with billable time. Unless you're in retail sales, then the wage for your salesperson is a direct expense. One last note - forget the word miscellaneous was ever invented. Do not allow it into your system. Everything is something, and if it doesn't rate a name on the page somewhere, what are you doing spending money on it? Not allowed. Go to the back of the class. Equity There are some crazy sounding numbers at the bottom of the liabilities section, that have to do with equity in the company. You should talk about these with your accountant and get her help in setting them up. They'll be different depending on what sort of outfit you are - sole proprietorship, partnership, limited liability company or corporation. Equity accounts have different ways of relating to one another, and different ways of being treated at the end of the year. Generally, you won't be adjusting the Equity Accounts anyway -- leave them to your accountant. In the accompanying chart of accounts, the example I give for these equity accounts is for a partnership. And of course no accounting lesson is complete without a word about taxes... There are tax rules to pay attention to in setting up your system - for example, where you might be tempted to lump all your travel expenses in one category, that would be a mistake because you can only deduct 50% of the meals...so do this: make up a chart of accounts that you feel contains everything you need, then choose a tax accountant and have that person add what (s)he needs, or make corrections. You'll save yourself money setting up as much as you are comfortable with in advance. You need a chart of accounts whether you are doing bookkeeping by hand or using a computer - this system predates computers. But if you're not using a computer, give yourself a break and work with someone who is. Simple accounting packages are pretty cheap, and are worth their weight in time spent and frustration. But, don't wait to start your bookkeeping system while waiting on a computer system - get started with pencil and columnar pad as soon as you start your business. Organization and 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, 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 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. 7

8 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 $ 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. 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, 8

9 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. 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 Debit Credit ASSETS Increases Decreases LIABILITIES EQUITY INCOME Decreases Increases Decreases Increases Decreases Increases EXPENSES 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: 9

10 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. Introduction Assume that you are sitting down to do your monthly bookkeeping. It is a day slightly past the end of the month you are doing the books for - say, the tenth. You paid as many bills as you could before the end of last month, you've received most bills you're going to get and - you're ready to do the monthly accounting. In this walk-through guide we'll cover the activities associated with your monthly accounting, section by section. We'll include a description of what you'll be doing as well as why you're doing it. We'll also include an explanation of the "debits & credits" in this guide, but as we've noted in a prior section, if you are using an accounting software application, the debits & credits are generally taken care of for you -- at least until you have to record journal entries, etc. So our approach will be based on a "semi-manual" set of books so that you learn more about the "why" -- this will make the job easier in the long run and provide you with a better foundation for really using your monthly financial statements. 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 10

11 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) $25.00 Small tools $13.52 Postage $22.30 Write a check to petty cash, which will be for the total of what you spent over the month, or $ 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. The Cash Book 11

12 The cash book records all cash receipts and payments. It is possible to maintain both the cash account and the bank account in the cash book. The cash account records the receipts and payments of cash while the bank account records the receipts and payments of money by cheque. Recording of Transactions in the Cash Book. A receipt of money by cheque is debited and the payment of money by cheques is credited to the bank account. Illustration to be given later. Sales and Customer Deposits Suppose 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. 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 12

13 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 $ (Call it $140 and be done with it). The whole sequence will look like this: First, you buy the brochures and put them in inventory: Debit Credit 1001 Cash $5, Inventory $5,000 Then, each month as you use the brochures, you will make an entry: Debit Credit 5312 Advertising Expense $ Inventory $140 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. 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. Depreciation of fixed Assets 13

14 Fixed assets like plant and machinery, motor vehicle and furniture are used in a business. These assets lose their value over a period of time. The decrease in the value of these assets is also a loss to the business which be taken into account. While calculating the net profit for any particular year. Depreciation means the estimated loss in money value of a fixed asset as a result of use, obsolescence or the passage of time. Calculation of depreciation using the reducing balance method Here a fixed percentage on the diminishing value of the asset is calculated to find the annual depreciation. Illustration: Original cost of a machine is shs 10,000. the depreciation is provided at a rate of 20% p.a by the reducing balance method. Show the amount of depreciation for three successive years. Original cost = 10,000 Year.1. 20% of shs 10,000 =2000 Cost carried forward = 8000 Complete the rest of the years calculations. Using the straight line method to calculate depreciation. This method spreads the evenly over effective life of the asset. The annual depreciation is calculated as follows; Depreciation = Cost-Scrap value divided by the working life of the asset. Illustration: A machine costing shs 10,000 is purchased. If the expected working life is 10 years, and at the end of this time, its scrap value will be shs 1,000 then; annual depreciation Annual depreciation= divided = 900 p.a 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 $ 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 14

15 shock when you thought you'd made $20,000, and your depreciation expense at the end of the year cuts that in half. Suspense. 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 fine-toothed 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! 15

16 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. See the attached appendices 16