Basic Accounting Reference Accounting equation: Assets = liabilities + capital (owner equity) Assets – liabilities = capital (owner equity) DR (debit) or CR (credit) Debit increases an asset account; decreases liability or capital account Credit increases a liability or capital account; decreases asset account Assets are what you own; items of value owned by the company. Cash is an asset, customer contracts or amounts owed are an asset, your furniture and your equipment are assets. Anything of tangible value to the company is an asset. Liabilities are what you owe, such as debts and mounts due to another party. The phone bill that is currently due is a liability, the amount owed on a credit card or installment agreement is a liability, and unpaid taxes are a liability. Capital, or owners’ equity, is the difference between what you own and what you owe. This is, essentially, the value of the company. At the end of the year, the difference between revenues (sales income) and the cost of doing business (cost of sales and business expenses) is calculated as the profit or loss for the year. General Ledger (GL) is the primary ledger of recorded business accounts, and contains the chart of accounts used to record the financial details activities within business. The basic framework of the chart of accounts addresses two main areas for reporting activity: the Balance Sheet, where assets, liabilities, and capital items are summarized and reported to provide an overall picture of the financial position of the company, and the Income Statement (frequently termed Profit & Loss, or P&L), which reflects profitability of operations (revenues and expenses). Assets Cash Bank account Accounts receivable Furniture & equipment Liabilities Accounts payable Installment loan payable Capital Owner equity Income Sales Expenses Payroll Supplies Phone & Utilities Rent The number of accounts in the company’s chart of accounts may be high, depending on the type of business and the nature of the reporting required. For most businesses, it is wise to break down different types of activities – different transaction types – into subledger systems. A standard approach in most accounting systems, the use of the subledger allows for detailed accounting of individual transactions as well as recording the details of the related item. This allows for more detailed action and reporting on the specific types of activity, while summarizing the data for more meaningful reflection in the balance sheet and income statement. Accounts Receivable (AR) is a subledger. This means that activities in the AR system are summarized and recorded in the General Ledger. The details of these activities are generally available only within the AR system. Accounts Receivable deals with recording income (sales revenue) and customer payments. The total amount of Accounts Receivable reflects the total amount owed to the company by its customers. When an item is sold to a customer, Accounts Receivable is increased by the amount due on the invoice. This same amount is recorded as sales income. Behind the scenes, the Accounts Receivable account is being debited (increased) by the amount owed by the customer, and income is being credited (increased) by the amount of the sale. When a customer pays their bill, the payment is recorded in the Accounts Receivable system. The customer account, or AR, is credited (decreased) by the amount of the payment, and the cash account is debited (increased) by the same amount. This decreases the customer balance in the Accounts Receivable, and records the receipt of funds from the customer. Customer buys something $10 to AR $10 to sales Customer pays bill $10 from AR $10 to bank Net effect of entry: $10 in sales recorded; $10 in bank recorded The summary of this activity is recorded in the general ledger, in the form of debits and credits to accounts receivable, sales and the bank accounts. But the specifics of the item sold and the customer who purchased – these are details that are stored only in the AR system, as they are not specifically relevant to the general ledger. Accounts Payable (AP) is also a subledger. Accounts Payable deals with expenses, purchases, and vendors (suppliers, etc). The total amount of Accounts Payable reflects the total amount owed by the company to its vendors. When a company buys something, the vendor typically issues a voucher (invoice or bill). Recording this in the AP system results in a credit (increase) to Accounts Payable, and a debit (increase) to the category of expense (such as rent). When the bill is paid, AP is debited (decreased) by the amount of the payment, and the bank account or cash is credited (decreased) by the same amount. Buy something from vendor $10 to AP $10 to expense Pay vendor voucher (bill) $10 from AP $10 from bank Net effect of entry: $10 in expense recorded, $10 from bank recorded.   Financial Statements: Balance Sheet and Profit & Loss (or Income Statement) The Balance Sheet is the first of the main statements of financial position. This statement, or report, contains information on the Assets, Liabilities, and Capital status of the company. Being the primary business report, the Balance Sheet is the summary of information which provide a statement reflecting the overall value of the business. This report includes asset information – value the company owns; liability information – value the company owes; and capital or equity – which is the reflection of the value of ownership. The Profit & Loss, or Income Statement, reflects summary information about the company’s operational performance. The Profit & Loss statement demonstrates the company’s earnings in sales revenues, and further reflects the costs of goods sold and expenses incurred. The net of these amounts is a reflection of the company’s profitability from operations. This profit or loss amount is then incorporated into the capital section of the balance sheet, completing the "picture" of the company’s financial status. It's important to understand the basics of the two principal accounting methods used to keep track of a business's income and expenses: cash method and accrual method (sometimes called cash basis and accrual basis). In a nutshell, these methods differ only in the timing of when transactions, including sales and purchases, are credited or debited to your accounts. The accrual method is the more commonly used method of accounting. Under the accrual method, transactions are counted when the order is made, the item is delivered, or the services occur, regardless of when the payment for them (receivables) is actually received. In other words, income is counted when the sale occurs, and expenses are counted when you receive the goods or services. You don't have to wait until you see the money, or actually pay money out of your checking account, to record a transaction. Under the cash method, income is not counted until cash (or a check) is actually received, and expenses are not counted until they are actually paid. Example Your computer installation business finishes a job in November, but it doesn't get paid for the job until three months later, in January. Under the cash method, you would record the payment in January. Under the accrual method, you would record the income in your books in November. Example You purchase a new laser printer on credit in May and pay $1,000 for it in July, two months later. Using cash-method accounting, you would record a $1,000 payment for the month of July, the month when the money is actually paid. Under the accrual method, you would record the $1,000 payment in May, when you take the laser printer and become obligated to pay for it.   Determining the Transaction Date With the accrual method, sometimes it's not so easy to know when the sale or purchase has occurred. The key here is the job completion date. Not until you finish a service, or deliver all the goods a contract calls for, do you put the income down in your books. Likewise, you don't record an item as an expense until the service is completed or all goods have been received and installed, if necessary. If a job is mostly completed but will take another 30 days to add the finishing touches, technically, it shouldn't go on your books until the 30 days pass. Choosing an Accounting Method Most small businesses (with sales of less than $5 million per year) are free to choose which accounting method to adopt. But if your business stocks an inventory of items that you will sell to the public, the Internal Revenue Service requires that you use the accrual method of accounting. Inventory includes any merchandise you sell, as well as supplies that will physically become part of an item intended for sale. Whichever method you use, it's important to realize that neither gives you a complete picture of the financial status of your business. While the accrual method shows the ebb and flow of business income and debts more accurately, it may leave you in the dark as to what cash reserves are available, which could result in a serious cash flow problem. For instance, your income ledger may show thousands of dollars in sales, while in reality your bank account is empty, because your customers haven't paid you yet. And although the cash method will give you a truer idea of how much actual cash your business has, it may offer a misleading picture of longer-term profitability. Under the cash method, for instance, your books may show one month to be spectacularly profitable, when sales have actually been slow and, by coincidence, a lot of credit customers paid their bills in that month. To have a firm and true understanding of your business's finances, you need more than just a collection of monthly totals; you need to understand what your numbers mean and how to use them to answer specific financial questions. Claiming Tax Deductions   The most significant way your business is affected by the accounting method you choose involves the tax year in which income and particular expense items will be counted. For instance, if you incur expenses in the 2006 tax year but don't pay them until the 2007 tax year, you won't be able to claim them in 2006 if you use the cash method. But you would be able to claim them if you use the accrual method, since under that system you record transactions when they occur, not when money actually changes hands. Example Zara runs a small flower shop called ZuZu's Petals. On Dec. 22, 2006, Zara buys a set of new lighting equipment for her shop, for which she will be billed $400. She installs the lighting equipment that day but, according to the terms of the purchase, doesn't pay for it for 30 days. Under her accrual system of accounting, she counts the $400 expense in the December 2006 accounting period, even though she didn't actually write the check until January of the next year. This means Zara can deduct the $400 as a business expense from her 2006 taxable income. Example Scott and Lisa operate A Stitch in Hide, a leather repair shop. They're hired to repair an antique leather couch, and they finish the job on Dec. 15, 2006. They bill the customer for $750, which they receive on Jan. 20, 2007. Because they use the accrual method of accounting, Scott and Lisa count the $750 income in December 2006, according to the date they earned the money by finishing the job. This income must be reported in their 2006 tax return, even though they don't receive the money until 2007. To reiterate: You can usually choose the method of accounting that is most advantageous for your business, unless your business stocks an inventory of items that you will sell to the public, or your business has sales of more than $5 million per year. Tax Years and Accounting Periods Income and expenses must be reported to the IRS for a specific period of time, called your tax year, your accounting period, or your fiscal year. Unless there is a valid business reason to use a different period, or your business is a corporation, you'll have to use the calendar year, beginning on Jan. 1 and ending on Dec. 31. Most business owners use the calendar year for their tax year, simply because they find it easy and natural to use. If you want to use a different period, you must request permission from the IRS by filing Form 8716, Election to Have a Tax Year Other Than a Required Tax Year. Also, your fiscal year can't begin and end on just any day of the month: It must begin on the first day of a month and end on the last day of the previous month one year later.