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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.
you have to add a negative number. it increased accounts payable. Both times you had balancing entries.another credit.debit (increase) the correct account number. it decreased cash. You aren't touching your cash account this time . and you are adding a negative number . one debit. you credit it. as you know. is a debit account. Take the drill example above. they will mostly be simple entries . The 4000 and 5000 series. and you better increase your cash debit cash. If. That just makes a bigger negative number. now that you've got the basics of the double entry system. 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. which is a debit. credit accounts payable. which is a negative number. instead of paying cash.So stay with me . Cash.the credit just did different things each time. when you have paid cash for an item. Make a sale.if you credit a liability account. or a credit. So the balancing entry has got to be a credit entry crediting sales increases the amount you are listing in sales. the next step is simply a matter of beginning to enter the info. The expense entry stays the same .instead. Whenever you make a purchase of an item that goes to one of your expense accounts. the expense accounts. Positive entry.sales are considered a credit account. one credit . A friend had a memory trick for learning this concept: " making a sale is a credit to you. you're increasing your accounts payable. you are actually adding a negative number to a negative number. because sales is a negative number. The 3000 series is just something you have to remember somehow. You enter an expense as a positive number (debit) to increase your record of what you've spent.the expense is increased. The number gets bigger. or debited. As you enter checks you've written. because to increase the liability. are all debit accounts. In the asset account. This is going to be the drill for the majority of your entries. So. you charged that drill. and credit (decrease) cash. Increasing your liability. to increase a liability account. there you have your balancing entry debit expense. you always increase your expense. And." Another way to consider it is by thinking of the simplest sale. where you sell something and get some cash. if you . Even those things you charge. (credit). In the liability account.
To keep the process simple. Regular exceptions to this process will be: . like a bank payment on a loan: credit cash.materials. Until then. go through it and total what part of the money due goes to which account. debit the liability account you're paying on for the amount of principal.When you make an addition to inventory: inventory is a cost you need to count as an expense only when you actually use it. but debit two accounts. it's an asset. . debit expense. . When you USE inventory. and debit (increase) the appropriate expense account . write it on the bill and use that when you make the entry into the system. when you receive a bill. make your entry after you pay your bill.When you pay an expense that has been listed as a liability. So when you purchase inventory.. and debit interest for the amount of interest expense. don't forget the information that you will need to set up your depreciation schedule. etc.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. supplies. and it will increase the record of what you have paid in interest expense. As you make these entries. credit cash and debit inventory .that will increase the value of your inventory. or an inventory change account. credit (reduce) inventory. Doing this will decrease what you owe on the loan by the principal amount you have paid. and the entry will always be credit cash.are keeping your bills current. .
expense. Any that were paid with cash should have that noted on them. the accounts payable balance per your books should equal all the outstanding bills). Assuming you pay all your bills each month. 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. You may have paid for some things with cash. your entry is debit expense. have a separate account number for each bank account. all those entries will be credit cash. When you are closing out our sample month. and cash. Cash Discounts . Later. Using your list. you will rebuild a new AP list for the current month. When you enter these bills. increase expense). Go through and enter all the other checks you have written by check number and to whom they were written. Accounts Payable. or additions to inventory. Each month. This is where that amount goes: you debit the entire expense to the materials account as if you didn't take the discount. Same entry . you have things you have used or purchased.it's just keeping track of these things that's different. you will have paid these bills. (And. which were in AP the previous month. In our sample chart of accounts we have set up account number 7100 for cash discounts on purchases. this step will bring your accounts payable to zero (and if not. You should have a file of receipts. If you have more than one cash account. reducing your cash. you need to make and keep a list of items that were in accounts payable at the end of the month. Reduce your cash. the entry will be: credit (reduce) savings. debit expense (decrease cash.so you don't list them again. In general. reduce your accounts payable. If you are paying a material order and get to deduct 2% for paying early. Make sure you put everything in the correct expense account.purchases. You already listed the expenses the prior month . At the end of any given month. The entry to show on your books that you have paid your accounts payable is: debit accounts payable. These are listed as accounts payable. but have not paid for. try to do so. The entry here is exactly the same as if you paid with a check . but credit the actual amount of your check to cash. and credit the remainder to the cash discounts account. along with what the item or account number was. credit accounts payable. identify the checks written for items that were listed in accounts payable the month before. This helps . payments made on large equipment or fixtures. credit cash. If you move money from a savings to a checking account. Expenses paid by cash.debit. credit. and most of them will match a check (it will be easier to confirm if you've written the check number on the receipt). and credit the account from which you are actually taking the money out of. by all means.Expenses paid by check. and debit (increase) checking.
Some of these come out of the employee's check . paper) Small tools Postage $25. You can do this as many times over the month as you need to . gross wages for the office help and sales are indirect expenses. which will be for the total of what you spent over the month.but even then.52 $22. The ones that come out of your pocket require two entries: they get debited to payroll tax expense (either direct or indirect. just write a check and make the balancing entries the same way. the taxes the government makes you withhold. Others come out of your pocket. and taxes that you have to pay that you don't withhold. but it needs to be accounted for correctly. Payroll. Then put that petty cash in a box. credit the bank account you are taking the cash from. This one's a bit trickier. If you have an accounting system and are using payroll.so take the time to book it correctly. Do a one-time entry in your books to set up the petty cash account. If you want $300 in the account. In Payroll you have: o o o the wages themselves. and at the end of the month you'll have a list that looks like this: Supplies (coffee. If you're doing payroll by hand. (Recall that gross wages for people actually producing your goods or providing your services are direct expenses. keep track of what you've taken out. and start all over again. with a receipt. and debit your petty cash account. you may need some understanding of exactly what that system is doing for you.you see the value of paying early. Gross wages get debited to the wages expense account ..divided properly between direct and indirect labor. When you enter that check.every time you need to replenish the petty cash box. and if you're in a position to do this fairly regularly. You never make the entries to Petty Cash itself after you initially set up the account. small tools and postage.) Payroll taxes. it looks great to your banker . Every time you take some out to spend.82. or $60. depending on where the employee's wages . unless you want to make it larger or smaller at some point.supplies. state and federal unemployment taxes. Cash the check. credit cash and debit the three appropriate expense account numbers . like the employer portion of FICA. you should be in good shape .00 $13. Petty cash is a handy item to have for small purchases.you've actually done a lot of things when you write that paycheck. Petty Cash.30 Write a check to petty cash.the federal withholding and the employee's share of FICA. you will calculate and record the components described below.. put the cash into the box.
Now.55 5. Determining tax liabilities.60 19. will contain all the FICA that was withheld from everyone's check. His workers' compensation rate is 13.either FICA payable. and that is what you owe for the employer portion of FICA. using a fictitious shop person who's going to have his salary listed under 4010. In the liability accounts. UI payable. All the taxes that are withheld from the employee's check as well as those which come out of your pocket . and it doesn't matter whether it comes out of the employees check or out of you pocket.go).00 Credit 53.are listed as liabilities.these taxes are figured as a percent of gross. as they must. 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. The FICA payable. For example. and credited to the proper liability account . there is no need to separate direct from indirect numbers .00 19.40 92. Unemployment will be based partly on a state multiplier and partly on your company's unemployment history. based on their W-4 status and earnings.00. multiply it by .60 92.75 . the entries balance. You can get a chart which shows the Federal and state taxes due for each employee. you take the gross wage. direct labor. he made $700. Debit 700.45 4010 Gross wages 2102 FICA withheld 2100 Fed withheld 2104 State tax withheld 1001 Cash (paycheck amount) Up to this point.40 78.65% of gross wages.55 42. In this payroll period. Here's the picture of what you do with payroll.2 %. FUTA payable or Workers Compensation payable. when the FICA and Medicare tax is 7. in addition to the amount that you are matching as the employer. as well as your company's performance. Fed payable. for example.it's just plain money you owe.00 585. and are easier to deal with if you sort them out by what kind of tax they are.0765. For each of these you have to figure the total due based on the gross wages for that period . Workers compensation will depend on the industry code your employees work under.
The sale. you do . because that's what her paycheck says. HOWEVER. and come up with an ending balance. your task is to figure out where the discrepancy is. These entries are pretty easy. which is a liability account (you would have to refund the money if you don't do the job). and this is beyond the scope of this walk-through guide. Now for the good stuff .15). your expenses. Inventory is a current asset account.00. Under the accrual method. You're just holding the person's money for them. or is costing you his gross wage of $700.it's a customer deposit. Inventory. put those on top. Accounts Receivable. That must equal the amount you list as AR on your books .45. Have a simple chart that shows who owes you money each month . If you have a lot of jobs going at any one time. and how much remains to be earned. The entry will be debit to cash (it's in the bank. send us an email and we'll forward some information to you.have a beginning balance which equals last months' ending balance. You have made. If you're adding any benefits like insurance or retirement. OK. Customer deposits turn into cash as you earn them .let's enter your sales. so you can easily keep track of how much has been turned into sales. you'll be entering sales as you earn them and invoice your customers.Accounts Receivables and sales operate much the same as Accounts Payables and your purchases. Remember: sales accounts are credit accounts. and have not actually done any work on that project this month. here's a point you need to keep in mind: that person. how you evaluate each month what part of each job is done. Credit sales. now you've entered your accounts payable. it is not yet truly a sale . you'll make your job easier if you give each job its own number in customer deposits. So when you want to increase the amount of sales. So if you need help with accounting for contractors. your payroll. which in this case total $171. who you thought was costing you $585. you have not yet earned that sale. if you have just signed a contract. you enter as an immediate sale. Right? So.As a side note. It's a bit of a call. which means it is something you have that can be turned into cash quickly.if it doesn't. This is a prime example of the kind of overhead you need to make sure gets added into your pricing structure. When you purchase inventory. either way) and credit customer deposit. if it is an item you have on hand and give to the buyer. you make the entry as a credit entry.15 ($700 wages plus the payroll tax costs to you.through the purchase of materials or labor performed. on the surface: you receive a check and put it in your account: debit cash. is actually costing you $871. the equal amount that you debited cash. keeping it safe. Sales & Customer Deposits. Enter any payments they've made or new charges they've incurred.
Deposits. and debit the 4101 account.000 over 36 months. by listing an inventory item.or at least part of it . and you'll find that each month you need to book $138.which matches what you paid for it. you will make an entry: Debit $140 Credit $140 5312 Advertising Expense 1003 Inventory What you're saying is that each month.technically. . Put that as a lump sum in your books for any given month. and you'll be a sad business owner. Basically. so the entire cost should not show up this month. with no cash changing hands.) As you use your raw materials. to increase inventory. Another item that has its own spot in your books is deposits you pay for various things. to a deposit with the post office for express mail. materials. Another way that inventory might come up is when you buy $5.89 (Call it $140 and be done with it).the other side. until it's all gone. The whole sequence will look First. you have to cover $140 as the cost of your brochures. Divide $5. I bought it this month.around. These amounts all go into the account called deposits.or outdated. from workers compensations to the cleaning deposit on a rental. so one side of the entry is credit cash .which is simple. It'll show up on your income statement as an actual cost.000 worth of brochures. 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. you'll think you're losing money hand over fist.000 this: Then. Each month the value of that inventory will decrease by that amount. to reduce it. each month as you use the brochures. These are items that will be returned to you when you finish using the service . it's your money that they're holding. try this: decide how long those brochures will last you. in our system #1800. you're just saying. as prices go up. Basically. which is of course under the Asset section of your Balance Sheet.so out of cash. You have a value of raw material in inventory . you credit inventory. Theoretically your brochures will be gone about the same time . Some common inventory items are materials . (You cannot increase the value of your inventory as it sits in the yards. say three years. think of it as buying the material from yourself. The trick with inventory is knowing how to book it when you use it.000 like Credit $5. is debit inventory. but I plan to keep it . So. you buy the brochures and put them in inventory: Debit 1001 Cash 1003 Inventory $5.
You take those totals. all those will have their separate totals that you work with the same way. tools) by the same amount. because things DO in fact wear out and have to be replaced. Depreciation 7100 Gain (or loss) on the sale If your balancing entry had been a debit. and this is where that process is built into your books. don't count those chickens until you figure in your depreciation. This is where you account for assets you sell or dump. You also have a record of how much it has been depreciated. on that sale. and you won't have to worry about it. and say. you'll go through each of these numbers and adjust it so it's exactly in line with your depreciation schedule. which was a gain of $1. my tools are going to depreciate a total of $890 this year. buildings.truck 1301 Accum. You enter the cash you make off that sale in 1001.400. Here's how to think about it: You paid $6. and whatever it takes to make those number balance is your gain.780.17. You managed to get someone to pay you $5.200. you have its value on that up to date list of assets you keep. its value had decreased by $3.820. and you have your monthly depreciation. OK. to you it's actually worth $3. So to give yourself a really good idea of where you are. Say you sold a truck which you bought for $6. each month make the entry of debit account 5341 (depreciation expense) $75.820 Credit $6. Take that number and divide by 12. or loss. Most computer accounting systems have a setup where you can tell it to make those entries for you automatically each month. your accountant will give you a sheet listing your assets and the amount they will depreciate this year.780 1001 Cash 1300 Fixed Assets .200 $1.200.780. So.580. It has depreciated by $3. It's real stuff.at the end of the year. Making the entries monthly saves you the shock when you . The entry to record this sale would be as follows: Debit $5.400 $3. Don't worry about being too exact . which in this case is $74. If you have office equipment. If you sell a vehicle. cash. 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. Depreciation. It's not a cash expense.400. and credit 1601 (accumulated depreciation.Gain or Loss on Sale of Assets. it would have meant you lost money on the sale. Basically. This is an entry that you can make the call on whether you're going to deal with it monthly or annually. meaning you had expensed out that amount of money over the period of time you had the truck. On your books. and you sold it for $5. vehicles. Then you balance that entry with a credit to the asset account and a debit to the accumulated depreciation account.
total up what you know you've added to or deleted from it. Each item should have a beginning balance. Even those accounts you don't check over with a finetoothed comb should at least be glanced at. $1. Divide it by nine and if it divides cleanly and evenly by nine. Check what your inventory was last month. To make this easy.293 item. Suspense. you're ready to check the rest of the books. and you have just got to turn your computer off and go home. If you are making all these entries and they don't balance. $500. the adjustment will be to debit office supplies (account 5550) and credit inventory. and an ending balance. Now I'm going to let you in on a secret if you promise not to take advantage of it. an amount of current activity.31.in a mid-year month.but it should never be allowed to get large. You've already done cash. That will reduce your inventory . Then. and petty cash is a static account.000. by the way. If inventory shows on your books as a higher number than you actually know you have.sorry! . make the correcting entry. and take it back out of suspense by making the opposite entry you did before. and your depreciation expense at the end of the year cuts that in half. you can let go. all your notes. whereas at the end of the year you will want to tie every single account down exactly. Divide that number by two and see if anything becomes obvious.but I do have some good hiccup cures for you after class). so the next item is inventory. How intense you get about this can well depend on what time of year it is . item by item. to make sure they make basic sense. and figure out the problem. Month End Adjustments. that means you have transposed an entry somewhere . put the remainder that won't balance in suspense. while you're out of the system. you'll know something is entered in the wrong place. look at all your entries.maybe you just left out an entry. IF you have tried everything you can think of. keep a list of what is in inventory: office supplies. If you had to credit suspense to make things balance.or you'll drive yourself even crazier. like March or July. this is not an old wive's tail . and you'd better get serious about finding out what that is. If you have $250 less value in actual office supplies than you show on the books. this time debit it .thought you'd made $20. and that should be your current total inventory. adjust that against the material expense..500 car liability all of sudden turns into a $15. (No. Suspense may end up with little bits and pieces of numbers . The process is this: go through your balance sheet. Come back in. also reduce your profitability. do this: first..maybe you said 765 instead of 756. Now that you're sure you have the right amount of cash in your system. check the number they don't balance by . If a $3. raw materials.which will. etc. you might be a little more lax about how closely you check every account.
you may want to adjust those once a year.When you close your books for the end of the year.until you have adjusted your books to match physical reality. Paper Trail. items entered backwards (credit when you should debit. what was added to or subtracted from that account over the month. make sure you're accounting for principal and interest correctly . you need to take actual inventory . items overlooked. whether or not you go through this step will depend on how much inventory you carry. This process. 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. These reports will show you the beginning balance for each account. giving your perceived profitability one more opportunity to fly out the window. or items that were transposed when they were entered. As with any of this work. At other times of the year. You need to be able to say what's in each number on your .count it all up and make sure you've really got what you think you do. The good news is that you don't have to do this to every expense 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. it will pay you to take a physical inventory of more often. and you need a good clean system for keeping this information.just check out that your asset and liability accounts are correct. will give you the assurance that your books are correct. If your books are computerized. which are the top four ways to end up out of balance. This will be the easiest place for you to look for those items entered in the wrong account. if you're talking about a small loan it may not be worth adjusting every month . and taking principal against the liability account. If you have large loans. Have a list and update it monthly.and the total of that list needs to equal the AP entry on your balance sheet. can you imagine?). 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. accounts receivable and a list of your assets. completed through your entire balance sheet. of what makes up Accounts Payable . Keep a list of everything you've done. 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. Any materials you have a large value of on hand. 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.putting interest in its own account. and then an ending balance. you will find a good friend in your Detail Trial Balance and Detail Transaction Reports. it can be relatively meaningless. This is actually about the first point in the process that I would actually look at the income statement . You or someone else will at some point need to go back and recreate something you've entered. and you can trust the bottom line on your income statement. Have a list of customer deposits.
) 3. 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. you'll find this process easier to follow and less time consuming. For more information on the types of records you need to keep. check out Documenting your journey. Each and every month you need to compare your income and expenses to your budget. Scan the check register. What?? You don't have a budget? Stop right now and let's go over to the Budget Workshop! 2. 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. 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. I'd say. did you know that the word in the English language with the most consecutive double consonants is subbookkeeper? A heady responsibility. you can take to the bank or use to produce a tax return. You will also need to keep good supporting documentation for your income and expenses. Multiple checks written around the same time to the same vendor could be an indication that funds are being diverted.) This step is important. 1.. And. This review is perhaps one of the most important tools for a small business owner. The following checklist will keep you in touch with your business. Congratulations! You've now got a real set of books that you can use to analyze your profitability and pricing. and it will save you hours of head scratching later. 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. The goal is not to have an accurate budget. there are a number of items that that you as the business owner should do periodically. (You also might want to reduce the time spent writing and posting multiple checks. 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. Review the bank reconciliation..balance sheet. Compare actual results to budget. and perhaps even prevent you from serious losses. particularly if you have one person doing . It's not nearly as intimidating as it sounds. 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. It's a great way to learn what's working and what's not working with your business. Every month.
Take a physical inventory. etc. what it owns (assets) and what it owes (liabilities and net worth). Again. Once you have a system in place. this can't be done if you don't get your canceled checks back from the bank. 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. you probably will want to work with your accountant and get some type of perpetual inventory system set up. 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. so if you have a large amount of inventory or a high volume business.4. BALANCE SHEET The balance sheet is a snapshot of the company's financial standing at an instant in time. 5. Many small businesses have very poor inventory records.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. 6. 8. Look at any adjustments to the bank accounts. 7. but they will send late notices). Look at canceled checks. The balance sheet shows the company's financial position. there are some excellent software packages available for the small business that will make this process relatively painless. preparing financials. all the bookkeeping: writing checks. The "bottom line" of a balance sheet must always balance (i. Review statements from vendors. The . Review Payroll register and handout the paychecks. or that an invoice has been overlooked. you should take a physical inventory at least once a year and compare the actual goods on hand to the inventory records. Now of course this isn't an issue for a business with only 1-2 employees. 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. Review your Accounts Receivable and aging. In this case you might want to spend a little extra time with the check register. posting entries. Here you want to make sure that your business is in good standing with vendors -. assets = liabilities + net worth). that you recognize the vendors and scan the endorsements on the back.long overdue invoices might be an indication that a check you thought was going to a vendor actually went in someone else's pocket. stale items. But "padding the payroll" is a common problem in some industries -. etc.e. Obviously. This needs to be done on a regular basis.
is the process of using cash to purchase current assets that are to be sold at a profit and collected as cash.individual elements of a balance sheet change from day to day and reflect the activities of the company. The Balance Sheet shows a "picture" of the assets. For example. when a supplier sends you inventory on credit. Liabilities and net worth are composed of creditors and investors who have provided cash or its equivalent to the company in the past. with the profits left in the business.what resources you own (Assets) and the creditor or owner/investor that made it possible to acquire these resources (Liabilites and Equity). In reality. you must be able to pay your supplier in cash in a timely manner. Remember that Assets = Liabilites + Equity! . In this lesson we'll discover how you can monitor your ability to collect revenues. and even assess your ability to satisfy creditors and stockholders. In this section. Assets. As a source of funds. liabilities and equity (net worth) of a business as of a specific day. 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. Recall from the Basic Accounting lesson that you record both an asset (inventory) and a liability (accounts payable) when you purchase goods on credit. how well you manage your inventory. a company uses funds to purchase raw material inventory that is produced into finished goods inventory. represent the company's use of funds. sold at a profit to create a receivable and collected to become cash once again. we will teach you about the elements of the Balance Sheet and how they either use or provide "funds". they enable the company to continue in business or expand operations. on the other hand. If creditors and investors are unhappy and distrustful. 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. the company's chances of survival are limited. The liabilities and net worth on the balance sheet represent the company's sources of funds. Analyzing how the balance sheet changes over time will reveal important information about the company's business trends. The Balance Sheet shows two "views" of the business -. Of course. Theoperating cycle. The company uses cash or other funds provided by the creditor/investor to acquire assets. As an example. she in essence is providing "funds" that you may use to operate your business. which is also known as the cash-to-cash cycle. then used to pay the supplier.
. longer term loans and so forth. After all.Assets . and so on. Current Assets.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. anything of value that is owned or due to the business is included under the Asset section of the Balance Sheet. 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. then inventory. Now let's take a moment to look at a picture of a Balance Sheet. then the short term bank loans. and who has helped you acquire them (and these folks expect repayment!). It is always shown in two parts to reflect the accounting equation (A=L+E). then accounts receivable... Throughout this lesson we'll refer back to the use of funds and cash in the business operation. trade creditors will be paid regularly. Assets are shown at net book or net realizable value (more on this later). so cash and short term investments are shown first. Individual items within each section are listed by how close they are to cash.Liabilites = Equity What you own . ASSETS As noted previously. but appreciated values are not generally considered. Recall the cash-to-cash cycle. On the liability side. Take a moment to study the operating/cash cycle diagram. Don't forget that you can click one of the red reference numbers anytime to view the sample Balance Sheet. remember that the Balance Sheet is just a report card showing where the funds are.
Current assets are those which mature in less than one year. The ABC Company gives Net 30 Day terms to its customers. It does not indicate the company's terms have been lengthened or that management of collections has decayed. Receivables which remain at one month's worth of sales. In 19X2 sales rise to $2. Accounts receivable are dollars due from customers. Include all checking. land. sales are $1. building. rise to $200. Cash pays bills and obligations. the investment you must make in receivables also rise.000. an invoice is sent to the customer. For more on terms refer to the article on Aging Accounts Receivables. which are equal to one month's sales. Accounts Receivable (A/R). money market and short term savings accounts under Cash. The receivable exists for the time period between the selling of the inventory and the receipt of cash.200. 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.000. ABC's customers are prompt payers and all receivables are collected on the 30th day. receivables. . Cash is the only game in town. If cash is inadequate or improperly managed the company may become insolvent and be forced into bankruptcy. Any sale made today will be collected one month from today. Inventory is sold and shipped. Inventory. They arise as a result of the process of selling inventory or services on terms that allow delivery prior to the collection of cash. This investment in receivables is automatic and unavoidable.000.000.400. go to the lesson on cash management and cash flow projections. Receivables are proportional to sales. On average. Receivables. ABC will have one month's worth of sales always invested in receivables. For more on cash management.000. the company is forced to increase its investments in accounts receivable by $100. and later cash is collected. Example: Receivables vary with sales. As sales rise. total $100. machinery and equipment do not pay obligations even though they can be sold for cash and then used to pay bills. In 19X1. Due to the growth in sales.
Your accountant can assist you with determining whether or not you should record an allowance for doubtful accounts. Thus. Selling inventory does not bring cash back into the company -. As your business matures. and 2) Change in average collection period. you will write off the receivable and record a "charge off" loss.it creates a receivable. 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.Analyzing Receivables: Receivables increase for two reasons. Look at your A/R Aging Report as a start. If the calculated collection period is greater than the offered terms. At some point in time you may have customers that are unable to pay for the goods or services they received from you. Inventory. you will be able to estimate the amount of such losses. the company's terms of payment are compared to the actual collection period. Many businesses calculate this expense on a monthly basis based on sales or a percentage of past due accounts. some measure of the receivable's quality must be used. To analyze the change in the collection period. Growth in sales is a healthy reason to increase receivables. When you determine that you will be unable to collect these accounts. At the same time. To determine receivable quality. In the process. The allowance for doubtful accounts is subtracted from gross receivables on the Balance Sheet to show the net receivable balance. Inventory consists of the goods and materials a company purchases to re-sell at a profit. Allowance for doubtful accounts. Purchasing inventory to be sold at a profit is the first step in the profit making cycle (operating cycle) as illustrated previously. 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. inventory is often the first use of cash. Only after a time lag equal to the receivable's collection period will cash return to the company. We do this by comparing the actual collection period to the stated payment terms. The actual collection period is known as Days In Receivables. The collection period and the terms should be about equal. 1) Growth in sales. . however may not be so favorable. Here's an example of how analyzing your financial statements can help you spot unfavorable trends before they become a problem. sales and receivables are generated. particularly if the reason is due to a collection problem with a customer. For a company that sells a product. then its time to dig deeper and see if some of your customers are lagging in paying their accounts. The company purchases raw material inventory that is processed (aka work-in-process inventory) to be sold as finished goods inventory. Changing the collection period.
the company never lets its stock of vases shrink to less than seven days worth of sales. A company's inventory cycle is divided into three phases: 1. The ordering phase is the time it takes the a company to order and receive raw materials. one day to paint and one more day to dry.the 3. If the company orders clay today.The correct level of inventory is a function of the length of the company's inventory cycle and the company's sales level. The ABC Company is a producer of specialty pottery vases. three days to dry. The production phase is the time it takes to produce finished goods from raw materials. 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 finished goods/delivery phase is the amount of time finished goods remains in stock and the delivery time to a customer. Ordering and receipt of the clay generally takes 14 days. The delivery phase is very short because most of the product will be delivered in the immediate area. and finished goods/delivery phase. To prevent stockouts. The company imports clay from the Big Timber Landfill. the clay base is mixed with water and rests one day to set up to the proper texture. a vase made of that clay can be delivered to a customer no sooner than 22 days from now. Once in the shop. Management estimates that delivery takes one day at most.the 2. it will receive the clay in 14 days.the ordering phase. 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. the company reorders whenever clay inventories drop to 14 days. Because it takes seven days to produce seven days worth of sales. production phase. 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. The production cycle from wetting clay to drying the paint is seven days. . It takes one day to spin the vase.
and that management operates more comfortably with 27 days' sales in inventory. The company must keep an investment in inventory equal to its inventory cycle. and particularly not the business of a small company with limited financial resources. stale inventory. another ratio can be used as an indicator of the "quality" of inventory. Thus in the above example. the company's total inventory cycle is 27 days. poor inventory controls. or fudging (miscounting). To measure quality. As sales rise. Notes receivable is probably a note due from one of three sources: . arising because the company made a loan. Knowing this. 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. 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. it eventually will run out of stock because clay ordered today cannot be delivered as a vase for 22 days. in the form of a promissory note. Days In Inventory Inventory Cycle In Days Notes Receivable (N/R) N/R is a receivable due the company. 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. Insufficient inventory indicates potential stockouts. Excessive inventory may indicate. Just as we measured the "quality" of accounts receivable. ABC must have sufficient cash to acquire at least 22 days of inventory. To keep the cycle running smoothly. Making loans is the business of banks. We have learned that this investment requires the use of cash. the amount of inventory sold daily rises and the investment in a day's worth of inventory must increase or stockouts will eventually occur. We do this by comparing the actual inventory level to the inventory cycle. not of operating business. inventory will be at a level slightly greater than the inventory cycle. If ABC keeps only 15 days' worth of investment in inventory.Therefore. the company must keep its investment in inventory equal to 27 days worth of sales.
Treating it in any other way leads to possible manipulation of the company's stated net worth. An officer or owner borrowing from the company is the worst form of note receivable. Miscellaneous and other current assets generally consist of small deposits or receivables. the benefit of which will be received within the next 12 months. The customer's obligation may have been converted to a promissory note. Insurance is the most common form of prepaid expense. Other Current Assets consist of prepaid expenses and other miscellaneous and current assets. it can co-sign on the loan advanced by a bank. Cash has been depleted by paying a bill before the benefit from the purchase has been received. Customers. They include assets such as: o o o Land Building Machinery and Equipment . Customer notes receivable is when the customer who borrowed from the company probably borrowed because he could not meet the accounts receivable terms. Non-current assets are defined as those that will not mature into cash within the next 12 months. but the company is neither a charity nor a bank. Employee. 3. Fixed assets represent the use of cash to purchase physical assets whose life exceeds one year. such as a down payment on a home. If the company wants to help the employee. and banks and other lending institutions frown greatly upon it. Prepaid expenses are the uses of cash to purchase in full a good or service. Employee notes receivable may be for legitimate reasons. They can consist of the following asset categories: o o o o Net Fixed Assets Investment into Subsidiaries Intangibles Other Assets Fixed Assets. Other Current Assets.1. When the customer failed to pay the invoice according to the agreed upon payment terms. Non-Current Assets. 2. The premium is paid prior to the receipt of the benefit. or Officers of the company. it should be declared as a dividend or withdrawal and reflected as a reduction in net worth. If an officer takes money from the company.
For most analysis purposes. intangibles are ignored as assets and are deducted from net worth because their value is difficult to determine. Intangibles represent the use of cash to purchase assets with an undetermined life and they may never mature into cash. Total Assets is the sum of all the assets owned by or due to the business . through incremental annual charges (amortization) against income. Other assets consist of miscellaneous accounts such as deposits and long-term notes receivable from third parties. an amount is charged to expense and accumulated annually in a contra-account known as accumulated depreciation. They are turned into cash when the asset is sold or when the note is repaid. As the asset wears out. Intangibles are recouped. An exception to this is purchased patents that may be amortized over the life of the patent. Other assets. the use of cash to purchase a benefit which will be expensed at a future date. The gross fixed asset (purchase price) less the accumulated depreciation equals the Net Fixed Asset Value (also known as book value).o o Furniture and Fixtures Leasehold Improvements Calculating Net Fixed Assets. Accumulated depreciation is the cumulative sum of all the years' worth of wearing out that has occurred in the asset. like fixed assets. Intangibles consist of assets such as: o o o o o Research and Development Patents Market Research Goodwill Organizational Expense In several respects. Standard accounting procedures require most intangibles to be expensed as purchased and never capitalized (put on the balance sheet). When a fixed asset is purchased for use in operations of the business it is recorded at cost. Gross Fixed (Purchase Price) Assets Accumulated Depreciation = Net Fixed Assets (Book Value) Intangibles. intangibles are similar to prepaid expenses.
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