Accounting
Like all small business
owners, you went into business with a dream: to sell your unique product or
services and make a living for you, your family, and your employees. As your
business grows ‘beyond the checkbook’ your record keeping and reporting and
compliance needs also increase. Now you have customers to track, vendors to
pay, sales to record, and a full set of accounts to maintain. You probably also
have an accountant who is preparing your federal and state taxes for you and
your growing business.
But now you find yourself spending more time
keeping your books than keeping your customers happy. You understand the
importance of having accurate books, but you have a lot of stresses on your
time, so accounting never seems to get the time it requires. Further, you
willingly skipped all those high school and college accounting courses,
figuring you weren’t “going to be an accountant anyway”. Well, surprise! Not
only are you an accountant, you are a lawyer, a shipping clerk, a customer
service rep and more – all in the pursuit of your dream.
So what can you do to make
this work? The first step is to understand what all those accounting terms mean
and how they all fit together. At the end of this booklet is a glossary of all
the relevant accounting terms that will help you understand the science of
accounting. Much like computers, understanding the terminology will help you
understand their meaning and their relevance to you and, more importantly, help
you analyze and run your small business.
Before we go any further,
keep this in mind: you don’t have to be an accountant to run MYOB. All
too often small business owners use this line to shun doing any type of record
keeping, to their own detriment. The reality is, I’m not a mechanic, but I can
drive my car. I’m also not a plumber, but I can fix a running toilet and I’m
certainly not a doctor, but I can put a band-aid on my kid’s bumps and bruises.
All it takes is the will to succeed and the desire to run a successful
operation. Period. Will it be easy? I wish I could say yes. Will it be
frustrating? I wish I could say no. Will it be invaluable to your business and
your long-term success? You bet! While our goal here is to help you understand
the basic concepts of accounting, one of the great things about MYOB is that it
does all the debits and credits for you.
Your Daily Lives
First, lets start with an
overview of how accounting fits into your daily life. Quite simply, every
transaction you make results in an entry into your “books”. Whether it is a
receipt of cash, a sale, a check you’ve written or a deposit from a customer –
every transaction gets recorded in your books at some point. The timeliness and
accuracy of when and how you record your transaction directly affects your
ability to manage your business and your cash flow.
If you think your business is
“checkbook-centric”, remember that there are plenty of transactions that do not
involve cash that should be recorded in your books. Anything that affects the
things you own (assets) like repairs or purchases, all require a transaction.
Anything that affects what you owe (liabilities) like sales taxes or payroll
taxes requires a transaction to be recorded. Anything that affects sales
(revenue), like an invoice or a product return needs to be recorded. And, as
you no doubt already know, all your vendor bills (expenses) are recorded when
paid. Just because cash is not exchanged does not mean there are no entries to
record. For example, you probably sell items or services on credit. In this
simple example, you record the sales when your invoice is issued, and then
subsequently record the cash receipt when your customer pays you.
Cash vs. Accrual
Accounting
Simply
put, cash based accounting recognizes revenue and expenses when cash is
received or expensed. In our simple example above, your revenue would be
recognized when you receive payment from your customer
– not when you invoice them. Conversely, expenses
would be recognized when cash is disbursed – not when the bill is received. For
most small businesses, a hybrid system works best and it looks something like
this: Revenue is recorded when invoiced so you have the ability to track
receivables. Expenses are recorded when bills are paid. In effect, you are
using accrual based accounting for revenue recognition and you use cash based
accounting for recognizing expenses. In the end, your accountant will make the
necessary adjustments in order to prepare and file your tax returns. They will
take your hybrid system and adjust it to reflect cash based or accrual based
numbers.
The Golden Rules of
Accounting
Lets discuss the Golden Rules of Accounting. They
are:
1.) Debits ALWAYS EQUAL Credits 2.)
Increases DO NOT NECESSARILY EQUAL Decreases 3.) Assets -Liabilities =
Owner’s Equity (The accounting equation!)
Don’t let the words Debits and Credits
scare you. They simply refer to the Left side and Right
side of a ‘T Account’, a graphical representation of the amounts
recorded into an account (see the examples below). Every
transaction recorded into MYOB is posted to your accounts as a combination of
debits and credits, we do al the work for you. For an individual transaction,
total debits always equal total credits. A check written to pay rent is an
increase to Rent Expense (a debit) and a decrease to Cash (a credit).
Chart of Accounts
The chart of accounts, or simply accounts, is a
list of categories into which all your accounting transactions will be
recorded. In MYOB they are defined by a five digit number and account name: A
one digit prefix designates what type of account it is (and where it will be
displayed on your financial statements), followed by a four digit main account
number. With MYOB, you have complete control over your account numbers and
their names.
Here is a table that will help you understand
what this means and how it applies to your business.
|
ACCOUNT NUMBER |
ACCOUNT TYPE |
INCREASE |
DECREASE |
Balance Sheet (As of a ‘point of time’) |
1-xxxx |
Assets |
DEBIT |
CREDIT |
2-xxxx |
Liabilities |
CREDIT |
DEBIT |
|
3-xxxx |
Owner’s Equity |
CREDIT |
DEBIT |
|
Profit and Loss (For a ‘period of time’) |
4-xxxx |
Revenue |
CREDIT |
DEBIT |
5-xxxx |
Cost of Goods Sold |
DEBIT |
CREDIT |
|
6-xxxx |
Expenses |
DEBIT |
CREDIT |
The exceptions are contra accounts, which are accounts that are offset
against another account. Examples include: Accumulated Depreciation, Sales
Discounts, and Sales Returns and Allowances.
Let’s drill down on how each account type
actually relates to your business.
Assets An asset is anything you
own in your business. They are the things in your office, your computers,your
vehicles, your receivables owed by customers and your cash on hand. Everything
you own is considered an asset of the business. Assets are used to generate
revenue and purchase other assets. For example, when you buy a new computer,
you use one asset (cash) in exchange for another asset (equipment).
Liabilities
Your liabilities are the
things you owe, like sales taxes received from sales but not yet paid to the
state, or loans payable to your bank. Another example are your credit cads,
unless you pay your balance off every month, the money you owe to your credit
card company is considered a liability on your books. Liabilities represent
claims against your assets.
• Owner’s Equity
The
difference between the value of your assets and the total of your liabilities
is the value of your company. As the Accounting Equation states: Assets
-Liabilities = Owner’s Equity. Depending on the type of taxable entity you
created when you first formed your company, the Owner’s Equity section of your
Chart of Accounts and Balance Sheet may have another name.
Revenue
The revenue of your company is the total amount
of proceeds generated for providing goods and services to your customers. This
is typically the total amount of the invoices you generated for your customers.
Cost of
SalesCost
of Sales refers to the total value of the goods and services that were sold to
your customers. Typically, this refers to items based businesses that buy
inventory for resale or a manufacturer who builds items for resale. Total
revenue less cost of goods sold equals your gross profit.
• Expenses
Expenses are the costs you
incur to run your business, whether they are fixed costs (independent of how
much business activity you have, like rent) or variable costs (directly related
to how much business activity you have, like shipping).
� T Accounts and
Double-Entry Accounting
T accounts are a graphical
representation of debits (left side) and credits (right side) in a specific
General Ledger account. Double-entry accounting means that every transaction
has at least one debit and one corresponding credit. The total debits always
equal the total credits
Account Name (x-xxxx)
debits
credits debits
credits debits
credits
Below is a series of
typical accounting transactions and their affect on the appropriate General
Ledger accounts. The next page shows the financial statements resulting from
these entries.
Financial Statements
The primary financial statements of any business
include the Balance Sheet and the Profit and Loss. Together, they represent the
total financial picture of your business. They must be reviewed as a set
because collectively they tell you about your business, both in the short term
and the long term.
• The Balance Sheet
The Balance Sheet, one of the primary financial
statements, is a reflection of your total assets, less total liabilities and
the difference, or owner’s equity. The balance sheet reflects a ‘point in
time’; for example, you could produce a Balance Sheet as of December 31, 2002
that would reflect all the account balances “as of” that date, or as of a point
in time. For example, you would see the balance of your assets, liabilities and
owner’s equity accounts on December 31.
The Profit
and Loss Statement (or Income Statement) The Profit and Loss, also one of the primary
financial statements, is a reflection of your total revenue generated, less the
cost of items sold (which equals your Gross Profit), less your operating
expenses (which equals your Net Income or Loss). The profit and loss reflects
results for a ‘period of time’: the net income or loss for a specific period of
time, for example, January 1, 2002 through December 31, 2002.
These are the financial statements that result
from the example transactions above. In our example below, the owner also
invested $5,000 cash into the business at the start of the year to fund its
operations.
ABC Inc. Balance Sheet ABC
Inc. June 30, 2002 Profit and Loss Statement January 1, 2000 through June 30,
2002
Assets
Cash |
$2,350 |
Revenue |
||
Accounts ReceivableInventory Total
Assets |
$550 $1,500 $4,400 |
Sales COGS Gross Profit |
$2,950 ($1,500) $1,450 |
|
Liabilities |
$ |
0 |
Expenses |
|
Equity |
|
|
Office Expense Rent |
$1,250 $800 |
Owners Investment Current Year
Earnings |
$5,000 ($600) |
Total Expenses |
$2,050 |
|
Total Equity |
$4,400 |
|
|
|
Total Liabilities and
Equity |
$4,400 |
|
|
The
Equity section of your Balance Sheet includes an account called “Current Year
Earnings” which represents the year to date net income or loss of your
business. The life to date history of profit and losses for your business is
recorded into the Retained Earnings account. At the close of every year, the
Current Year Earnings accounting is rolled into (closed) the Retained Earnings
account. In our example above, our business is brand new, so the loss for the
year is presented on the Balance Sheet as a reduction of Equity in the Current
Year Earnings account. If the next fiscal year produces a $2000 profit, the
Retained Earnings account will reflect the balance of $1,400 (a $600 loss plus
a $2,000 profit), the cumulative balance. Each year, your Profit and Loss
information is closed into your Retained Earnings account, that is how the
Balance Sheet and the Profit and Loss report are tied together.
Again,
it is important to remember, that a Balance Sheet represents a point in time
(as of June 30), while a Profit and Loss represents a period of time (January 1
through June 30).
� Terminology
Accounts Payable: Money or other obligations
owed to creditors for services and materials, a Liability on the Balance Sheet.
Accounts Receivable: Money or other
obligations due for services rendered or items sold on terms, an Asset on the
Balance Sheet.
Accrual Based Accounting: Represents a method of
recording accounting transactions when they occur, whether or not cash has
changed hands.
Accrued Liabilities: Represents expenses that
are incurred prior to being paid. For
example, salaries earned by your employees and paid in a subsequent month are
accrued as a liability until they are paid.
Accrued Revenue: Represents revenue that
is earned and recorded but not yet received in the form of cash.
Asset: The things a company
owns, seen on the Balance Sheet and represented as 1-xxxx accounts in your
Chart of Accounts.
Balance Sheet: The primary financial
statement that shows detailed assets, liabilities and equity at a point in
time.
Cash Based Accounting: Represents a method of recording accounting
transactions most easily described as accounting for cash transactions. Entries
do not affect your financial statements until cash changes hands. In this
environment, you do not track receivables and payables. Cash received is
recorded as income when received and expenses are recorded when paid.
Chart of Accounts: A list of categories or
accounts where transactions are recorded.
Cost of Goods Sold (COGS): Represents the cost of
items or services sold to customers.
These costs are kept in the Inventory asset account (1-xxxx) until they
are sold. Then they are passed over to the COGS (5xxxx) account. Seen on the
Profit and Loss and represented as 3-xxxx accounts in your Chart of
Accounts.
Credit: A credit is the right hand side of an account,
represented in T-Account format on the previous page.
Current Year Earnings: This account represents
year to date earnings, not yet recorded into the Retained Earnings account.
Debit: A debit is the left hand side of an account,
represented in T-Account format on the previous page.
Deferred Revenue: Represents income
received, but not yet earned. This is typically a liability account.
Double Entry Accounting: MYOB products follow the
convention of Double Entry Accounting.
Every accounting transaction is comprised of debits that equal credits.
Equity (Capital): The owner’s interest in
the business, which is the total assets minus the total liabilities of a
company, seen on the balance sheet and represented in as 3-xxxx accounts in
your Chart of Accounts.
Expenses: Costs incurred in the
business used to generate revenue, seen on the Profit and Loss report and
represented in your Chart of Accounts as 6-xxxx accounts.
General Ledger: An accounting record where
all of your accounts are maintained. In
MYOB products, when you enter any transaction, the General Ledger accounts are
automatically updated.
Gross Profit: Represents your revenue
from sales of inventory or services, less Cost of Goods Sold, before overhead
expenses.
Journals: Account ledgers where
entries are recorded. MYOB products have General, Disbursements, Receipts,
Sales, Purchases, and Purchases journals. Every transaction creates a
corresponding set of debit and credit entries in a specific journal.
Liability: The things a company owes in cash or other
resources, represented as 2-xxxx in your Chart of Accounts. These are claims
against assets.
Net
Profit/Loss: Total
Income minus Total Expenses. The bottom line!
Operating
Profit:
Profit before Other Income is added and Other Expenses are subtracted.
Overhead Expenses: Represents the expenses
of a business independent of how much revenue is generated. Can also be
considered Fixed Costs, things like rent, salaries, and utilities.
Profit and Loss Statement ( or Income Statement): The
primary financial statement that shows detailed revenues and expenses for a
period of time.
Prepaid Expenses: Represents expenses that
are paid in advance of incurring them. For example, you might pay a year’s
worth of insurance and accrue 1/12 of it each month. This is typically an asset account.
Retained Earnings: Represents the
cumulative net income or loss of a business since its inception. When you Start
a New Year in MYOB products, the program automatically transfers your year-end
income or (Current Year’s Earnings) loss to this account. This is called the
closing entry.
Start a New Year: The process in MYOB
products that closes a fiscal year, transfers your Current Years Earnings to
Retained Earnings and prepares the accounts for a new fiscal year. All Income and Expense accounts are ‘zeroed
out’ to start the new year.
Subsidiary Ledgers: Customer and vendor
balances that equal the amount of the Accounts Receivable and Accounts Payable
General Ledger accounts.
Trial Balance: A list of all your General Ledger accounts
and their current balances.
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