Accounting Terms

Depreciation

Depreciation is an annual expense that takes into account the loss in value of equipment used in your business. Examples of equipment that may be subject to depreciation includes copiers, computers, printers, and fax machines.

Balance Sheets

A balance sheet is a snapshot of a business' financial condition at a specific moment in time, usually at the close of an accounting period. A balance sheet comprises assets, liabilities, and owners' or stockholders' equity. Assets and liabilities are divided into short- and long-term obligations including cash accounts such as checking, money market, or government securities. At any given time, assets must equal liabilities plus owners' equity. An asset is anything the business owns that has monetary value. Liabilities are the claims of creditors against the assets of the business.

Income Statements

An income statement, otherwise known as a profit and loss statement, is a summary of a company's profit or loss during any one given period of time, such as a month, three months, or one year. The income statement records all revenues for a business during this given period, as well as the operating expenses for the business.

Assets

Assets are subdivided into current and long-term assets to reflect the ease of liquidating each asset. Cash, for obvious reasons, is considered the most liquid of all assets. Long-term assets, such as real estate or machinery, are less likely to sell overnight or have the capability of being quickly converted into a current asset such as cash

Sell the Product

At last we're ready to make a sale. If it's a credit sale, our accounting system must record these transactions: • Reduction in finished goods inventory • Increase in accounts receivable • Increase in sales revenue If this was a cash sale, replace the increase in receivables with an increase in cash. We just finished the eighth step of the business cycle.

Complete the Manufacturing Process

At last, we have completed our manufacturing process. Now we can move the product from the work in process inventory to the finished goods inventory. This transaction particularly interests the sales staff, since it means that the product is now available for sale, and that's what generates their commissions. The entries into the accounting system that record this event go like this: • Reduce work in process inventory • Increase finished goods inventory We've now completed the sixth and seventh steps of the business cycle.

Assets and Liabilities

Balance sheet accounts are the assets and liabilities. When we set up your chart of accounts, there will be separate sections and numbering schemes for the assets and liabilities that make up the balance sheet. A quick reminder: Increase assets with a debit and decrease them with a credit. Increase liabilities with a credit and decrease them with a debit.

Current assets

Current assets are any assets that can be easily converted into cash within one calendar year. Examples of current assets would be checking or money market accounts, accounts receivable, and notes receivable that are due within one year's time

The General Ledger Creates an Audit Trail

Don't let the word audit strike fear in your heart; I am not talking about a tax audit. Although, if you are called to respond to an outside audit for any reason, a well-maintained general ledger is essential. But you will also want an internal trail of transaction so that you can trace any discrepancy (such as double billing or an unrecorded payment) through your own system. You must be able to find the origin of any transaction in order to verify its accuracy, and the general ledger is where you will do this.

First in/first out

First in, first out means exactly what it says. The first widgets you bring into inventory will be the first ones sold as product. First in, first out, or FIFO as it is commonly referred to, is based on the principle that most businesses tend to sell the first goods that come into inventory. Suppose you buy five widgets at $10 apiece on January 3 and purchase another five widgets at $20 apiece on January 7. You then sell five widgets on January 30. Using first in, first out, the five widgets you purchased at $10 would be sold first. This would leave you with the five widgets that you purchased at $20, which would leave the value of your inventory at $100.

Fixed assets

Fixed assets include land, buildings, machinery, and vehicles that are used in connection with the business. • Land Land is considered a fixed asset but, unlike other fixed assets, is not depreciated, because land is considered an asset that never wears out. • Buildings Buildings are categorized as fixed assets and are depreciated over time. • Office equipment This includes office equipment such as copiers, fax machines, printers, and computers used in your business. • Machinery This figure represents machines and equipment used in your plant to produce your product. Examples of machinery might include lathes, conveyor belts, or a printing press. • Vehicles This would include any vehicles used in your business.

Gross profit

Gross profit is derived by subtracting the cost of goods sold from net sales. It does not include any operating expenses or income taxes.

Amortization

In the course of doing business, you will likely acquire what are known as intangible assets. These assets can contribute to the revenue growth of your business and, as such, they can be expensed against these future revenues. An example of an intangible asset is when you buy a patent for an invention.

Inventory Accounting

Inventory accounting may sound like a huge undertaking but in reality, it is quite straightforward and easy to understand. You start with the inventory you have on hand. No matter when you sell product, the value of your inventory will remain constant based on accepted and rational methods of inventory accounting. Those methods include weighted average, first in/first out, and last in/first out.

Cash

Money available immediately, such as in checking accounts, is the most liquid of all short-term assets.

Notes receivables

Notes receivables that are due within one year are current assets. Notes that cannot be collected on within one year should be considered long-term assets.

Identifying assets

Simply stated, assets are those things of value that your company owns. The cash in your bank account is an asset. So is the company car you drive. Assets are the objects, rights and claims owned by and having value for the firm. Since your company has a right to the future collection of money, accounts receivable are an asset-probably a major asset, at that. The machinery on your production floor is also an asset. If your firm owns real estate or other tangible property, those are considered assets as well. If you were a bank, the loans you make would be considered assets since they represent a right of future collection. There may also be intangible assets owned by your company. Patents, the exclusive right to use a trademark, and goodwill from the acquisition of another company are such intangible assets. Their value can be somewhat hazy. Generally, the value of intangible assets is whatever both parties agree to when the assets are created. In the case of a patent, the value is often linked to its development costs. Goodwill is often the difference between the purchase price of a company and the value of the assets acquired (net of accumulated depreciation).

Pay Suppliers

Sometime during the production process we must pay our suppliers if we bought the raw materials on credit. The accounting entry for this transaction does two things: • Reduces accounts payable • Reduces cash

Owners' equity

Sometimes this is referred to as stockholders' equity. Owners' equity is made up of the initial investment in the business as well as any retained earnings that are reinvested in the business.

Straight-line depreciation

Straight-line depreciation is considered to be the most common method of depreciating assets. To compute the amount of annual depreciation expense using the straight-line method requires two numbers: the initial cost of the asset and its estimated useful life. For example, you purchase a truck for $20,000 and expect it to have use in your business for ten years. Using the straight-line method for determining depreciation, you would divide the initial cost of the truck by its useful life. The $20,000 becomes a depreciation expense that is reported on your income statement under operation expenses at the end of each year. For tax purposes, some accountants prefer to use other methods of accelerating depreciation in order to record larger amounts of depreciation in the early years of the asset to reduce tax bills as soon as possible. You need, additionally, to check the regulations published by the federal Internal Revenue Service and various state revenue authorities for any specific rules regarding depreciation and methods of calculating depreciation for various types of assets.

Accounting for the business cycle

The business cycle is nothing more than the flow of transactions needed in your business to complete a sale and collect the proceeds. It's important to setting up your accounting system. We want to know what types of transactions are involved and the accounting entries to make along the way. Most companies business cycles progress something like this: 1.Purchase raw materials. 2.Enter goods into raw materials inventory. 3.Begin the manufacturing or assembly process. 4.Enter goods into work in process inventory. 5.Pay suppliers or pay employees (at service companies). 6.Complete the manufacturing or assembly process. 7.Enter goods into finished goods inventory. 8.Sell the inventory. 9.Collect payment for credit sales. Briefly, here is the way your accounting system interacts at each stage of the business cycle.

Depreciation

The concept of depreciation is really pretty simple. For example, let's say you purchase a truck for your business. The truck loses value the minute you drive it out of the dealership. The truck is considered an operational asset in running your business. Each year that you own the truck, it loses some value, until the truck finally stops running and has no value to the business. Measuring the loss in value of an asset is known as depreciation. Depreciation is considered an expense and is listed in an income statement under expenses. In addition to vehicles that may be used in your business, you can depreciate office furniture, office equipment, any buildings you own, and machinery you use to manufacture products. Land is not considered an expense, nor can it be depreciated. Land does not wear out like vehicles or equipment. To find the annual depreciation cost for your assets, you need to know the initial cost of the assets. You also need to determine how many years you think the assets will retain some value for your business. In the case of the truck, it may only have a useful life of ten years before it wears out and loses all value.

Collect the Receivable

The final stage of the business cycle is conversion of the receivable (which is an asset) into spendable cash. When the customer pays, the accounting system records a decrease in receivables and an increase in cash. This ends the business cycle and the various accounting transactions involved. The accounting system we're setting up will cover every one of these transactions.

General Ledger

The general ledger is the core of your company's financial records. These constitute the central "books" of your system, and every transaction flows through the general ledger. These records remain as a permanent track of the history of all financial transactions since day one of the life of your company

Debits and Credits

These are the backbone of any accounting system. Understand how debits and credits work and you'll understand the whole system. Every accounting entry in the general ledger contains both a debit and a credit. Further, all debits must equal all credits. If they don't, the entry is out of balance. That's not good. Out-of-balance entries throw your balance sheet out of balance. Therefore, the accounting system must have a mechanism to ensure that all entries balance. Indeed, most automated accounting systems won't let you enter an out-of-balance entry-they'll just beep at you until you fix your error. Depending on what type of account you are dealing with, a debit or credit will either increase or decrease the account balance. (Here comes the hardest part of accounting for most beginners, so pay attention.) Figure 1 illustrates the entries that increase or decrease each type of account.

Operating expenses

These are the daily expenses incurred in the operation of your business. In this sample, they are divided into two categories: selling, and general and administrative expenses.

WHAT YOU WANT FROM YOUR ACCOUNTING SYSTEM

The kind of information we found in the prior examples is what you want from your accounting system. This feedback must • Be accurate • Fulfill management's requirements • Be easy to use We can employ information like this in solving problems and running the business. As well as having the attributes of accuracy, relevancy, and simplicity, our accounting system ought to be set up in such a way that it does not require an inordinate amount of time to maintain. Remember, you aren't an accountant, and we don't want you to spend your time trying to do accounting. Further, your accounting system should not require a CPA to operate it or to interpret the output. Some of the popular automated accounting systems require specific knowledge not only about computers but about the field of accounting as well. Make sure that those running the system have the background needed to install and operate it. If they don't, get a package that is more in tune with your firm's capabilities. Further, if you are using an automated accounting package, it must run on the computer equipment that is either currently in place or to be acquired in the near future. If you choose to use an automated accounting system, this book will be of immense help in teaching you the basics of how it works. Whether manual or automated, all accounting systems use debits, credits, a general ledger, and subledgers. All entries are posted the same way. The only difference is which buttons to push. The last chapter demonstrates methods of selecting the proper automated accounting system for your company.

Information Means Profits

The purpose of the accounting system is to communicate. It produces useful information (not raw data) that tells specific things about the company. To those who understand what this intricate system is saying (and you'll be one of them by the end of this book), it's like money in the bank. Suddenly, information that you need to run the company is at your fingertips. Of course, this information is couched in financial terms. That's the language your accounting system uses. But it's not complicated and-with help from this book-it's not foreign.

Setting up the General Ledger

There are two main issues to understand when setting up the general ledger. One is their linkage to your financial reports, and the other is the establishment of opening balances. The two primary financial documents of any company are their balance sheet and the profit and loss statement, and both of these are drawn directly from the company's general ledger. The order of how the numerical balances appear is determined by the chart of accounts , but all entries that are entered will appear. The general ledger accrues the balances that make up the line items on these reports, and the changes are reflected in the profit and loss statement as well. The opening balances that are established on your general ledgers may not always be zero as you might assume. On the asset side, you will have all tangible assets (the value of all machinery, equipment, and inventory) that is available as well as any cash that has been invested as working capital. On the liability side, you will have any bank (or stockholder) loans that were used, as well as trade credit or lease payments that you may have secured in order to start the company. You will also increase your stockholder equity in the amount you have invested, but not loaned to, the business.

Long-term liabilities

These are any debts or obligations owed by the business that are due more than one year out from the current date.

Retained earnings

These are earnings reinvested in the business after the deduction of any distributions to shareholders, such as dividend payments.

Identifying liabilities

Think of liabilities as the opposite of assets. These are the obligations of one company to another. Accounts payable are liabilities, since they represent your company's future duty to pay a vendor. So is the loan you took from your bank. If you were a bank, your customer's deposits would be a liability, since they represent future claims against the bank. We segregate liabilities into short-term and long-term categories on the balance sheet. This division is nothing more than separating those liabilities scheduled for payment within the next accounting period (usually the next twelve months) from those not to be paid until later. We often separate debt like this. It gives readers a clearer picture of how much the company owes and when.

Differences between Manual and Automated Ledgers

Think of the G/L as a sheet of paper on which transactions from all four categories of accounts-assets, liabilities, income, and expenses-are recorded. Some of them flow up from various subledgers, and some are entered directly into the G/L through a general journal entry. An example of such a direct entry would be the payment on a loan. The same concept of a sheet of paper holds for each subledger that feeds the general ledger. A computerized accounting system works the same way, except that the general ledger and subledgers are computer files instead of sheets of paper. Entries are posted to each and summarized, then the summary is sent up to the G/L for posting.

Components of the Accounting System

Think of the accounting system as a wheel whose hub is the general ledger (G/L). Feeding the hub information are the spokes of the wheel. These include • Accounts receivable • Accounts payable • Order entry • Inventory control • Cost accounting • Payroll • Fixed assets accounting These modules are ledgers themselves. We call them subledgers. Each contains the detailed entries of its specific field, such as accounts receivable. The subledgers summarize the entries, then send the summary up to the general ledger. For example, each day the receivables subledger records all credit sales and payments received. The transactions net together then go up to the G/L to increase or decrease A/R, increase cash and decrease inventory. We'll always check to be sure that the balance of the subledger exactly equals the account balance for that subledger account in the G/L. If it doesn't, then there's a problem.

Total liabilities and owners' equity

This comprises all debts and monies that are owed to outside creditors, vendors, or banks and the remaining monies that are owed to shareholders, including retained earnings reinvested in the business.

Total assets

This figure represents the total dollar value of both the short-term and long-term assets of your business.

Liabilities and owners' equity

This includes all debts and obligations owed by the business to outside creditors, vendors, or banks that are payable within one year, plus the owners' equity. Often, this side of the balance sheet is simply referred to as "Liabilities."

Accrued payroll and withholding

This includes any earned wages or withholdings that are owed to or for employees but have not yet been paid.

Accounts payable

This is comprised of all short-term obligations owed by your business to creditors, suppliers, and other vendors. Accounts payable can include supplies and materials acquired on credit.

Accounts receivables

This is money owed to the business for purchases made by customers, suppliers, and other vendors.

Common stock

This is stock issued as part of the initial or later-stage investment in the business.

Net income

This is the amount of money the business has earned after paying income taxes

Mortgage note payable

This is the balance of a mortgage that extends out beyond the current year. For example, you may have paid off three years of a fifteen-year mortgage note, of which the remaining eleven years, not counting the current year, are considered long-term.

Total current liabilities

This is the sum total of all current liabilities owed to creditors that must be paid within a one-year time frame.

Last in/first out

This method, commonly referred to as LIFO, is based on the assumption that the most recent units purchased will be the first units sold. A "widget" is an imaginary item that could be just about any product. The advantage of last in, first out accounting, or LIFO, is that typically the last widgets purchased were purchased at the highest price and that by considering the highest priced items to be sold first, a business is able to reduce its short-term profit, and hence, taxes. Suppose you purchase five widgets at $10 apiece on January 4 and five more widgets at $20 apiece on February 2. You then sell five widgets on February 20. The value of your inventory, using LIFO, would be $50, since the most recent widgets purchased, at a total value of $100 on February 2, were sold. You were left with the five widgets valued at $10 each.

Net income before taxes

This number represents the amount of income earned by a business prior to paying income taxes. This figure is arrived at by subtracting total operating expenses from gross profit.

Cost of goods sold

This number represents the costs directly associated with making or acquiring your products. Costs include materials purchased from outside suppliers used in the manufacture of your product, as well as any internal expenses directly expended in the manufacturing process.

Notes payable

This represents money owed on a short-term collection cycle of one year or less. It may include bank notes, mortgage obligations, or vehicle payments.

Weighted average

Weighted average measures the total cost of items in inventory that are available for sale divided by the total number of units available for sale. Typically this average is computed at the end of an accounting period.

Purchase Raw Materials

What happens when you buy the raw materials used to create your company's product? You receive the goods, and you either pay cash for the goods or obligate the company for future payment. Both transactions require these accounting entries: • Increase raw materials inventory • Decrease cash (if you paid on the spot) • Increase accounts payable (if you didn't) At this point, we've covered the first two steps of the business cycle listed above.

Begin the Manufacturing Process

When we use raw materials to make our product, the accounting system transfers the inventory from raw materials to an intermediate stage called work in process (WIP for short). This transaction explains the third and fourth steps of the business cycle.

Subledgers and the General Ledger

Your accounting system will have a number of subsidiary ledgers (called subledgers) for items such as cash, accounts receivable, and accounts payable. All the entries that are entered (called posted) to these subledgers will transact through the general ledger account. For example, when a credit sale posted in the account receivable subledger turns into cash due to a payment, the transaction will be posted to the general ledger and the two (cash and accounts receivable) subledgers as well. There are times when items will go directly to the general ledger without any subledger posting. These are primarily capital financial transactions that have no operational subledgers. These may include items such as capital contributions, loan proceeds, loan repayments (principal), and proceeds from sale of assets. These items will be linked to your balance sheet but not to your profit and loss statement.