HISTORY OF ACCOUNTING

Once upon a time, Luca Pacioli wrote a math book. It was just a little survey and should have been treated like ordinary books of the time and read and then disappeared into historical archives and forgotten. A few brief chapters on practical mathematics made this one special. The time was 1494. Columbus had discovered America just two years before. The author was a Franciscan monk. The chapter on practical mathematics addressed mathematics in business. He said that the successful merchant needs three things: sufficient cash or credit, an accounting system that can tell him how hes doing, and good bookkeeper to operate it. His accounting system consisted of journals and ledgers. It rested on the invention of double-entry bookkeeping. Debits were on the left side because thats what debit meant, the left. The numbers on the right were named credits. If everything was done right, then the bookkeeper could do a trial balance (summa summarium). Add up all the debits and then add up all the credits, he said. If everything had been done right, the totals should match. If not, that would indicate a mistake in your Ledger, which mistake you will have to look for diligently with the industry and intelligence God gave you. He wrote. Experience Before computers came along Jack had never got a trial balance right the first time. Many hours were spent looking for the mistakes, though not necessarily with the reverent attitude that Father Pacioli advised! Double-entry bookkeeping was so simple and met the needs of business so well that it caught on immediately. In 1850 14 accountants offered services to the public in New York City, 4 in Philadelphia, and 1 in Chicago. The British Isles was the superpower of world commerce. Many enterprises and individuals employed the services of public accountants. Citing the needs of courts to employ public accountants to aid those Courts in their investigation of matters of accounting select accountants were titled Chartered Accountants. The US equivalent title is Certified Public Accountant. These titles are used to this day. The arrival of the income tax laws were another major event in accounting history. Attorneys naturally thought that since income tax returns were legal documents, they would have exclusive rights to prepare them. Accountants replied that since that the bulk of the work in preparing a return involved accounting calculations, they were more properly accounting work. The substance of the tasks trumped legal argumentation. US law firms in the 1920s were slow to incorporate income tax preparations into their business skills. Public accountants saw a new lucrative opportunity and jumped into tax work with both feet. By the time the lawyers

challenged the accountants for practicing law without a license, income tax preparation had been so thoroughly identified with accountants that they lost the case. The Great Depression rocked the integrity of the accounting profession. The British Steamship Company was just one of the large world giants that went bankrupt just after posting large profits. How could profitable companies go bankrupt? Investors asked. Court cases showed that the economic reality was that the companies werent profitable after all. The profits were the result of bookkeeping tricks. Moreover the reserve funds that were on the books were nonexistent. So far, these events could be chalked up as individuals' fraud (albeit widespread fraud) and handled through the ordinary course of justice. What made the events historic was when the accountants testified in court that the bookkeeping practices were generally accepted accounting principles and then proceeded to prove that they were. This was more serious than just individual malfeasance. If the basic rules of accounting gave false information, then something was wrong with the basic rules of accounting. Worse, followed. Corporate accounting was anything goes. There were no rules, per se. There were just generally accepted accounting principles. They were generally accepted because most accountants did certain things. Since accountants were hired by and answered to corporate management, they served the needs of management, not the public. That meant that in practice, the primary function of accounting was to make management look good. Things had to change. While the profession managed to escape the full New Deal government takeover, rules, standards and legal responsibility had to be shouldered. The American Institute of Certified Public Accountants (AICPA) created their own rule-making body, the Committee on Accounting Procedure. They accepted government licensure. Most importantly, auditing financial statements was limited to CPAs and they were made personally liable for their audit reports. The new Securities and Exchange Commission (SEC) required audit reports for all publicly traded companies. With these measures, accountants contributed to restoring public trust in the stock market and the economy during the depression years. Time passed by. Criticism mounted that the AICPAs rulemaking was not keeping pace with the needs of the expanding economy. Around 1960 the American Institute of Certified Public Accountants scrapped the Principles Committee and set up the Accounting Principles Board (APB) in 1959. Still the cry for more uniformity and consistency in accounting continued. In 1973 the Financial Accounting Standards Board (FASB) replaced the APB. It brought two major changes over the previous rules-setting bodies. First it was independent of the AICPA. Second, previous procedural impediments to rule making were overhauled. In short, it was geared to crank out rules lots of rules.

In the next several decades, it did. And for those accounting areas where it did not want to go, other bodies were set up. There was the Cost Accounting Standards Board and The Government Accounting Standards Board. In addition to the statements from these Boards, the accountant had to contend with new rules from such sources as Statements of Position, and Accounting and Auditing Guides from the AICPA, and Technical Bulletins and Interpretations from FASB. By the 1990s the complaint was standards overload. Rule making continued apace. Ronald Reagan set an historic precedent in 1982 by killing an accounting board (the Cost Accounting Standards Board). The idea that society has enough accounting rules in an area remains a unique event in the history of accounting. The auditing standards mirrored the accounting standards. Small business was deeply impacted by new auditing requirements. More audit rules meant more audit work and hence more costs to businesses. In the 1980s the AICPA announced the Statements on Standards for Accounting and Review Services (SSARS). Henceforth, CPAs provided three levels of accounting services: 1) Compilation, 2) Reviews and 3) Audits. Auditing: The Expectation Gap covers these. Responding to public pressure, they okayed plain paper management only statements in 1998. Other countries had their own rule-making activities. As the gray areas in accounting came to be covered by rules the flexibility of accountants to accommodate the differing practices of different countries disappeared. What to do? More rules, of course! The International Accounting Standards Commission promulgated the rules for international accounting. This was set up in Britain just before the turn of the century. With the corporate scandals directly involving misleading accounting in the early years of the 2000s, accounting has come back to the days of 1930s. This time it did not escape direct government oversight. And they are not living happily ever after.

GAAP vs. OCBOA

GAAP stands for Generally Accepted Accounting Principles. OCBOA stands for Other Comprehensive Basis of Accounting. As the terms imply one is the standard accounting and the other is other. The backbone of GAAP accounting is the concept of the matching principle. This means that revenues should be matched with expenses and vice versa. Accountants record transactions when economic events occur in addition to when cash is transferred.

Example Assume you bill a customer $1,000 for services. When you send the bill, you credit revenues $1,000 and debit accounts receivable for $1,000. When you produce the financial statements, they show $1,000 of revenue even though you havent yet got the money. Later the customer pays up. You credit accounts receivable and debit cash for $1,000. Use the same principle for expenses. Who makes these rules? The main rule making body is the Financial Accounting Standards Board (FASB). The Government Accounting Standards Board (GASB) uses FASB statements as their base. International Accounting rules comes from the International Accounting Standards Commission (IASC). The Cost Accounting Standards Board went defunct in 1982. Their standards applied to Federal Government Contractors that were big businesses. Even though that board no longer exists, their standards still apply. (See Code of Federal Regulations, Title 4 of the General Accounting Office.) The main OCBOA accounting principles are cash basis and tax basis. Cash basis accounting means that transactions are only recorded when cash exchanges hands. Experience Over the years weve encountered hardly any cases of pure cash accounting. Accountants usually slip in some accrual accounting. Accounts receivable and payable are not cash basis transactions yet they frequently pop up in financial statements labeled cash basis. Cash basis statements should have no liabilities at all except for loans of cash. Practical needs of business seem to constantly impinge on the cash basis accountants world. Management wants to know how much money they really owe the bank. What about those pesky payroll deductions? And what happened to their depreciation deduction? So accountants in practice usually let some non-cash transactions slip onto their books. What Cash Basis financial statements usually means is that not all the required accrual entries have been made. Tax basis accounting means that the financial statements use the same methods that will apply to the tax return. There should be differences between book and tax amounts when this accounting basis is used. Tip On the income statement use the term taxable income. Below that have a section titled Other Revenues and Expenses. Put non-deductable expenses and excludable revenues here.

Example Assume the salesman buys lunch for some prospects. The cost is $50. Only of meals and entertainment is deductable. Therefore the only expense that should be recognized should be $25. What about the other $25 that the salesman spent? Code that to nondeductable expenses in the Other category. Experience Tax basis is the most popular form of Certified financial statements. There are two reasons. 1)Managers like these kind of statements because they tell them what their taxable income is looking like. 2) CPAs like them because the rules arent as sticky as for GAAP basis statements. Knowing what accounting basis were used to produce the financials is critical to understanding them. OCBOA statements may not show all the liabilities and assets. GAAP statements may show income that substantially differs from taxable income.

TYPES OF ACCOUNTANTS
Whats the difference between a bookkeeper and an accountant? Oh, about $10 an hour. Thats an old joke Jack first heard when he took his first accounting class way back in 1974. Its point is that there is a blur. Heres a list of the different jobs in this line of work and what they mean. Bookkeeper Theoretically these people are at the bottom of the accounting food chain. Theoretically. In reality, good bookkeepers are the most valuable of the accounting team. The basis of all the financial reporting system rests upon their data input. In theory bookkeepers record transactions from main sources like invoices and checks. Accountants make accruals and adjustments. Full Charge bookkeepers, however, can do the whole accounting process complete through final financial statements. Many of these people command considerable salaries. Accountant These people can take the basic data and adjust it to final status. In large companies accountants may specialize in one area such as payroll or accounts payable. Controller (also Comptroller) This is the head of an accounting department. Its a fancy word for chief accountant. Chief Financial Officer (CFO) The CFO is head of sever finance related departments. Accounting is only one. Others might be financial management, collections, and fixed assets. If a company has an internal auditing staff, this department should report to the CFO. This is so that the CFO can receive independent opinions about accounting operations.

Enrolled agent (EA) These are usually but not necessarily accountants. EAs may represent taxpayers before the IRS. They must pass an exam administered by the IRS. Accountants who offer their services to the public usually try for the EA status. Certified Public Accountant (CPA) CPAs can attest to the validity of financial information. This means that they can audit financial statements and report on whether they are accurate or not. This authority is licensed by law. CPAs receive a license to practice from a state board of accountancy. They must pass exams to achieve this. Current requirements include two years of experience and five years of college. The IRS grants CPAs and attorneys automatic authority to practice before it. Other designations Accounting titles have sprung up like weeds in the last few decades. Some of the main ones are: CMA stands for Certified Management Accountant. This is great for cost accountants. CIA stands for Certified Internal Auditor. In addition for the internal auditors, government auditors of contractors have found this designation to be useful.

INTERNATIONAL ACCOUNTING
The two main problems with accounting for companies that are either partially or wholly outside of the United States are: 1. Different countries have different accounting rules and 2. Different currencies. The problem for the former are being settled by the promulgation of International Accounting Standards. The second issue cannot be addressed by simply issuing a regulation. Example Assume: Youre recording a checks from a US bank account in the accounting books. You finish with that task and now go on to the next checkbook. This is for a French bank account and all the amounts are in francs. What do you do? If you record the checks as written then you will have a general ledger with amounts meaning different things. You must convert all foreign currencies to one single currency. That means you've got to determine the exchange rates of each transaction and then multiply them out. Example Assume: Supplies has 2,000 chalked up to it. If 1,000 are from the US bank and 1,000 are from the French bank, how much has been spent on supplies?

When dealing with different currencies youve got to compare apples to apples. If the financial statements are to be stated in francs, then all of the US dollars have to be converted to francs. If the financial statements are to be stated in dollars, then vice versa. What about reconciling bank statements? Imagine printing out a Quickbooks report where all of the amounts are in dollars but the bank statement is in francs. Now dont forget that currencies fluctuate continuously and you get the scope of the problem. International accounting is one of the most intellectually challenging areas of the field.

THE FUTURE OF ACCOUNTING

2002 was a major watershed in the history of the profession. Major corporate scandals rocked the world. Enrons and Worldcoms bankruptcies was notorious because they had been reporting profits instead of losses. How can you play the game if you dont know the score? Worse, what if the scorekeeping is misleading? These were the significant questions that society has to face. The bankruptcies were caused by liabilities that were not reported on the balance sheets of these companies. They were termed off-balance sheet liabilities. Something had to be done. For several decades now, the primary criticism directed against rules-makers such as the Financial Accounting Standards Board (FASB) has been standards overload. The complaint has been that there are too many standards. Accounting rules have become too nit-picky and costly to implement. The quality of financial statements are only marginally enhanced by new rules. Thus the criticism. Experience When we first learned about FASB in college they had just finished Statement Number 33. Their statements are now pushing Number 150. Many of these statements are very detailed and require much work to implement. The government is going to have more of a role in promulgating accounting rules in the future. This is not a good thing. The IRS Code remains complicated, invasive, and contradictory. The glory of FASB and its predecessor bodies has been that they have been above politics at least that kind of politics. Another trend of recent decades has been the concentration of public accounting. When we were in college, the majority of public accounting was controlled by the big eight accounting firms. Mergers brought the number down to the big six. With Arthur Andersons collapse, it is now down to five. Many companies will only hire accountants who have worked for these select big firms. The future of this trend is unclear. Elitism and the good old boy/girl networks will push the

trend in the direction of concentration. The internet pushes it in the opposite direction. Today the accountant can operate on a truly global scale. Next day air, long distance telephones, video conferencing, faxes, and e-mail can partially offset the lack of a local presence. Customers who are smart will value reliability and personal attention over corporate bigness in their accountants. Computer software are reaching the limits of their potential. This may seem like we are really sticking our necks out on this one. The small businesses packages will acquire the more of the features of the big, expensive packages. However, bookkeepers must still use judgment on the treatment of transactions. That means that accountants must still manipulate the data in accounting programs. Internet banking is increasingly taking over the data entry function. That only can cover deposits and checks. Other business transactions still have to be entered in by hand. Many public accounting firms are turning to consulting as their revenue generators of the future. Many predict the demise of the staples of public accounting write up work and tax return preparation. Unfortunately for the public but fortunately for the accountants, increasing complexity of accounting rules and tax laws will increase demand for public accountants help. Last, accountants are going to be increasingly affected by the trends towards the paperless office. Already, tax returns can be filed on disk along with workbooks. Source documents can be scanned into such programs as Adobe Acrobat and saved on disk with the tax return file. The IRS has been encouraging e-filing for some years now. For all the glitz about equipment, rules, and globalization, accounting still depends on human beings. The age old qualities of reliability, caring, and honesty will remain the basis of the profession.

THE FINANCIAL STATEMENTS

The Balance Sheets This shows the assets and liabilities of the company. The difference between the two is the equity. Traditionally, assets were listed on the left side of the page. Liabilities and equity were listed on the right. This is significant in understanding debits and credits. Liabilities and equity are always shown together. This means that if liabilities are greater than assets, then equity is negative. The balance shows the position of the company at a single point in time. Its heading always contains a single date. The statement tells you that at the moment the business closed for the

day on the date in the heading, those were the amounts for assets such as cash in bank, liabilities such as taxes due, and equity. The Income Statement This shows the revenues and expenses of the company. The difference between the two is net income. Revenues and expenses are self explanatory. Many income statements just show those two categories with net income at the bottom. However, many situations call for a further breakdown. Companies that buy and sell inventory need to know how much they are making on it. This is gross profit. To do this expenses are broken into two parts: Cost of Goods Sold and Operating Expenses. Example Assume: A furniture store sells $10,000 worth of furniture. It banks $30,000. Expenses other than the cost of the furniture was $15,000. The Income Statement would look like this: Revenue $30,000 Cost of Goods Sold 10,000 Gross Profit $20,000 Operating Expenses 15,000 $ 5,000 Net Income ====== Companies have costs that are not operating costs. Costs from discontinued operations, gains and losses from sale of assets are examples of non-operating amounts. For corporations, income tax expenses gets a below the line (non-operating expense) category. Income statements show the result of activity over a period of them. That is why the dates in the heading will always say something like For the month ended . . . or For the Year Ended . . . These are placed in Other Income and Expense listings below Income from Operations. The Balance Sheet and the Income Statement are the two primary statements because their amounts come straight from the Trial Balance. Net income connects the two. It shows up as an item in Equity on the balance sheet and at the bottom of the income statement. The Cash Flow Statement This compares net income to changes in cash. FASB Statement 95 allows two methods; the direct and the indirect method.

Experience The statement recommends that everybody use the direct method. Almost everybody uses the indirect method because it is easier. Both methods require a reconciliation between net income and net changes in cash. Net income is at the top of the page. Cash is at the bottom. All those things that account for the difference between the two amounts are listed in between. Example Depreciation is an expense that reduces net income. However, no cash actually goes out of the bank account when it is recorded. Therefore it has to be added back to net income as part of the process of reconciling it to cash. The items are broken out into three categories: Operating Activities, Financing Activities, and Investment Activities. Statement of Changes in Retained Earnings This can be changes in capital depending on the type of company. It starts with the beginning balance and then shows the major elements that increased and decreased the equity during the period. Footnotes complete the required financial reporting package. Tip Note the word required in the above sentence. A Financial Statement Report can contain supplemental information depending on what the company needs it for. It can be packaged together with Management Reports, graphs, charts, tables and other information. Management can use the supplemental reports to put its best foot forward.

ASSETS, LIABILITIES, AND EQUITY

Assets are what you own. Liabilities are what you owe. Equity is whats left over. It is your net worth. Assets always equal your liabilities plus equity. If assets are less than liabilities then your equity is negative. Assets are on the left of the balance sheet; liabilities and equity are on the right. This directly corresponds to debits and credits. Debits mean left; credits mean right.

Assets and liabilities are grouped into two main categories: current and non-current. Current assets are those assets that can readily be converted to cash. Bank accounts are of course most readily convertible, but any assets that can be converted to cash within a short time are current assets. Current liabilities are those liabilities that have to be paid off within a short time. Short time for both current assets and current liabilities usually means one year or less. For some companies, it may be the normal business cycle. Non-current assets are further divided into fixed assets and other assets. Even though items of machinery and other assets may be sold in less than one year, fixed assets are still non-current. This is because they are intended to help operate the business for periods of greater than a year. If an asset is bought with the intent to sell for a profit, then it is inventory and is a current asset. Equity consists of money invested in the company by the owners, money taken out of the company by the owners (i.e. their return on their investment), and net income.

DEBITS AND CREDITS

Warning: think of this page as accounting boot camp! This is basic training and I am your drill sergeant. Attention! Alright recruits, heres the acid torture test of accounting. If you have trouble understanding accounting it is because of this one concept. It is the hardest task in all of accounting. After you understand this one concept everything else accounting-wise will be a piece of cake. But before you can go anywhere else, you must first get past this point. There are no fancy icons on this page! Uh, uh! If you want to leave youre going to first have to get by me! Alright recruits! Suck in that gut! Straighten out those shoulders! Forward march! Debits Here is all you need to know about debits: Debits are on the left. Got that? Alright! Next:

Credits Here is all you need to know about credits. Credits are on the right. Got that? Alright! Now some of you recruits are still having trouble with this concept, so let me explain it to you again. Debits are on the LEFT. Credits are on the RIGHT.

And I will repeat: that is ALL you need to know about debits and credits. Generations of accounting students get blocked by this concept. They dont get blocked because it is so difficult. They get blocked because they insist that there must be more to it than this. They bring to accounting the preconception that debits are something that are bad or credits are something that are good. Or they think that credits will increase financial position in some way -or that debits will hurt. Accounting teachers and professors in countless classes over the centuries have tried to get people to remove this excess mental baggage. Theyve tried reason. Theyve tried persuasion. They tried torture. Still people struggle with this concept. Listen to me! I am your drill sergeant! You WILL remove all other thoughts about debits and credits from your mind except for what I tell you! Debits are on the left! Credits are on the right! Period! Fall in! Move out!

Welcome to the obstacle course. Heres where were going to put this concept to work. (Grin!) Assets are on the left. Got that? Debits are on the left. Got that? Do any of you meatheads see a connection? Whenever you code an entry to an asset account that increases the amount, you put the amount in the debit column. And yes, you over there, those assets include cash. If money is received, cash is debited. Not credited, DEBITED!

Why? Because cash is an asset. Assets are on the left. Debits are on the left. Increases to assets are debited. I am your drill sergeant. So there! Over here are the liabilities and the equity. Right face! Over here! The same thing goes for them. They are on the right. Credits are on the right. If you take out a loan, you will credit your liability. That is because loans increase liabilities. Liabilities are on the right. Credits are on the right. And I am your drill sergeant! Now what about the reverse? What about when assets or other stuff goes down? Well, the reverse is (drum roll) the reverse! Credit assets to remove value. Debit liabilities and equity to make them go down. When you write a check, you credit cash. Checks reduce cash. Cash is an asset. Assets are on the left. Credits are on the right. Credits make assets go down. They are the reverse of debits. When you pay off a loan, you debit liabilities. Liabilities are on the right. Debits are on the left. Debits make liabilities go down. They are the reverse of credits. Now hear this! Assets are on the left. Liabilities and Equities are on the right! I will say this again. Debits are on the left. Credits are on the right. Period! Next! Equity consists of (1) money owners have invested in the company and (2) the results of operations. Thats net income to you. Net income comes from where? The Income Statement. Revenues minus expenses are net income. And as I just said, net income is an item in Equity. I am your drill sergeant! Rely on this! Equity is on the Right. The Income Statement accounts all result in net income. Net income is in equity. Which is on the right. This means that anything that increases net income will increase equity. Which is on the right. Revenues increase net income. They are credited. Because they are on the right! Expenses decrease net income. They are debited. Because they are on the left! Period!

You now know all you need to know about debits and credits. Back to the home page! Forward march! Hup two, three, four. Left, right. Left, right. . . . .

DOUBLE ENTRY BOOKKEEPING

Every debit must have a credit and vice versa. Example Assume you write a check for your monthly rent. You reduce cash and increase expenses. Credit cash; debit rent expense. Every transaction has to be analyzed with its impact on at least two accounts. Sometimes a transaction involves more than two accounts. Example You make a loan payment. Part of any loan payment is for interest and part is for principle. So one part of your check is debited to interest expense and the principal reduction is debited to loans payable. The two amounts added together equals the amount of your check which is credited to your asset account for cash in bank. None of this will make sense unless you understand the basic concept of debits and credits. What if you can only see just one account that would relate to a transaction? Punt! Sorry for this flip answer. If it is any comfort to you, this is like solving a puzzle when you know what the answer must be even though you may not see it right away. There ALWAYS is another account. For every entry, for every credit there is a debit ALWAYS!

ACCOUNTING SOFTWARE
What Microsoft is to office software Intuit is to accounting programs for small business. Intuit produces Quickbooks. This has the biggest market share of small accounting programs. Peachtree is the main competitor. One-Write Plus split off from Safeguard Business Systems in 1994, had a rocky transition to Windows from DOS, and has never recovered its former market position. Dac Easy and MYOB are also-rans. There are, of course, a whole lot of others. These programs service the bottom tier of small business. They can handle most general business accounting needs.

The problem that many businesses have with them is that they dont run themselves. Expertise in accounting is needed to install and set them up properly. Many accounting firms including ours will help set the programs up and train personnel to run them. The problem that business owners find is that they initially pay a few hundred dollars for a program and then a couple of thousand dollars in consulting costs. Unfortunately, there is no getting around the necessity of some accounting training to operate these programs. Mid-range programs include Great Plains and MAS90. These programs are for larger businesses with specialized needs. Great Plains has been taken over by Microsoft, so it is getting the full MS treatment. $1,270 is the bottom price for this product. For this price, you do not get the functions that come with Quickbooks or Peachtree. Restaurants or other businesses with specialized payroll needs may want to use a payroll service and stay with the lower end software. For other specialized needs, consider also using spreadsheets and databases. You can enter individual transactions there, then just the totals into the accounting program. Open Office is a free Suite of office programs that rival Microsofts. It has a word processor, spreadsheet, database, graphics, and mail manager modules in it. It is free. The documentation however, isnt as much as for Microsofts Office. The major companies are moving to internet based software. With this concept, you pay an annual fee and run the software off the internet. Software companies like this because only constant upgrades have kept the money flowing in. The biggest change that internet software brings is that it shifts the business model from customers buying software to renting software.

CURRENT LIABILITIES
Current Liabilities are those debts the company owes that come due within one year. Like Current Assets, the operating cycle can be different. In that case, use that to classify debts into current and non-current. Experience The most commonly seen Current Liabilities are those items that affect expenses. Many cases the only items in this section are Accounts Payable and the payroll related items. Accounts Payable, like Accounts Receivable warrant a page all of their own. So does payroll. However, this area affects so much of the Current Liabilities section, that we say more about payroll liabilities here. Payroll Taxes Payable is a big issue with companies. Even cash basis companies need to keep track of their payroll tax liability.

Experience We can negotiate with the IRS regarding income taxes due. They will grant payment plans. With the right reason and the right approach, Offers in Compromise can even reduce the amount of income taxes due. With payroll taxes due, however, the IRS plays hardball. This is because this money was never the employers money to begin with. They deducted it from the employees paychecks for the IRS. Therefore there should be no reason for a company to be unable to pay. Thus the IRS view. In practice, even with the best attorneys and CPAs in the world, it is very bad to mess with payroll taxes. Since this such a big issue, many of even the smallest businesses want to see their payroll tax liability on the Balance Sheet. Payroll tax liabilities come in three flavors: Federal Form 941 Taxes, State Income Taxes, Unemployment Taxes. The 941 Taxes are the income taxes and the social security/medicare taxes. Income Taxes are wholly deducted from the employee. The social security/medicare family of taxes are deducted and then matched by the employer. This means that you deduct a total of 7.35% from the employees paycheck but you pay 15.3% to the IRS. The difference between the two is Payroll Tax Expense but the total is Current Liability. State income taxes, like federal income taxes are deducted from the employees paycheck. Keep state income taxes in a separate account because it is a separate tax. Separate unemployment taxes into federal and state accounts, too. These accounts are paid on separate forms. Use the Federal Form 940 for Federal Unemployment Tax. The amount due will depend on the amount paid for the state unemployment in certain circumstances. To sum up, you need the following payroll tax payable accounts: Federal 941 Taxes, State Income Taxes, Federal Unemployment, and State Unemployment. Generally Accepted Accounting Principles (GAAP) requires other payroll related liabilities. Anything else that the company deducts from an employees paycheck is a liability. The money by law must be paid to the party for which it was deducted. On any date the company will owe wages. This liability is the difference from the date on the calendar and payday. Example Imagine if an employee just quits. You still owe him for the time he worked even though his check is not due until payday. Not just wages, but the rest of the employees deductions have to be accrued, too.

Experience Most of the time OCBOA financials dont report these. Life is complicated enough. Employee benefits are current liabilities. These may include retirement plans, health insurance, bonuses and so on. Short term debt are current liabilities. This means any debt that is due within one year. If a multiyear loan is on its last year, it needs to be reclassified out of Long Term Debt to Current Liabilities. A very important item that many accountants miss is overdrawn bank accounts. If Cash in Bank has a negative balance then it is no longer an asset. It is a liability and it is a current liability. It must be reclassified from Current Assets to Current Liabilities. Title the liability account Bank Overdrafts. Tip Use a reversing entry to do this. This means debit and credit the accounts so that the credit balance is in the Current Liabilities. Then in the following month do another entry that reverses this. Most software accounting programs have an automatic reversing entry feature for situations like this. Unearned Revenue is a Current Liability. Example Lets say you engage our firm Le Moine and James as your accountants. You pay us $1,000 as a retainer. This means that we owe you $1,000 worth of work. If you werent expecting us to provide you $1,000 worth of services, you would never have forked over the cash to us. Of course, if you want to just give us $1,000 smackers gratis and we dont have to do anything for it, then this accounting rule doesnt apply. (Grin!) Another kind of circumstance where unearned revenue comes up is when the end of the period comes before the end of the job. Example We check into your hotel and pay five days in advance. The end of the month comes two days later. The accountant closes your books to provide you your monthly financials. At that point you still owe us three days because you have our money. Unearned Revenue differs from the other liabilities in that the liability gets taken care of by time rather than payments. In the hotel example above, you wait three days, our time is up, we check out, and the liability is done. The account Customer Deposits is a form of Unearned Revenue. An important area of Current Liabilities is owner loans. Many times the Owner or Shareholders

of the business must loan the company money to get by. These loans are Current Liabilities regardless of the owners intent. This is be the owner by definition is in control. To be conservative, accounting rules assume that the owner can pull his money out of the company at any time. The very last thing in the Current Liabilities section is Current Part of Long Term Debt. This will be covered in the next section.

ACCOUNTS RECEIVABLE AND ACCOUNTS PAYABLE

Accounts Receivable is an asset. It represents money that customers owe you. Accounts Payable is a liability. It represents money that you owe for being a customer of somebody else. Both these accounts serve the same function. They allow you to put money into the income statement without cash actually moving. When invoices are sent or received, then transactions are recognized. Example Assume: You get an invoice from the phone company. Book the amount as a debit to Telephone Expense and the credit to Accounts Payable. When you finally get around to paying the bill, book the debit to Accounts Payable instead of Telephone Expense. You dont want the same bill expensed twice! Many accountants record Accounts Payable even though they may pay a bill right away. This is because they want the software program to keep track of each vendors activity. The same is true for keeping track of customers in Accounts Receivable. Key reports for management from this area are Aging Reports. These list the amounts by customer/vendor and by how old they are. Example Assume your Accounts Receivable totals to $10,000. The Aging Report will show you how much of it is current, how much is 30 days past due, how much is 60 days past due, and etc. It will also show the amounts for each customer in each category. Management can use this to analyze their credit policies and, most importantly, to collect the money. GAAP requires that an allowance must be made for bad debts. An estimate must be made on some kind of percentage basis. Credit a contra-account Allowance for Bad Debts on the Balance Sheet. Debit Bad Debt Expense. A contra-account is a balance sheet account whose purpose is to reduce the amount of another account. That is why asset contra-accounts have credit balances while liability contra-accounts

have debit balances. Contra is a latin word that means against. Professional firms like Law Firms or even us Accounting firms may use an account called Unbilled Accounts Receivable. This is for work theyve racked up but arent ready to bill the clients yet. The offset account is a liability account Unearned Revenue.

DEPRECIATION
(in which Office Manager Judi Baker offers a dissenting point of view.) You know that when you take a brand new computer out of its box it is no longer as valuable as the price you paid for it. Fixed assets depreciate in value. The difference between what you bought an asset for and what is is now worth is depreciation. Depreciation is an expense. It is also a contra-account against fixed assets. Example This is what the Fixed Assets section of a Balance Sheet might look like: The journal entry for this might have been Machinery and Equipment $ 50,000 Buildings 100,000 Depreciation Expense (debit) 5,000 Less: Accum. Dep. (20,000) Accumulated Depreciation $130,000 5,000 Total Fixes Assets (credit) ======= Tip - Jacks Make only one journal entry for all your assets. Use only one Depreciation Expense amount in your Income Statement and one Accumulated Depreciation amount in your Balance Sheet. These amounts should be the total of all your depreciation calculations. This is easier on both the accountant and the readers of the financial statements. Few people want to go into all the details of depreciation and it just makes them look more complicated than they need to be. Ignore Kathys tip below. (Grin!) Tip - Judi's Ignore Jacks tip above. (Grin!) Separate listings of Depreciation Expense and Accumulated Depreciation should be in the financial statements for each category of assets. This gives the user valuable information on the aging of a companys plant and equipment. Together with the Cash Flow Statements section on which assets have been bought and sold, an analyst can form useful conclusions about a companys present and future capital needs. Jacks Rebuttal Most users couldnt be bothered. If a user wants to know all that, then provide them the depreciation schedule that gives them even more information. Otherwise why assault users with additional information when financial statements are complicated enough? Judis Rebuttal

Breaking out depreciation isnt all that complicated to do or to read. Aw, come on Jack! Okay, so even partners like us can have our professional disagreements! (Grin!) What about the other $15,000 in Accumulated depreciation (the 20,000 less the 5,000)? Accumulated depreciation is the total of all depreciation for the current period and all prior periods. Not all of the amount of an asset is depreciated at one time. The idea of depreciation is that depreciation goes up as the assets value goes down. So how are the amounts determined? There are a variety of methods. Here are the two most common.

The Straight Line Method

Take the total cost of an asset. Estimate how much it will be worth when you dispose it. The difference between its starting amount and the ending amount is going to have to be depreciated. Now estimate its total useful life. Divide the total difference by the total life. That is the amount to depreciate this period. Example Assume a widget that costs $10,500. Its useful life is 10 years. Its value at the end will be $500. Over the next 10 years you will need to adjust this widgets book value from $10,500 down to $500. In other words, youve got to decrease it by $10,000 over 10 years. This works out to an average of $1,000 per year. The straight line method is to just use the average.

The IRS Method

This is not generally accepted accounting principles (GAAP). It is for accounting on the Tax Basis of accounting which is an Other Comprehensive Basis of Accounting (OCBOA). More on GAAP vs. OCBOA here. The IRS has tables that you use to look up the deductable depreciation amounts. Remember that these tables like all IRS rules are the result of politics not any accounting theory. For example there is the Section 179 Expense election. This allows you to deduct all of the value of new assets up to a certain amount.

Peachtree has a module to track fixed assets and depreciation. Quickbooks does not. A spreadsheet can also track depreciation.

With a spreadsheet like Excel, each row is for individual assets. Columns are for the Assets name, Class, Date Purchased, Amount, Depreciation Method, Accumulated Depreciation Beginning of Year, Depreciation Expense, Accumulated Depreciation - End of Year. The class is the Balance Sheet line description. Then sort by class (Judis tip) and sub-total for your series of journal entries. Use the Depreciation Expense column subtotals for your series of journal entries. Otherwise, just use the total at the bottom for Jacks one comprehensive journal entry.

INVENTORY
Assets whose purpose is for sale to customers are inventory. In a grocery store, food is inventory. Books and magazines are inventory. Cash registers are not inventory. Example A developer builds a tract of homes and puts them up for sale. Are those buildings fixed assets or inventory? Answer: inventory because their purpose is for sale to customers. For people live in those homes, they are fixed assets. Even though a homeowner may hope to sell it sometime down the road, hes using the asset, not just holding it for sale. Inventory accounting shows up in two places in the financial statements. It is a current asset in the Balance Sheet. It is also a part of Cost of Goods Sold in the Income Statement. Experience Few software packages handle the Cost of Goods Sold accounting properly. While in theory Cost of Goods Sold should show Beginning Inventory, Purchases, and Ending Inventory, we lump them all into just one account. This is where you may want to consult your particular accounting programs limitations, to see if you need to do this, too. At the end of the year each company should physically count its inventory. The accountant should price this merchandise at cost and then adjust the books to the inventory that is actually on hand. Both GAAP and IRS rules require a physical count once a year. But how do you count for inventory in the meantime? One method is the percent of sales method. First, you should code all inventory purchases to Inventory (the Balance Sheet account). Next, figure your average markup. This can be based on the ratio of Cost of Goods Sold to Sales in previous years. Then at the end of the period (usually a month or a quarter) make an adjusting entry to credit this amount out of inventory and debit it into Cost of Goods Sold. Example Assume markup of 20%. August Sales were $10,000. Cost of Goods Sold should be $8,000.

Dont try to be too exact with these estimates. They are, after all, estimates. Use rounding. Dont imply accuracy that is not there and is not possible to achieve. Note that this is why a physical count is so important. That should be calculated to the last penny! How do you cost inventory? So the clerks have gone all around the plant and you now have a whole bunch of count sheets. The amounts of each item should be multiplied by how much these items cost to get your cost. But how can you know? What if the prices were different at different times of the year? Which prices should you use? This is where you go to work! First, youve got to have records of how much units were bought at what prices. Next, you have several options: First in First Out (FIFO), Average, and Last in First Out (LIFO). As the names imply, you go through your lists, crossing out items as sold until you get to the number of units that match your count. Those are the prices you use to cost the items on your count sheets. Easy for us to say! Now, go to work!

LEASES
When the Financial Accounting Standards Board issued their statement on leases, this hailed as the most complicated accounting standard issued to date. What a long time ago that was! The basic concepts are really simple. Lease is another word for rent. They mean the same thing. All the rental arrangements come in just two flavors for accounting: Operating and Capital Leases. Just those two flavors. How to determine what category a lease falls into? The magic number is 90%. If the lease is 90% of almost any aspect of the asset, then it is a Capital Lease. Otherwise it is an Operating Lease. If the total lease cost is 90% of the assets value, then it is a Capital Lease. If the length of the lease agreement is 90% of the total life of the asset, then it is a Capital Lease. Even if there is a bargain purchase option that affects that 90% of cost figure, the lease is a Capital Lease. Operating Leases go on the Income Statement as Rent Expense. The accounting is the simplest for these leases. You write your monthly check to the leasing company and then record it to Rent Expense and youre done. A Capital Lease is a Fixed Asset for the Lessee. The amount is the net present value of the lease payments. This means that an interest rate has to be imputed and expensed. Since it is treated as an asset, depreciation is taken.

Lessors books get the opposite treatment as you might expect. The imputed interest is income instead of expense. The capitalized part of the lease is a liability instead of an asset. This the guts of accounting for leases. There is much more in the details of how to do this. This is where a professional accountant needs to be consulted.

PAYROLL
Payroll would be easy if it werent for all of those pesky deductions. On a cash basis of accounting (see GAAP vs. OCBOA), the net amount of the paycheck would be debited to Wages Expense and Cash in Bank credited. When payments are made to the IRS and the various state tax and employment departments, debits are made to Payroll Tax Expense and credits again to Cash in Bank. Oh, the accounting is so simple! One problem here is that the payroll tax expense is higher than reality. What about all of those amounts that were deducted from the paycheck? Those werent expenses to the company. They come our of the employees money. The other problem is that Wages Expense is too small. The gross not the net pay is the true amount that is the expense to the company! Okay, so the cash basis accountant will just add up all the differences in all the paychecks and make an adjusting journal entry to bring the two amounts to the correct balances. The cash basis accountant is now done. There is still a problem for everybody else. What about all those monies that are owed to the IRS, the State, the Union, ex-wives, and maybe some retirement fund, health insurance fund, savings plan, and who knows what else? Those are liabilities. And speaking of liabilities what about employer taxes? All of these have to be accounted for. For this reason, most people (yes, even otherwise pure cash basis accountants) record liabilities for payroll. A typical journal entry for a paycheck might look like this: Gross Pay (debit) 1,000.00 Social Security Payable (credit) Medicare Payable (credit) State Income Tax Payable (credit) Union Dues Payable (credit) Child Support Payable (credit) Cash in Bank (credit)

62.00 13.50 60.00 50.50 100.00 714.00

Total debits and credits

1,000.00 1,000.00 ======= =======

Notice that none of the deductions hit any expense account. They reduce the employees finances, not the companys. Also notice that the amount credited to cash exactly equals the amount of net pay. Employment tax liability is created for every paycheck. Heres how that journal entry looks: Payroll Tax Expense (debit) 75.50 Social Security Payable (credit) 62.00 Medicare Payable (credit) 13.50 --------Total debits and credits 75.50 75.50 ========== The payroll tax liabilities are reduced like any other liability when payments are made. Debit the liability and credit Cash in Bank. Tip This applies to liability accounts for Federal Form 941 taxes (income, social security, and medicare taxes). Use a contra-liability account for tax deposits. Debit this account for tax payments here. This will make it easier to adjust the accounts at the end of each quarter when the form is filed. Tip Another idea is to just have one liability account for all Form 941 taxes. Activity in this account will consist of deposits (debits), paycheck deductions (credits) and tax accruals (credits). With everything in one place, it is easier to check the amounts against the tax returns. The first tip is if you wish to break out your taxes separately; the second is if you just want the totals to be right. Experience It is important to check the accounting against the taxes when payroll tax returns are sent out. Many embarrassing mistakes can be caught IRS notices prevented. All accounting software has a payroll feature to it. Payroll services like us also will do this. Companies with specialized or complicated payroll may want to use an outside service. Example Restaurants should use a payroll service because of the special IRS rules on tips.

CASH
By far, the single most sensitive item in the financial statements is cash. This is what its all about. Even Net Income means nothing until it results in cold, hard cash. Cash is so important that it is even on two different financial statements. It is in the Assets section of the Balance Sheet and at the bottom of the Cash Flows Statement. So, lets account for that cash!

Cash in Bank
Each bank account should have a separate account in the Chart of Accounts. The activity and the balances in each of these accounts should be reconciled to its bank statement each and every month. The bank reconciliations should be printed and saved. Tip Accounting software has bank reconciliation features in their program. Use them! Experience More mistakes get caught with bank reconciliations that with any other kind of error trapping activity.

Petty Cash
Cash kept in a drawer or a cash register for small expenses needs to be tracked, too. The person in charge should keep receipts (or vouchers if none) for each disbursement. This paperwork is totaled and turned in to the accountant for recording. Take a check made out to cash to replenish the petty cash fund.

Example Assume 3 receipts: $10 for paperboy, $5 for coffee, $7 for box of pens. Here are the journal entries. First to record the outgo: Second to record the influx from the check: Dues and Subscriptions (debit) 10.00 Petty Cash (debit) 22.00 Breakroom Supplies (debit) 5.00 Cash in Bank (credit) 22.00 Office Supplies (debit) 7.00 --------Petty Cash (credit) 22.00 Total debits and credits 22.00 22.00 ------ -----===== ===== Total debits and credits 22.00 22.00 ===== =====

Coins

Many businesses have vending machines. They have a supply of coins on hand to make change for customers. So while youre reconciling the bank statement, you see a withdrawal for a role of quarters. Where do you post that? The journal entries needs to follow the flow of the cash. What happened to the paper dollars that were exchanged for the quarters? Lets follow an assumed cycle from the beginning. A fund is set up for coins: Coin Fund (debit) 20.00 Cash in Bank (credit) 20.00 Dollars are turned in: Cash in Bank (debit) 20.00 Coin Fund (credit) 20.00 More coins needed: Coin Fund (debit) 20.00 Cash in Bank (credit) 20.00 If dollar bills are making it into the bank via the Petty Cash Fund, then journal entries should track that. Experience Many times they might not make it into the bank at all. They just stay in Petty Cash. This is why these funds should be physically counted and the accountant should record the receipts. The dollar bills to not hit revenue. The quarters that come out of the vending machines hit it, instead. After all, thats the best source of scoring how much the machines are really producing. Cash needs to be carefully watched. The same person who handles the money should not be accounting for it. Cash funds should be counted often and by at least two people. Different people should handle checks and deposits from those who record them in the books.

OTHER CURRENT ASSETS

Current assets are those assets that are expected be converted into cash within a year (or the normal business cycle). Accounts Receivable and Inventory are discussed elsewhere. These are always current assets. Investments such as stocks, bonds, loan receivables are discussed elsewhere, too. A particular item may be current if it is expected to be converted into cash within a year. Example

List a 90 day note receivable among the current assets because it will become due in less than a year.

Prepaid Expenses
Use this to record paid expenses that apply to future periods. Example Assume: You pay a 1 year insurance policy for $2,000. You prepare financial statements each month. Code the check to Prepaid Expenses. Each month credit this account for 1/12th of the payment and debit Insurance Expense. Tip Dont use this account unless the amounts are substantial. The amounts are timing differences only. They are seldom worth the trouble.

Lower of Cost or Market

This is a principle that applies to almost all assets. It applies to inventory, to investments, and even to Accounts Receivable (through the Allowance for Bad Debts account). It means the amounts on the Balance Sheet should reflect reality. If the true value of the item is less than its cost, then the true value must be the one used. The reverse is NOT true. If the true value is greater than cost, cost is still used. That is why the rule is called LOWER of Cost or Market. Credit the assets and debit Unrealized Losses in the Income Statement.

FIXED ASSETS
These are physically tangible property. They should be substantial in amount. They should be used in the business. Items purchased for resale are inventory no matter how large it is. Example Your company builds a giant $1 billion fighter jet for the Air Force. That aircraft is inventory, not a fixed asset. Experience Many accountants will not capitalize anything under $1,000. They expense it, instead. Here are some common categories of fixed assets:

Automobiles and Trucks Buildings Computers and Electronics

Furniture and Fixtures Land Machinery and Equipment

All of these items should be depreciated except for land. Land never depreciates. IRS rules require that at a reasonable part of the purchase cost of real property be allocated to land. Assets under construction are in a separate account. They do not start depreciating until they are finished and placed in service. All direct costs get coded to this account while the asset is under construction. Direct materials (such as lumber and paint) go into the cost of the asset. Other direct costs to include: direct labor, direct travel, meals, expendable tools, and so on. Even capitalize associated interest costs. Trade-ins are a special case of asset valuation. The new assets value is the market value of the asset you give up plus any money you pay. Accountants call this money boot. If you talk the other party to pay you money instead, then subtract that from the value. If the market value of the asset received is more readily determinable, then use that as the basis, adding or subtracting boot as the facts determine. All of this is pretty simple. Special cases make it more complex. Gains and losses are recognized on exchanges of assets in some cases. An asset cannot have a value less than 0. The IRS has special auto trade-in rules. Donated assets are valued at their market value. Assets purchased on credit are valued at the present value of the loan payments. Add the cost of major repairs to an asset to its cost. Expense minor repairs. Experience Once upon a time Jack was auditing a federal laboratory for the government. As he was looking down the listing of assets, he spotted a suspicious item. It was a camera. It was valued at some $21,000. Id like to see this wiz-bang camera, Jack said to himself. So he put it on his list of things to spot check. When the asset manager got to that item on the list, he directed Jack to the Security Department. The laboratorys Chief of Security said that it was one of the special security cameras. So, they trotted off to find it. When they arrived at the designated location, it wasnt there! Since this was a very public area, people started to congregate. Whats going on? someone in the crowd asked. Another said, Security lost one of their cameras! People started to chuckle. The chiefs face got redder and redder still. Finally, with much relief all around the camera was located. Its location had been improperly stated on the asset sheets. No big deal but boy was it fun to see those security guys who are always hassling people getting a little payback!

Moral of the story: dont hassle the auditor or if you are the auditor and you hassle the Chief of Security, dont go back but thats for another story.

INVESTMENTS
Investments can be short term or held for the long haul. Short term assets must be readily marketable for them to be classed as Current Assets. Otherwise, they are long term. Were discussing loans receivable here, because like bonds they are creditor/debtor instruments. The main issue to be concerned with in investments is to be sure to carry them at lower of Cost or Market. This rule is treated elsewhere. Dont make direct write-offs to investments for unrealized losses. When the market is lower than its cost but youre still holding on to the investment then this is an UNREALIZED loss. You realize the loss when you sell the investment. But what if you hang onto it and the market goes back up? Use a contra-account. Call it Allowance to Reduce to Market: Post unrealized gains and losses to it so that you can keep track of the actual costs of the investment. Where there is no market for an investment, then there can be no such calculation. Example Assume you own 10% of your dads dry cleaning store. What happens when your dad retires and the family sells it? Youll find out when it happens. Since there is no way to readily determine the market value of your share, you dont need to worry about unrealized losses. Accounting for investments when they comprise a substantial portion of the investee company is discussed elsewhere.

INTANGIBLE ASSETS
Patent rights, copyrights, goodwill, organization and startup costs, are examples of Intangible Assets. These are assets that you cant touch or feel but still have economic reality. Intangible assets have four major characteristics: 1. They have no physical substance 2. They have future economic benefits but the value of those benefits are difficult to determine 3. Their useful life cant be readily determined, either 4. They generally have operational use vs. investment use in the business. Amortization costs works like depreciation does for fixed assets. A life is calculated for each

asset and a percentage is amortized each year. Just like an allowance account is used for accumulated depreciation, one should be used for accumulated amortization. Unlike fixed assets, one does not have to wait for it to literally be scrapped or sold in order to write it off. Write it off as soon as its value is zero. Classify intangible assets as Other Assets on the Balance Sheet. This is the last of the major asset categories. Other assets besides intangibles go here, deposits for example. Tip List intangibles separately from the rest of the items in Other Assets so that the readers of the financials dont confuse them.

CURRENT LIABILITIES
Current Liabilities are those debts the company owes that come due within one year. Like Current Assets, the operating cycle can be different. In that case, use that to classify debts into current and non-current. Experience The most commonly seen Current Liabilities are those items that affect expenses. Many cases the only items in this section are Accounts Payable and the payroll related items. Accounts Payable, like Accounts Receivable warrant a page all of their own. So does payroll. However, this area affects so much of the Current Liabilities section, that we say more about payroll liabilities here. Payroll Taxes Payable is a big issue with companies. Even cash basis companies need to keep track of their payroll tax liability. Experience We can negotiate with the IRS regarding income taxes due. They will grant payment plans. With the right reason and the right approach, Offers in Compromise can even reduce the amount of income taxes due. With payroll taxes due, however, the IRS plays hardball. This is because this money was never the employers money to begin with. They deducted it from the employees paychecks for the IRS. Therefore there should be no reason for a company to be unable to pay. Thus the IRS view. In practice, even with the best attorneys and CPAs in the world, it is very bad to mess with payroll taxes. Since this such a big issue, many of even the smallest businesses want to see their payroll tax liability on the Balance Sheet.

Payroll tax liabilities come in three flavors: Federal Form 941 Taxes, State Income Taxes, Unemployment Taxes. The 941 Taxes are the income taxes and the social security/medicare taxes. Income Taxes are wholly deducted from the employee. The social security/medicare family of taxes are deducted and then matched by the employer. This means that you deduct a total of 7.35% from the employees paycheck but you pay 15.3% to the IRS. The difference between the two is Payroll Tax Expense but the total is Current Liability. State income taxes, like federal income taxes are deducted from the employees paycheck. Keep state income taxes in a separate account because it is a separate tax. Separate unemployment taxes into federal and state accounts, too. These accounts are paid on separate forms. Use the Federal Form 940 for Federal Unemployment Tax. The amount due will depend on the amount paid for the state unemployment in certain circumstances. To sum up, you need the following payroll tax payable accounts: Federal 941 Taxes, State Income Taxes, Federal Unemployment, and State Unemployment. Generally Accepted Accounting Principles (GAAP) requires other payroll related liabilities. Anything else that the company deducts from an employees paycheck is a liability. The money by law must be paid to the party for which it was deducted. On any date the company will owe wages. This liability is the difference from the date on the calendar and payday. Example Imagine if an employee just quits. You still owe him for the time he worked even though his check is not due until payday. Not just wages, but the rest of the employees deductions have to be accrued, too. Experience Most of the time OCBOA financials dont report these. Life is complicated enough. Employee benefits are current liabilities. These may include retirement plans, health insurance, bonuses and so on. Short term debt are current liabilities. This means any debt that is due within one year. If a multiyear loan is on its last year, it needs to be reclassified out of Long Term Debt to Current Liabilities. A very important item that many accountants miss is overdrawn bank accounts. If Cash in Bank has a negative balance then it is no longer an asset. It is a liability and it is a current liability. It must be reclassified from Current Assets to Current Liabilities. Title the liability account Bank

Overdrafts. Tip Use a reversing entry to do this. This means debit and credit the accounts so that the credit balance is in the Current Liabilities. Then in the following month do another entry that reverses this. Most software accounting programs have an automatic reversing entry feature for situations like this. Unearned Revenue is a Current Liability. Example Lets say you engage our firm Le Moine and James as your accountants. You pay us $1,000 as a retainer. This means that we owe you $1,000 worth of work. If you werent expecting us to provide you $1,000 worth of services, you would never have forked over the cash to us. Of course, if you want to just give us $1,000 smackers gratis and we dont have to do anything for it, then this accounting rule doesnt apply. (Grin!) Another kind of circumstance where unearned revenue comes up is when the end of the period comes before the end of the job. Example We check into your hotel and pay five days in advance. The end of the month comes two days later. The accountant closes your books to provide you your monthly financials. At that point you still owe us three days because you have our money. Unearned Revenue differs from the other liabilities in that the liability gets taken care of by time rather than payments. In the hotel example above, you wait three days, our time is up, we check out, and the liability is done. The account Customer Deposits is a form of Unearned Revenue. An important area of Current Liabilities is owner loans. Many times the Owner or Shareholders of the business must loan the company money to get by. These loans are Current Liabilities regardless of the owners intent. This is be the owner by definition is in control. To be conservative, accounting rules assume that the owner can pull his money out of the company at any time. The very last thing in the Current Liabilities section is Current Part of Long Term Debt. This will be covered in the next section.

LONG TERM DEBT

Loans that will be paid off for periods greater than one year are Long Term Debt. In the accounting for them we have found it best to list each loan separately in the Balance Sheet. This means a new account for each loan in the Chart of Accounts.

Recording a loan is easy. Example Assume you took out a loan of $10,000 for the bank. You will pay it off in 5 years. Debit cash for $10,000 and credit Long Term Loans Payable. Recording a payment for a loan is not. Each payment consists of two parts. Part of your payment goes to Interest Expense. The other part reduces the amount you owe. This part is the Principal. Each payment should properly show both interest and principal. Example Assume your payment is $500. Of this $500, $150 is interest and $350 is principal. Here is the journal entry to record it. Interest Expense 150 Long Term Loans Payable 350 Cash in Bank 500 This method of recording payments is applicable to both short term and long term loans. If interest expense is not taken out of the payment and the entire amount is debited to the loan payable, then the financials will show the liability to be less than it really is. Now for the really big question. How do you figure these amounts? The tool that accountants use to figure out the payments is the Amortization Schedule. It lists out the payments and shows the different parts of each payment. Here is what one looks like. It assumes an interest rate of 5%. Calculate interest by dividing the annual rate by the portion of the year that your payment covers. If payments are monthly, then divide by 12. If quarterly, then divide by 4. Experience Lenders will provide these schedules. Write your account codes on them and keep them handy. Then check each line off when you code the payments. Its a good idea to check with the lender periodically. Get the account balance and sync it up with the balance in your accounting. Its a good reality check. Only a part of a long term loan is non-current. If you have to make payments within a year, then part of the loan is really current. A reader of financial statements needs to know how much of the liabilities are due within a year and how much is due in later years. Heres how to do this.

At the end of your Long Term Debt section, have an account called Less: Current Part of Long Term Debt. From the amortization schedules of all your long term loans, add up all the principal parts of the payments that are due within one year. Take the grand total of all that and debit the Current Part account. Dont touch the loan accounts themselves. The reader will want to know how much money is owed to XYZ Bank. The Current Part account reduces the total amount of Long Term Debt to its proper, non-current amount. It is like Accumulated Depreciation in this regard. It is an account that reduces its sections total. The credit goes to another Current Part of Long Term Debt account. This one is at the end of the Current Liabilities. This increases Current Liabilities to its true total. Mastering amortization schedules is the key to mastering long term debt.

EQUITY
Look at equity from two different angles. From one point of view, equity is what is left over after subtracting liabilities from assets. From another, equity is the result of investment activity and operations. The last line in the section is Retained Earnings. This is usually seen in corporation balance sheets. It represents the sum total of all profits and losses for the current period and all prior periods. Dividend distributions to shareholders reduce Retained Earnings. Partnerships and Proprietorships fold this amount into the capital accounts (see below). Corporations also have Treasury Stock. When a corporation buys back its own stock, the debit goes to this account. Treasury Stock reduces equity. Reducing outstanding stock is the same as paying off a loan. If a company buys back a piece of its equity then it has reduced the amount that investors have put into the company. That is why a companys holdings of its own stock reduces equity rather than increases investments in the asset section. Withdrawals of money are a key factor in equity accounting. Investors put their money into the company to make a profit on their investment. That means that at some point money has to be taken out of the company. There is a line in the equity section for this. Proprietorships and partnerships call it draws. Corporations call it Dividends. In all cases, this is a temporary account. At the end of the year a journal entry moves the debit balance elsewhere. Corporations move this to the Retained Earnings account. The other companies move it to the capital accounts. The capital accounts show equity at the owner level. For Sole Proprietorships, there is only one capital account. Partnerships have separate capital accounts for each partner. If a partnership has many partners, then it may lump all of them together into one line item for financial statement purposes. A subsidiary ledger keeps track of

each partners capital account. At the end of the year, all other equity accounts are folded into the proprietor and partner accounts. This includes draws and earnings. The idea is that the balance should be each partners ownership position in the company. This is how much a partner can theoretically withdraw. Experience We are continually surprised at how owners of companies fail to do the most basic things in setting up their companies. Corporations should have shares of stock. Even if there is only one owner, he should know how many shares of stock the corporation has issued and how much each share was issued for. How can an owner know his investment without knowing that? Investments consist of the amounts originally contributed into the enterprise, any additional amounts put in, and the amounts withdrawn. The equity section of the balance sheet can tell the user much about the organization of the company.

KINDS OF COMPANIES
The type of entity forms the basis of equity accounting. This section covers the major forms a company can take.

Proprietorships
If a company has only one owner and has done nothing else to organize his company, than it is a proprietorship (P). For many companies, this is the best form for them to take. There are three accounts in the Equity Section for P's: 1. Owner's Capital 2. Draws 3. Current Profit (Loss) Current Profit (Loss) comes from the Income Statement. This is year to date net income. Draws are the money the owner takes out of the company. Owners do not take out wages. It is a good idea, however, for owners to budget themselves periodic payments in lieu of wages. Both of these accounts are closed to the Capital account at the end of the year. Any money that owners invest in the company can go to two areas: capital or loans payable. For P's there are little tax consequences for investing money either way. P's get hit with two taxes: the income tax and the selfemployment tax. P's taxes are determined on the Schedule C on the personal 1040 tax return. Net income is adjusted for allowable expense deductions. Taxable net income from the business is transferred to the front page of the 1040 and included in the rest of personal income from other sources. If the business lost money, then that amount gets transferred, too.

Self-employment taxes correspond to the payroll taxes (social security and medicare) on employees. In payroll accounting, the business pays half and the employee pays half of these taxes. But for P's the owner is both. Hence, the self-employment tax. This is the combination of employer and employee payments. The rate is 15.3%. This rate is computed on Schedule SE. The amount is transferred to page 2 of the 1040.

Partnerships
Partnerships (Ptnr) are like Proprietorships. Ptnr's have more than one owner. Partners should always have a partner agreement to form a business. This is a practical requirement, not necessarily a legal one. Experience Jack once had a car repair outfit for a client. The partners insisted on not having an agreement. One man said, "A handshake is all I need. If I need a signature to trust his word, then I don't want to do business with him." The two men were best friends and had known each other for years. Within a few months they split amid much acrimony. We believe that the two were honest. The problems were misunderstandings of the basis of the business and each partner's obligations to it. An agreement would have dealt with those. Failure to do an agreement cost them not only their business but also their friendship. P.S. They talked Jack out of not doing an agreement for his accounting services, too. Misunderstandings rose from that. (Their own emotional break-up probably contributed.) Anyway, he ended up having to sue them to get his accounting fees. Moral: always do business in writing! Each partner needs his own capital and drawing accounts. These accounts represent his ownership position in the company. Partners may take wages from the company. These enter the Partnership tax return as "Guaranteed Payments". They are deductible to the partnership company and income to the individual partner. The partner pays self employment tax on these. The partners also pay self employment taxes on their portion of the total net income of the partnership. Income tax returns are filed thru Form 1065. This form is similar to the tax return for the Sub S Corporation discussed below. Part of this return is a Schedule K. This shows the total income taxes, credits, and other taxable items that flow out to the partner's individual income tax returns. Each partner gets a Schedule K-1. This shows his/hers' share of the Schedule K items. There is a special kind of partnerships called limited partnerships. These have to have at least one general partner. General partners are fully liable for the business. Limited partners can only

loose their capital investments. Limited partners have no say in the running of the business. They just share in the profits. Limited partners' share of net income is not subject to self employment tax. If they do work for the business, then their compensation for that is. Partnerships are automatically dissolved upon the death of partners with 50% or more of ownership.

Corporations (regular)
Corporations are separate "persons" under the law. They can sue and be sued. They are registered with the state. They file income tax returns like a partnership (using Form 1120) but unlike a partnership, they pay income taxes on their net income. Shareholders control the corporation to the extent that they own shares of voting stock. Corporations may issue different classifications of stock. Common stock is the voting stock. Preferred stock generally is not. Since corporations are separate "persons" shareholders of the corporation they shield shareholders from legal liability. If a lawsuit drives a company bankrupt, then the shareholders will loose their investment in the company but no more. In order for plaintiffs to go after the owners of the company, they have to sue them individually. In the equity section the corporation shows "Common Stock" with an amount. Depending on how it is organized the stock may be shown at par or no-par value. If the company has set a par value for the stock, then any money investors put in over that amount is in another line just under "Common Stock" called "Contributed Capital in Exess of Par". If a company buys back some of its own stock, then it is debited to "Treasury Stock". This is another line item in the equity section. As corporations earn profits, "Retained Earnings" build up. If the company racks up losses then call the account "Retained Deficits". Corporations distribute profits to shareholders by declaring dividends. The total amount of money it decides it can pay is divided by the number of shares to determine the dividend per share. The money is paid to shareholders and subtracted from retained earnings. Form 1120 income tax returns don't issue K-1's like partnerships and Sub-S Corporations. They pay taxes themselves. Shareholders report their dividend income in their 1040's on Schedule B. Corporations must be sure to issue 1099-DIV to the shareholders each year.

Sub S Corporations
Subchapter S refers to a section of the IRS Code. Usually states do not require any special

registration beyond the normal corporate licensing for Subchapter S Corporations. Subchapter S was adopted by Congress in the 1950's to help small businesses. To qualify for Sub S status with the IRS, the corporation must file Form 2553, have only one class of stock, and only 75 or fewer shareholders. Distribution of profits must be based on ownership. Further, at least some of the owners must be active in the business. That means the IRS will look for "Officers' Wages" on the 1120S tax return. There had better be some and it had better be reasonable. It there is not, then that can be a huge audit flag. Small businesses jump through all of these hoops to gain one big advantage: dividend distributions are not taxable! Shareholders of regular corporations end up having to pay taxes twice:

at the corporate level, when their corporation pays taxes on its annual net income and at the personal level, when they have to pay taxes on the part of net income is distributed to them

Shareholders of Sub S corporations pay taxes only once: when they have to transfer the net income amounts of their K1's into the Schedule E of their 1040's. Shareholders do not pay self-employment taxes. Very important point! The payroll taxes are paid through deductions on "Officers' Wages". The corporation pays the employer's share. This substitutes for self-employment taxes. This is why shareholders want their wages to be as low as possible and their dividend distributions to be as high as possible. The IRS wants the reverse. The question reduces to what is reasonable.

Limited Liability Company

Limited Liability Companies appeared in the 1990's. They are like Sub S Corporations but with more flexibility. They file Form 1065 (or Schedule C if only one owner). They can elect to be taxed as a corporation. They then file Form 1120. Income can be distributed on a different basis than ownership. For example, if two partners own 50-50 of the business but agree that one partner should get 60% of the profits, they can agree to do that. Owners are referred to as "members". The choice of what kind of entity the company will be is one of the most crucial choices entrepreneurs can make.

REVENUES
Revenues are not net income. Revenues are all the money that the company earned during the period. Income is what is left after subtracting expenses. The two sources of revenues are cash sales and sales on account (i.e. Accounts Receivable). Statements on the cash basis do not report receivables in their balance sheet. Hence, they do not include them in revenues. Sales for cash basis accounting is all the cash sales for the period plus all cash taken in for sales from prior periods. Customer deposits are not cash. They are liabilities. When the service is performed, or when the goods are delivered, then they can be reclassified into revenue. Unearned revenue is a similar animal. Both of these topics are covered in Current Liabilities. Like expenses it is okay to list major sales categories. Revenues can be checked against bank deposits and accounts receivable. New receivables, and deposits (less those deposits for sales made in prior periods) equal revenues. Sales taxes are not revenues. Sales taxes are collected from customers and then paid to the state. The credit for sales taxes should go to current liabilities. Some states (such as Georgia) give discounts for prompt payment of sales taxes. This discount is revenue. At the end of a period a company may have several NSF checks that it is trying to collect. Since NSFs reduces cash they reduce revenues, too. This is why it helps to have a separate account in the revenues. Revenues are generally pretty easy on accountants. But wait for whats coming next!

EXPENSES
We have one rule for accounting for expenses: dont get fancy. Refunds or returns of purchased items should be credited direct to the expense account. We discourage contra accounts in the expense area. Exception Cash Short (Over). This is where the difference between the book amount of cash on hand and the physically counted cash goes. For simplicitys sake, the account stays in expenses even when there is more cash counted than there should have been. Dont use too many categories. This confuses both the bookkeeper and the reader of the

financials. The goal should be to use the minimum number of expense categories that management needs. Experience Quickbooks, Peachtree and other accounting software come with pre-designed accounting templates for various industries. They all come out with huge numbers of expense categories. Over many years of receiving the output of these programs that were prepared by clients, we have noticed some patterns therefrom. Amateurs use these pre-built categories because they think that they are supposed to. The bewildering array of accounts and sub-accounts are so confusing to them that they place the same kinds of transactions in different categories. For example, a gift might be coded to charities one month and the same gift to the same party might be coded to gifts the next. The bookkeeper either forgot where it was coded before or he wanted to cover all of his bases. The programs then spew out page after page of financials. The small business manager takes one look at the morass of numbers and is overwhelmed. We believe that it is better to cut out redundant categories and turn out financials that managers will use. Tip One way to trade off lots of information versus info overload is to present an Income Statement with just one line for expenses called Expenses. Then list the expenses as a supplementary schedule behind the standard financial statements. Present expense items in alphabetical order. Even with a minimalist approach such as we recommend, you are going to have an Expense Section with more than ten lines. Usually Income Statements have a lot more expense lines than that. Readers and Bookkeepers both need to find the desired expense account quickly. Alphabetical order is simple and everybody can pick up on it. Some companies may want major areas of expenses grouped together. We usually break our own rule and group all labor costs together. Officer Salaries, Wages, Contractors, Fringe Benefits, and Payroll Taxes are all costs of having people work in your company. Its handy to know how much the total labor costs are. One should look very hard at further grouping of expense accounts. The governing question should be, Will management use this grouping? Many owners and employees are called upon to pay company expenses out of their own pockets. The company then reimburses them. We recommend that companies have a policy of requiring expense reports with receipts attached for reimbursed expenses. This helps control abuses. It also helps the bookkeeper code the items in the report to the proper expense category.

COST OF GOODS SOLD

Cost of Sales (COS) is similar to Cost of Goods Sold (CGS). They both break out large expenses and subtract them separately from the rest. The result is gross profit. The other expenses are then subtracted from that to get net income. So, why go through all of this? Tax regulations require Cost of Goods Sold whenever a company carries inventory. Beyond that costs that directly drive sales and are substantial should be broken out. Example Construction companies may have costs for materials that go into what they build. Other costs that directly go into a construction project might be the labor of the workers, subcontractors, and travel costs. These kinds of costs would go into COS. Todays software (Quickbooks and Peachtree) does not handle Cost of Goods Sold correctly. That is why most financial statements present this section on a close enough basis. Heres how this section should really look. Start the Cost of Goods Sold with Beginning Inventory. Add Purchases. The total of these two is Total Goods Available for Sale. Subtract Inventory. The result is Cost of Goods Sold. Why? The logic of this comes from simple algebra. If a b = c, then a c = b. Beginning Inventory (at cost) plus Purchases (the cost of additional inventory) gives us the Total Goods Available for Sale (at cost, of course). If we subtract the Cost of Goods Sold we will get Ending Inventory (at cost). The presentation on the Income Statement switches CGS and Ending Inventory as per the equations. Neat, huh? Purchases may be modified by Purchase Discounts and Purchase Returns and Allowances. We have more on Purchases on our Inventory page. Special cases for manufacturing and construction companies are treated in their pages. The software has problems with Beginning Inventory for different periods. The Beginning Inventory for the first of the month is different from the Beginning Inventory for the first of the Year. This means that if you have an Income Statement that has two columns of figures, Month activity and Year to Date activity, software will be unable to handle the proper presentation of Cost of Goods Sold. Practice It is a wonder to us that after all these years and all of the extras that accounting programs now provide that they still cant deliver basic accounting functions such as this. Typically the software produces an abbreviated CGS section. They scrunch everything into one line called Cost of Goods Sold. This is an area where some more detail would be helpful to

management.

AUTOMOBILE EXPENSES
Most small businesses have auto expenses. This is a tricky area because of IRS rules regarding auto deductions for business purposes. You may deduct auto expenses either at actual costs or on a mileage basis. This decision must be made the first year the car is in use. For 2002, the mileage rate is 34.5 cents per mile. If you use the actual costs method, then you may only deduct that portion of your expenses that are related to business. That portion is determined by mileage. So, how do you account for this? Moreover, what if you have more than one car or truck and some are on one method and some on the other?
Important! Keep a drivers log for all cars/trucks no matter what method is used. This should show the date, the miles for each trip, and the purpose of each trip. This log will be a primary document an IRS auditor will look for. Further note that the tax return specifically asks whether you have evidence to support the business mileage and if so, is this evidence in writing. You will need this log! Log books can be purchases at any office supply store.

We recommend two auto expense accounts. Use one for mileage and the other for actual.
Mileage

For cars on the mileage method, all costs for car payments, gas, and service should be paid out of the owners personal account. The company may pay the costs, especially if the car has been designated as a company car. Each month the drivers log should be consulted. Multiply the miles in that log by the IRS rate. That is your auto costs for the month for that car. Debit Autos and Trucks Mileage. Where should the credit go? If the owner has paid the actual costs out of his own pocket, then write him a check for the costs. The credit then goes to cash. If the company has paid the actual costs for the car, then debit those costs to a special auto account in the Equity Section. (Those costs do not go to the Income Statement because they are not deductible.) The credit for each months entry for autos on the mileage method then goes here. Hence, the ending amount in the Equity Section account will be the difference between actual costs and mileage method costs. The auto expense account will exactly match the deductible amount on the tax return.

Experience An alternative place to put the offset account is Other Expenses on the Income Statement. This creates another book vs. tax difference. We prefer to minimize these differences for small businesses as much as possible. That is why we prefer to use the Equity Section. The difference then goes to draws.

The above assumes that statements are prepared on the OCBOA basis. For statements on the GAAP basis, then you must use actual costs for business use. For GAAP statements, book vs. tax differences goes with the territory.
Experience Do NOT take depreciation for company cars on the mileage method. Depreciation is included in the mileage rate. Actual Costs

Believe it or not, you must still consult the drivers log each month for vehicles on the Actual Cost method. This is to determine business use vs. personal use. The % of personal use must be multiplied by the total costs paid by the company. Those costs must be credited to the expense account and debited elsewhere. But where? Using the same logic as above, we recommend a special account in the Equity Section. This account then is added to the owners draws.
Other important things to watch out for

Depreciation may be limited by the IRS luxury auto rules. Certain Sub S Corporations and Limited Liability Companies may be limited in how much may be distributed. In that case, you may need to take the Schedule M-1 book vs. tax difference. There are special trade-in rules on cars.

Final Word

Accounting for autos can be tricky. The main thing is to keep those log books!

GAINS AND LOSSES ON ASSET DISPOSALS

In a metaphysically perfect world for accountants, there would be no gains or losses when companies sell or otherwise dispose of fixed assets. The journal entries would all be like the one in the following example: Example Assume: A machine purchased for $1,000 that has been depreciated $700 is sold for $300.

The journal entry would be this: Cash Accum. Dep. Machinery

300.00 700.00 1,000.00

In this example cash is debited because that is how much is received. The 700.00 of accumulated depreciation credits is zeroed out by the debit entry. The same is done to the 1,000.00 of debits in the Machinery account. This journal entry resets both the Machinery and Accumulated Depreciation accounts to where they would have been if the $1,000 machine had never been purchased. In effect, both the machine and its depreciation has been flushed out of the accounting books. Cash is adjusted to reflect the amount received for the sale. Both total debits and total credits balance. Now, what if it was not sold for $300? What if it was sold for $400? -- Or $200? Then debits to cash would change. The total debits and credits would no longer balance. The difference must go to another account. This account is Gains/Losses on Disposal of Assets. Since this kind of thing is not part of normal operations, it is usually found in a separate category after Expenses called Other Income and Expenses. For tax form for these kinds of transactions is IRS Form 4797.

THE WORKBOOK
Accounting projects generate lots of paperwork. We use workbooks to organize ours. Accounting paperwork needs to be tied down. Otherwise people tend to misplace them when they look something up. In busy offices paperwork does tend to wander. We prefer 3-ring binders. Reports are punched and put into them. After each period is closed, print out the reports and file them in the same binder as the previous period in their proper order. Experience In older times computers used dot-matrix printers. Some readers may still use these. They used perforated paper that was one continuous sheet that come out of a box. For accounting reports, these were cheaper than the current laser-printer output. These reports went straight into cardboard folders. The one drawback was that desired reports were difficult to find. The system were talking about here presumes output from laser printers. Index tabs separate the major sections. 1. Chart of Accounts. This chart is the structure of your accounting system. It lists the ID number and the name for each account. Accountants will consult it often for data entry. Managers will use it as a roadmap to understand the General Ledger and the rest of the accounting reports. 2. Financial Statements. Keep all the statements together in one section. Readers need to be

able to quickly refer to the Balance Sheet while reading the Income Statement and vice versa. 3. General Ledger. This shows the debits and credits that make up the balances on the financial statements. 4. General Journal. This shows the adjust entries. 5. Bank Reconciliations. Include here the copies of each bank statement as well as the schedule that shows how the ending balance relates to the General Ledger. Other papers that contain calculations for Adjusting Journal Entries that come out the bank reconciliation process should go here, too. 6. Cash Journals. Software may kick out a number of reports here. Traditional reports include the Cash Receipts Journal and the Cash Disbursements Journal. 7. Accounts Receivable (A/R) Reports. First comes an Aging Schedule. This breaks out A/R by customer and invoice. It also shows how long each debt has been out there. This is a must-see report for management. The other major report is the Sales Journal. 8. Accounts Payable (A/P) Reports. Similar to the A/R reports, the Aging Schedule shows how much your company owes vendors and for how long. The Purchase Journal belongs here. 9. Payroll Reports. There should be a Payroll Ledger and a Payroll Journal. 10. Job Cost Reports. If a company has a cost accounting system in place, these reports will show revenues and expenses for each job that the company is working on. Management will turn to this section to see which jobs are making money and which arent. Other reports will show which jobs are over budget and which arent. This is a workbook for accounting reports, only. Tax Returns including payroll tax returns, property tax returns, and sales tax returns belong in separate files. Personnel records belong in a separate file, not behind the Payroll tab. Accounting reports can be quite lengthy even for small companies. A binder can fill up surprisingly rapidly. Because people will need to refer back to these reports often, a 3 ring binder can protect the papers and keep them together. After a year has passed, and the tax returns done, the need to refer back to these reports falls back dramatically. Because sturdy 3 rings are expensive, we transfer the papers out of the binder and bind them between cardboard covers. These covers are available from any office supply store. IRS retention rules are three years for most cases. Some accountants insist on saving these reports for 7 years. You may want to save them longer. There are many other systems for organizing paperwork. Some have tabs for each month and then put all the reports for that month behind the tab. We dislike this approach because it makes it difficult to follow transactions from one month to another. The advise on this page is just our personal opinion. One can use whatever system of organizing your accounting papers as one may wish. The important part of an organizational plan is that it

good to have one. The key to controlling your accounting system is to organize your paperwork.

THE GENERAL LEDGER

Whenever we make any accounting entry we always visualize how it will affect the General Ledger. The General Ledger (or GL for short) is the heart of the accounting system. The GL shows each item in the Chart of Accounts. For each item it shows:

the beginning amount, each entry whether debit or credit, and the ending amount.

We can look at the financial statements with confidence because we know that each line item in them can be explained by the GL. Example: The Income Statement shows that Office Supplies was $550 for the last month. What made up that amount? We look at the GL. In the account for Office Supplies we find: Balance forward: Office Max Joes Supplies Charlies Expense Report Activity Ending Balance: 130.35 100.00 330.37 120.00 550.37 680.75.

Last months expenses were $550 (rounded). The Year to Date expense was $681. Depending on the software, the GL report may not show all of the detail. It may just give you a summary with a code to tell you where to get the details. When this happens, you may have to go to the Purchase Journal, the Cash Disbursements Journal, or even the General Journal for the specific transaction. We greatly prefer the detailed reports so that we dont have to go chasing down the transactions! Whether the report is detailed of summarized, know that where the data comes from. It comes from everywhere! Every transaction that gets entered into the Accounts Receivable, the Accounts Payable, Cash Receipts, Cash Disbursements, or anywhere else transactions get entered all make it into the General Ledger. This means that this is the place to look to see everything that has gone on.

The first thing we always look for when we examine a GL is the period it covers. Typically, a report may cover only one month at a time (as in the example above). This is because when the financial statements are printed, the accountant should want a copy of the GL to answer questions about the numbers came to be. We always do this when we produce financials. The trade-off is that we need to look at past months reports to get the full story about an account. Example: Continuing from the last example, it we wanted the full story on that $680.75 of Office Supplies, we will need to look at past months reports until we find where the $130.35 came from. This is why in the workbook (where we keep our reports) we like all of our GL Reports together in one tab. Software usually allows you to print out GL reports for the entire year. Warning: Not all of them do. MAS90 users pay attention here! A big problem with GL Reports occurs when the accountant makes entries to prior periods after the GL is printed. Unless the GL is reprinted for each month after the entry is made, they wont match up to what is in the system. Practice: This can generate a lot of paperwork and extra trouble. Most companies discourage prior period entries. In the real world, our experience has been that entries made in previous months of the current year cant be avoided. Management wants accurate comparisons of monthly activity. How to resolve the trade-off between accurate accounting and accurate GL Reports? One method is to keep a log of prior GL entries. This serves as an interim solution. Periodically we print year-to-date GL Reports. Heres a few very important things the accountant should do with the GL. Check that the ending balances in the cash amounts equal the bank reconciliations. If they dont then find out what went wrong and fix them. The GL amounts for cash always equal the reconciled amounts. Always! Accounts Receivable and Accounts Payable always equals the totals in their aging reports. Why would an item be on the GL account but not on the aging schedule? There is no good reason. If you do not wish it to be on the aging schedule, then reclassify it into some other account. These accounts need to be managed on a monthly (if not on a weekly) basis and that means that

management needs to know what is in there. At the end of the year, wages need to equal what is on the W-2s (adjusted for accrued wages). Weve faced payroll audits where they did not. Wed rather face Arnold the Terminator saying, Big Mistake! Practice: Dont be afraid to break payroll among several GL accounts. We typically have payroll in Officers Salaries and Wages for the regular employees. At the end of the year, the totals of these accounts equal the totals of the W-2s. During the year, the quarterly totals equals the totals on the payroll tax returns. Look out for equity activity. Any entry to equity should be looked at with the darkest suspicion. We find that most entries to an equity account are wrong! Usually they should have been made to an income statement account. IRS auditors love this stuff! Practice: In our firm, our rule is that no entry is made to Retained Earnings without my approval. This effectively means that no entry is ever made to Retained Earnings. In business tax returns there are specific areas that ask for the differences between book and tax Retained Earnings. This is a huge headache at tax time. We avoid it by not having any GL differences. (Yes, there are differences that are unavoidable and beneficial to the taxpayer, so were ready with the explanations.) We just dont have unnecessary differences. We always print out the GL before printing the financials. We go down each account and make a check mark to show that weve at least looked at it. Yes, this can use a lot of paper and ink but we catch a lot of mistakes that way. Then we print the financials, the final reports (including the final GL) and close out the month. The General Ledger is the heart of the accounting system because it shows how each item of the financial statements came to be what it is. Know the GL and face the world with confidence!

JOURNALS
When we first heard of accounting books as in were auditing your books we wondered why more than one book? After all, if H.G. Wells wrote An Outline of History in one book, why does a small company need more than one book? Then we took our first accounting class and we learned about the General Ledger and the General Journal. Okay, so theres two books now. One shows the activity in each account. The other shows all of the transactions. Were cool with that. But why do we need still more books? Theoretically, two books are all that are needed. The Journal lists the transactions that make up

the General Ledger which makes up the financial statements. Example: Heres a transaction. You buy a machine for $700. The deal is $100 down and the rest in 3 months. The Journal Entry is: Machine Cash Loans Short Term 700 100 600

The General Ledger will show each account. It lists each account. Then it shows the beginning balance for the account, then its activity, and finally the ending balance. It does this account by account down the balance sheet and then down the income statement. Thats the General Ledger. More information is here. So, there it is: a journal and a ledger. What more could you want? More Journals, of course! The reason for the extra journals is that they are convenient. Unlike the General Journal where debits and credits can be in any accounts, these special journals have common debits or credits for most (if not all) of the transactions in them. Heres a summary of the special journals. Journal Name Cash Receipts Journal Cash Disbursements Journal Sales Journal Purchase Journal Payroll Journal Debits to Cash Expenses Accounts Receivable Expenses Wages and Salaries Credits to Revenues Cash Revenues Accounts Payable Cash and varous payroll liability accounts.

.These special journals are for normal transactions. The General Journal is for the rest of the transactions. There are some transactions that lie in a gray area between the two. Credit memos, discounts, and refunds are the kinds of transactions that may make it into the special journals. Quickbooks and Peachtree both can handle these transactions in the special journals. The cash journals and the bank statements present a special problem. Bank statements come with transactions on them such as bank charges which need to be entered into the journals. We try to

enter as many of them as possible through the cash journals. Journals are the accountants diary. They form the link between the General Ledger and the receipts.

METHODS
Hello there! I am a widget. This is how I look on the outside. Im bright and shiny. I even do a good imitation of a paperweight! But on the inside, oh thats a different matter! On the inside Im a complex collection of cost accounting methods, allocations, and financial theorems! (This is how the accountant sees me.) I cost money to produce - but how much money? Yes, how much money is inside me and where does it come from. Ouch! Somebodys pounding on me. Must be softening that rough edge. Ahh! That feels much better, now! Somebodys been working on me. I bet that somebody is getting paid to work on me. That means that theres a labor cost to making me. Ooh! Here comes the money now. It tickles my insides.

Example Suppose a workman takes 30 minutes to make a product. He earns $20 per hour. The Direct Labor cost to the company for this product is $10. Speaking of insides, thats metal there guys! Somebody had to pay for that metal! That means that theres a material cost to making me. The costs of materials and the costs of labor that directly go to the product are called Prime Costs. All costs that are direct to the product are Direct Costs. Other Direct Costs than Prime costs may include such items as direct travel, specific research or development costs, and bid proposal costs. The factory and the equipment that is used to make me also cost money, too. Some part of that goes to me, too. So how do they figure all of this out? Ill let Jack and Kathy explain how. Then Ill come back later.

There are two main methods. Deciding which method to use will depend on what the company needs to track. Job Cost Method This method tracks costs by discreet products or by service. Example A government contract is awarded your company on a cost plus fee basis. This means the government will pay you all your costs for doing the job plus a fee for your trouble. A job cost system will track your costs for the contract. The accounting system will set up a job number. Then all direct costs for this job will need to be tracked. Invoices for materials will need to be coded with the job number. Employees will need to keep track of what they work on and for how long and code their times with the right job numbers. Overhead is then allocated to jobs by using some allocation rate. Process Cost Method This tracks costs by department or by production process. Example Jack once worked for a salmon cannery in Alaska. He (okay, I) had to decide how much the fish cost the company. The cannery had three production processes: frozen fish; canned fish; and salmon roe. The roe was a great delicacy in Japan. Management needed to know how much a pound of frozen fish cost; how much a can of fish cost, and how much a bag of roe cost. (The canning costs were complicated because the company produced different sizes of cans but we wont go into that.) Thousands of fish were purchased from the fishermen. We didnt track the cost of each fish. Indeed, we had no way of knowing if the contents of a can came from the same fish or not! The costs for each department were divided by the total units (pounds, cans, and bags). That example gives you the basic idea. The main complication of process costing is what to do with units that are not completed. This involves a calculation of equivalent units. If 100 units are 60% completed then they are assumed

to be equivalent to 60 completed units. (In the canning business, we didnt do this. If 100 cans of fish were left without the tops on the fish rotted and that was that. 100 cans of 60% completed work = 0 completed cans.) Activity Based Costing This is a new system of cost accounting. It emphasizes the activities that drive costs. These are also known as cost drivers. In Activity Based Costing (ABC for short) the operation is broken down by activity. (Duh!) Building usage is broken down to cost by square foot. Machine cost by time usage. Office machines by paper output. And so on. All of these activities use different methods to allocate costs to products and services. Its more accurate than traditional cost accounting methods but the trade-off is more work.

Standard Costs Okay, Im back. Im finally a fully completed widget and Im sitting on the loading dock ready for shipment. All of these systems require that the costs be finalized at the end of the year. In the meantime some interim pricing has to be used. This is the standard cost. This is a cost that is based on past experience, scientific analysis, time and motion studies, and/or current accounting data. At the end of the year when the last adjusting entry is made, Ill be long gone. Somewhere an accountant will make that final entry into by ledger and the last pile of money will drop into my insides (unless it reached in and took some out!) and my final cost to the company will finally be known. Meanwhile, Ill just sit right here in this box and wait for the truck to arrive to pick me up. I do hope that I made a profit for the company. They seemed like nice people.

MANUFACTURING
Hello, again! Im the widget from the last web page. Yes, the truck finally came. It loaded me up and took me to the store. The store bought me from the manufacturer. Im right now sitting on the shelf. Soon a customer will buy me (I hope) and then I can go to work.

The stores accounting of me is different from the factorys. For the store, Im added to inventory at their cost and taken out when sold. My amount in the Cost of Goods Sold is the price that the store paid the factory for me. Its all pretty simple, actually. The factory has a different problem. You see, they didnt buy me from anybody. They manufactured me. So what is my cost of goods sold? The start of the production process is Raw Materials. This is the first part of inventory. Beginning and ending Raw Materials Inventory shows in the Cost of Goods section of the Income Statement. The materials are put down the assembly line and people start to put them together. Thats how I first came to be like the fine fellow that I am today. Too bad I wasnt finished when the end of the period came and the accountants closed the books. I went into the second part of inventory: Work in Process. Around me were many other widgets. Some were 50% completed, some 90% and some hardly even started. All of the time we were being made costs were incurred. So, our costs at that point depended on how completed we were. Our costs included direct costs (Direct Labor + Direct Materials + Other Direct Costs) and factory overhead. There were described in the last page. Factory overhead pertained to the plant floor. Things that were used in production was factory overhead. All of these costs were included in the manufacturers Cost of Goods Sold section on his Income Statement. General costs such as marketing costs, administrative costs, and company-wide costs were included below in the section titled General and Administrative Costs. Heres a few weird things that happened to me on the way from Work in Process to Finished Inventory. Joint-Products There were some other widgets that were made at the same time as me but they werent like me at all! It was like in the oil business where the crude came in one door and gasoline, engine oil, and kerosene came out the other! Production costs had to be allocated to the different kinds of widgets. There are two methods for doing this. The Physical Unit Method just allocated costs by individual units. Units may not be just individual widgets, but pounds, gallons, or cubic feet. The Relative Sales Value Method allocates costs based on the products relative sales.

By-Products These are products that have a small value relative to the main product. They dont affect the production decision. Still, they make some money for the factory. For by-products, their net revenue (revenue minus direct costs) is just deducted from the cost of the main products. Some companies put Net Revenue from By-Products under Other Sales at the top of the Income Statement or Other Income at the bottom of it. Scrap This is stuff that got thrown away. Accountants treat this the same way as (ahem!) Shrinkage. This is a kind term for the stuff that just disappeared. Either it got lost or it got legs and walked away (and ended up on our friend Billy Bob Bodines garage). Shrinkage. The cost for scrap and for shrinkage may appear as a separate line in the Cost of Goods Sold section. Ooh! A customer is coming! Shes looking at me! Please buy me! Im so tired just sitting here on this shelf. All of my other widget friends have gone and left me all alone. I dont cost very much. Just Direct Costs, Factory Overhead, and General Overhead. Oh, no! I didnt explain that part yet, did I? Well, then turn to the next page quickly. Shes still trying to decide whether to buy me!

OVERHEAD
Heres a true story. This story occurred in Washington State in 1990 but thats not important. It could have occurred anywhere; it could have occurred yesterday. I called the relevant state department and asked this question. What is the overhead portion of the States welfare budget? Well, I got shuffled to and fro. Eventually I got hold of the right person. At least everybody else said he was the right person there to talk to. More importantly, he said he was the right person to talk to. He was a manager of some cost accounting department in the agency. They had more than one, department that is, and lots of cost accountants so Im sure he was very important. Anyway, he wanted to know what I was talking about. So I explained I wanted to know how much of the budget actually went to help poor people and how much went to government overhead. Government overhead, he asked, whats that? Well, you know . . . the salaries of department directors, program administrators, managers, their deputies, their staffs, office equipment for them, buildings to house same, trips to

conferences to meet other managers, etc. You know, stuff like that. Well, this is an interesting question. We had never encountered this question before. What are the components of your budget then? I asked. We list the various programs but we dont track how much is direct benefits and how much is overhead. Despite the look of this on the page the man really was trying to be helpful. At length he said, Now come to think of it somebody did ask this question once. Somebody from the legislature. Ill look that up and get back to you. He did. He gave me the name of a state representative. Yes, if youre wondering, he was one of those conservatives. Anyway, I called him up. He said that yes, he remembered the question. He was only passing along a question that a constituent had asked him. He didnt save the answer and didnt remember what it was. Anyway, it was nothing elaborate. Some cost accountant had simply done a quick and dirty calculation for him so he could satisfy his constituent. Okay, so its now 13 years later and Im in the opposite corner of the country. Yes, I realize I used a lot of direct quotes up there. I dont remember exactly what was said but I think I came pretty close to what was said. I do know this. Very little of the money government budgets for welfare actually goes to help poor people. I know this for sure because I know the basic principles of finance. (Okay, so maybe not the very advanced but I do know the basic ones!) One is that unless management takes care to control it, overhead tends to expand. The first step to control overhead is to know what it is. I do not mean knowing academically what it consists of. I mean actually keeping tabs on it on a month-to-month and a year-to-year basis. I mean it. If the reader gets nothing else from this web site, remember this piece of accounting advise: KEEP TRACK OF YOUR OVERHEAD!! Okay, Im done with my rant. Now lets get back to our friend the widget. We last saw him pining away on the store shelf. Oh youre back! Thank goodness! That nice lady is trying to decide to buy me! Im pretty sure shes not thinking, How much of the cost of this widget is Direct Materials Cost, how much is Direct Labor Cost, or how much is other costs? She assumes that the store will make a profit on the purchase. That assumes that the cost accountant has done his job properly. No, she just wonders if she wants to pay the price to

buy me. If the cost is going to be below the price, its going to have to include the overhead. But how to do that? Thereby hangs another story! Once upon a time I (Jack again) audited a small engineering firm in western Colorado for the U.S. Department of Energy. The owner of this firm was an independent fellow and he was (sorry!) an engineer. So when I asked to for his documentation for the overhead part of his cost claim to the agency he produced a set of flow charts. He was an engineer, so he thought in terms of flow charts. (Sit still, widget! The nice lady isnt going away. Im writing this and I just reminded her of her place. A literary device should keep quiet and not wander off! At least on this web page she will!) Now where was I? I explained to him that he had to total up all of his overhead costs. That means listing them line item by line item and then adding the numbers up. He could understand that. In fact, he said that this was a good idea! Next he had to figure that part of the overhead that should be charged to the Department of Energy. This took a little head scratching for him. So I helped him out. (This kind of attitude did not make me very popular in certain sectors of the government.) Overhead consists of all of those costs that are not directly attributable to projects. The Presidents salary is overhead. Interest on the building mortgage was overhead. Office equipment was overhead (depreciation expense). All of these items are the overhead pool. Think of a giant swimming pool of costs. Put all of the overhead items into this pool and add them up. Next we need to determine the projects. Then we need to determine a proper allocation basis. These allocation basis can vary from firm to firm. For an engineering firm, the normal base is a multiplier of direct labor. The overhead divided by the direct labor of the project gave the amount of the overhead to allocate to the project and to charge to the government. The overhead claim looks a lot like an Income Statement. At the top is the listing and totaling of the Overhead Pool. The next section is a listing and a totaling of the direct base. Last is the Applied Overhead. This corresponds to Net Income. Net Income is the result of subtraction (sales minus expenses). Applied Overhead is the result of division (pool divided by the base).

There are different methods for allocating overhead. There is the Job Cost Method, the Process Cost Method, and the Activity Cost Method. Allocation basis can include Direct Labor Hours, Direct Labor Dollars, Prime Costs, and Total Cost Input. That last one is all of the other costs that already have been allocated to projects. A company can have more than one overhead pool. I (Jack) once worked on a laboratory that boasted that it had the most complicated cost accounting system in the world. I decided to diagram all of its overhead pools and how they flowed into one another. Their internal audit manager said good luck and if I succeeded to please get him a copy! The cost accounting I described above has all of the pools flowing direct to end products (or services in the case of the engineering firm). The laboratory had pools flowing into other pools. These were Intermediate Cost Pools. The calculation of this flow is the same as for applied overhead to direct costs. The base for an application of an intermediate cost pool is base components of the pools it is being allocated to. Warning Uncontrolled cost pools can attract cost codings from people from all over the company as people try to spend more than their budgets. Alright! Enough already! This is turning into one widget with a temper! How about me? Is that lady going to buy me or not? Well, now theres that labor cost to consider, widget. Labor cost? What labor cost? This is the OVERHEAD page you idiot! How are you supposed to compete with widgets from China where workers earn $1 per hour while the workers that made you earn $20 per hour? Oh, those Chinese widgets over there. I notice theyre coming in from Latin America and from just everywhere now. Thats why we think of overhead. Overhead? Yes, overhead. American companies cant compete with many foreign countries on labor cost. Nor should they try. But they can compete on overhead. Hey, overhead is pretty important, then. Not just to the individual widget but to the entire future of the world economy! You got it, widget! Sold!

CONSTRUCTION
So youre finally got your dream job in the construction industry! Youll get most of construction accounting if you understand three key concepts. 1) Project Costing If all you have to worry about, then this isnt much of an issue. All of the costs goes to this one project. But if you have more than just one project, then youve got to keep track of which costs go to which one. Its best to think of each construction project as a job. Job costing is the easiest and best kind of system to use. Each cost gets two codes. The first is the account code. This is the usual code that accounts always gets. This code takes the transaction to the general ledger and to the trial balance. This code determines which line item in the financial statements the transaction will be included. The second code is the job code. This code determines which project the cost goes to. Of course, the construction manager may want more information than just the total amount of the costs that has been charged to his project. He may want some kind of breakdown. Sub-codes take care of that. Example Your dream house may be project A-105 to the contractor. Labor costs may be code 1; materials may be code 2; Inspections code 3, other costs code 4. Then $200 to the city department for a permit inspection will be coded to project A-105-3. The A-105 tells the accounting system that it is your dream house; 3 tells it that it is for inspections. The other cost issue is allocating overhead to projects. We have nothing spectacular to say about overhead allocation that we havent already said here. 2) Revenue recognition Completed Contract The real problems with construction accounting is when do you show revenue? On a cash basis, then you show it when it is paid. This can present some real problems.

Example Your company gets a $3 million contract to make a bridge. The contract pays half down and half on completion. It takes 3 years to build this bridge. Well, the first year you get $1.5 million. Construction costs may be minimal because youre just starting. The time is spent on designing it and getting permits. Your manager looks really great because hes showing over a $million profit on this bridge. Next year you get zilch. Youve got to spend a whole ton of money on construction costs. Your financial statements post a whopping loss. Your manager looks so bad, hes fired. The last year, on the other hand is great! The bridge is completed on time and your company gets paid the remaining $1.5 mil. Your company looks great now. Epilog: The fired manager goes to work for a competitor who understands construction accounting and goes on to win bid after bid over you and brings his projects in on time and on budget just like had done for you. Clearly, this manner of accounting is not going to work. Some way must be found to match revenues with expenses. Construction accounting ties this to the completion time of the project. Under the Completed Contract Method, the costs and revenues are shown as deferred items on the balance sheet. They are then reclassified to the Income Statement when the project is finished. This is easier said than done. Somewhere a job cost schedule has to be maintained showing the Income Statement account codes where all of the cost and revenue items will eventually end up. You wont want all of these items showing up on the Balance Sheet; only the totals. The Balance Sheet captions may be Costs and Estimated Earnings in Excess of Billings (debit balance totals) or Billings in Excess of Costs and Estimated Earnings (credit balance). Put these deferred titles in Current Assets or Current Liabilities. 3) Revenue Recognition - The Percentage of Completion Method The mechanics are the same as the Completed Contract Method. The big difference is the timing of when the earnings and costs are transferred down to the Income Statement from the Balance Sheet.
So how to determine how much of a project has been completed? What kind of objective measures are used? Input measures are things that go into a project.

Examples
Percent of costs incurred to total estimated costs. Percent of labor hours used to total estimated labor hours. Output measures are things that are the outcome of a project.

Examples
Number of miles of a highway already completed versus the total miles to build. Number of stories in a building completed versus the total stories of the building. Output costs are not as reliable as input costs. Early work on a project may involve a learning curve. The earlier part of a project may take longer and be more costly than the later parts because the builder simply learns how to be more efficient. Yes, construction accounting is one of the more difficult areas to learn. In our books page, we will recommend some good reading.

NON-PROFIT ACCOUNTING
Welcome to a new world! Yes, this is. Just plant your flag atop that hillock over there and lets survey the countryside. Okay, so theres no harbor. Quit complaining! The entire concept of profit and loss is gone. This is Non-Profit Accountingdom! The entire base of accounting is different here. The result of revenues and expenses is of secondary importance here. The results used to be called Surplus and Deficit instead of Net Income and Net Loss. The lords of FASB (thats Financial Accounting Standards Board to you, immigrant) have signaled their distain by mandating the terms Net Increase in Net Assets and Net Decrease in Net Assets. Surely, they could not be so demented as to think that these new terms are improvements! Look around. The landscape sure is different! Thats because when people read non-profit financial statements, they are looking at different issues then when they read regular financials. How much of its funding does this charity spend on its programs and how much does it spend on overhead? Is officer salaries a small grove or a whole forest? Look for things like that.

Over there are still other unique concerns. Some of the money is restricted. Charities have Building Funds, Homeless Funds, and other funds that have been raised for specific purposes. Some of the money is temporarily restricted. So where did these restricted funds go? People want to know! Now unrestricted funds on the other hand are a different matter. They can get spent on anything. The accounting needs to keep track of all of these because the financial statements need to show them. Okay, so now lets hit the road and look into the shops and see how these things are done. First, you got to know the right titles. The Balance Sheet is now The Statement of Financial Position. The Income Statement is now the Statement of Activity. The Cash Flow Statement is the same. Now theres a new statement, though. The Statement of Functional Expenditures. This breaks out the expenditures (oh, yes another name change) to programs, fundraising costs, and overhead. We keep track of fund accounting by using department accounting. Each fund is a department. When the charity borrows money from one fund to pay another funds bills, we show that as receivables and payables on each funds books. Just like Columbus when he discovered the Western Hemisphere, you are now standing upon a whole lot of territory to explore. We hope that this page helps you get your bearings.