When I prepare financial statements, I always review the general ledger (GL) account numbers that the client has coded on the check register. Whenever I see a balance sheet GL account number, I automatically double-check it. The reason I do this is that the balance sheet is the least understood part of the financial statements for most clients. This is especially true regarding the equity section. In a way, this is rather strange, since the equity section represents the owner’s share of the business. I would want to keep a very close eye on my investment and, to do that effectively, I would need to know the nature of each equity account and how to interpret the changes in those accounts as they occur.

If I am a sole proprietor, it’s not as crucial because everything in the equity section is mine. That’s not to diminish the importance of knowing what the accounts mean, as there are other good reasons to track the increases and decreases that occur within them. However, if I am a partner in a partnership or a stockholder in a corporation, it is my responsibility to protect my investment interest from mistakes and/or deliberate misstatements. This can be a challenge and accounting knowledge is required.

It is in this light that I thought a review of the equity accounts for a sole proprietor, partnership, and corporation could prove useful. In order to do this, you need to understand how debits and credits work. If you need a reminder, you can click on this link: http://www.reallifeaccounting.com/accounting_model.asp and print out a copy of the “Accounting Model” for a guide.

Sole Proprietor

The equity section title in a sole proprietorship is most commonly called “Owner’s Equity”. The accounts within this section are usually laid out in this fashion:

Owner’s Equity
Current Year Capital Contributions
Owner’s Draw
Net Profit or Loss

Look at the accounting model chart and find the equity section. An increase to the equity section requires a “credit” entry, while a decrease requires a “debit” entry. Following this “accounting logic”,
it makes sense that a contribution of personal money to the business requires a debit entry to Cash and a credit entry to Current Year Capital Contributions. On the other hand, if cash is removed from the business for personal reasons, a debit entry to Owner’s Draw and a credit entry to Cash would be required.

Furthermore, if the business showed a profit, that would indicate an increase in equity (credit), or if it showed a loss, that would indicate a decrease (debit) in equity.

Since the Owner’s Equity account (a credit balance account) is an “accumulation account”, all the other accounts are closed out at the end of the year into the Owner’s Equity account. This makes perfect sense when you follow the journal entries required to close out the accounts. For Instance:

Net Profit or Loss is automatically closed into Owner’s Equity at the end of the year by your computer. If a journal entry were written, it would look like this:

Or

As you can see the function of the sole proprietor equity accounts is not complicated or difficult to understand.

Partnership

Depending on how many partners there are, partnership equity accounts usually are organized as follows under the title, “Partner’s Equity”:

Partner A, Capital Account
Partner B, Capital Account
Partner C. Capital Account
Net Profit or Loss

All the increases or decreases occur within the partner’s capital accounts. In other words, the partner capital accounts are the equity accounts. If a partner makes a capital contribution, then his/her capital account is increased (credit). If the partner takes a distribution, then the capital account is decreased (debit). If the business has a profit or a loss at the end of the year, then that profit
or loss is distributed among the partners at whatever ownership interest or other arrangement is appropriate.

General partners who work in the business are paid a management fee called a “guaranteed payment”. This fee is a legitimate business expense and therefore acts to lower the net profit of the business. This fee is similar to a salary paid to a working stockholder in a corporation, except, according
to U.S. tax law, a fee paid to a working partner cannot be run through payroll. It is treated as a draw, subject to self-employment taxes. Both the general partner’s guaranteed payment and share of the profits are taxable and subject to self-employment taxes.

Sometimes a business may not have enough cash to make a distribution to the partners even though the business realized a profit. Partners may have a rude awakening to discover that they still have to pay taxes on those profits regardless of whether they received any money.

Another scenario to be aware of if you are a non-working general partner or a limited partner is this one: You and your partner contributed an equal amount of cash for working capital. The reason for investing your money is because you expect to share in the profits. Your partner is a working partner and is entitled to receive a management fee for services rendered. You need to keep an eye on the books because there may never be a profit to share in if your partner simply continues to increase his/her management fee. It can be a sticky situation because the working partner may feel he/she is never making enough money to justify all the work he/she has to do. It is best to define what the management fee is going to be in the partnership agreement beforehand.

Corporation (Primarily closely held corporations)

Closely held (private) corporation equity accounts are a little more complicated than a sole proprietorship or partnership. These are the typical accounts found in the corporation equity section under the title, “Stockholder’s Equity”:

Retained Earnings
Paid-in-Capital
Dividends Paid
Common and/or Preferred Stock
Net Profit or Loss

Retained Earnings is similar to the Owner’s Equity account in that the Net Profit or Loss is closed into that account at the end of each accounting year. Paid-in-Capital is the account used to record capital contributions made by stockholders. Keep in mind, as in the examples above, that increases to an equity account are credits. For example:

If dividends were paid the journal entry would look like this:

When common stock is sold or issued to raise money or acquire property:

When Net Profit is closed out for the year:

These accounts are also found on public corporations, however they may have additional equity accounts that are necessary to explain more complex activities.

You can see that the equity accounts in all three business entities function in a similar manner. From year to year, there should be continuity. This means there should be a logical explanation for any increases or decreases in theequity accounts. As an investor or owner, you have a right to know the reasons for any changes. If there has been a mistake, willful or otherwise, it is most likely going to show up in the equity section. Stay vigilant and protect your investment.

The reason we hear of these cases so often is that, in a small business, theremay only be the owner and a bookkeeper. The owner doesn’t like doing the books, doesn’t understand them, and relies on this one person to take care of things. The bookkeeper, who is usually having personal financial difficulties, takes a small amount of money intending to pay it back. No one seems to notice, so more is taken. Over a period of time, it starts to mount up to a lot of money.

This is where the concept of “internal control” comes in. Essentially, every business should have, at some level, an internal control system in place to protect against losses, both intentional and unintentional. This is because “internal control” systems will: 1) protect cash and other assets; 2) promote efficiency in processing transactions; and, 3) ensure reliability of financial records. An internal control system consists primarily of policies and procedures designed to provide reasonable assurance that these three objectives will be achieved. The size and complexity of the business will determine the extent of the internal control system.

Regardless of size, one of the most important aspects of an internal control system is the concept of separation of duties. Separating duties makes it more difficult for theft and errors to go undetected. It is highly unusual for two employees to “collude” in an effort to steal from the company.

I worked as an internal auditor for a newspaper chain for three years. My job was to walk in to the newspaper offices unannounced and go directly to the cash boxes, count them, and verify receipts. One of my most important audit steps was to make sure the internal control procedures were in place and working properly. Here are a few suggestions for internal control procedures regarding
handling of cash:

• Allow only specific designated individuals to handle cash.
• Give responsibility for bookkeeping to an individual who does not handle cash.
• Use numbered receipts to document all payments.
• Make all bank deposits promptly.
• The person who prepares the bank reconciliation should be different than the one handling cash.
• If possible, the person who makes the bank deposit should be different than the one who handles
  the cash and the one who prepares the bank reconciliation.
• Make deposits intact with no amounts withdrawn to pay expenses.
• Keep cash and checkbook in a locked drawer or cash register.
• Since tills will never be 100% correct all the time, establish a tolerance level for overages and shortages to determine the point at which corrective measures will be triggered.
• Make all disbursements by check, except minimal amounts paid from petty cash.
• Make certain every payment is related to a paper document, such as a voucher,
  to ensure that a paper trail exists for all disbursements.
• Conduct random surprise counts of petty cash and cash drawers.
• Count inventory and other assets frequently and compare with company books.

An internal control system set up early as a preventative measure is more efficient than establishing a corrective system in reaction to a loss. If it so happens, that there is just you and the bookkeeper in your small business, you need to learn how to do some of the bookkeeping tasks so you can spot check the bookkeeper’s work. That, in itself, is an excellent preventative measure.

Having worked in the field of accounting for twenty-five years, I have had ample opportunity to observe, first hand, many a client who has bought a “business-in-a-poke”. In the old days, there were no accepted valuation formulas available to determine a reasonable price for a business. As a result, “rule-of-thumb” methods were used, but often had no correlation to the real worth of a business.

Choosing the correct valuation formula and applying it properly can be a daunting task and should be left to the auspices of an experienced professional. However, you can become familiar with the general guidelines of a widely used business valuation formula that will, at a minimum, give you an idea of what’s involved. Armed with this information, hopefully you can avoid being scammed into buying a “business-in-a-poke”.

Have you ever tried to sell or buy a business? It’s not exactly a straightforward, easy thing to do. Most likely, if you are the seller, you will want to get top dollar for your business. After all, you worked hard to make your business work and would like to be amply compensated. Often, small business owners have a feeling for what they think the business is worth. When asked to justify the selling price, you may hear all kinds of stories.

For example, one of the most common reasons sellers give for their asking price is the potential of the business. This is sometimes better known as “blue sky” or “pie in the sky”. There is no way to accurately estimate this feeling for potential, yet sellers will tell you that if you buy their business you will be in a great position when this new technology arrives, or this big store moves in next door, or if you are willing to work extra hours, and on and on.

Another story you will hear is how much money the owner takes out of the business including salary and perks. Somehow the seller is equating compensation from work performed in the business to earnings. This may impress you if you are looking to buy a job. But even then, you need to pay only what the business is worth. So what do you have to do to determine the true value of a business? Rest assured that the process of valuing a business can be exceedingly complex. Much depends on the size and nature of the business you are buying or selling. The variables can seem unending. An essential element of valuing a business is determining whether Goodwill exists, and if so, what price to put on it.

What exactly is Goodwill?

Goodwill is the difference between the value of a business enterprise as a whole and the sum of the current fair values of its identifiable tangible and intangible net assets. Net assets are the assets that are left after subtracting the company’s liabilities. Goodwill is only recorded when its amount is substantiated by an arm’s-length transaction. Goodwill cannot be sold or acquired separately but has to be included in a purchase with the net assets of a business enterprise.

How is Goodwill valued?

Let’s say someone is selling a small business and is asking $100,000. The first question to ask is, “What exactly is he/she selling?” What assets are you going to receive in the deal and what, precisely, is their fair market value? After appraising the assets, are they worth $100,000? If not, the difference is what the seller construes to be Goodwill. For our hypothetical example, let’s assume the net assets have a fair market value of $60,000. This means the seller wants $40,000 for Goodwill.

Is this reasonable? Here are some general steps you can follow to find out:

First, determine what a reasonable rate of return on an investment of $60,000 should be. (Determining this rate of return can be complex and probably requires the help of a professional.) For our purposes, let’s use 8%.

$60,000 x .08 = $4,800

This is the amount of normal earnings the company should be making each year.

Second, determine from an average of five years of financial statements, backed up by tax returns, what the net profit is. Be sure to “normalize” the earnings, which is to say, remove expense items, such as depreciation and owner’s perks, or add in a manager’s salary if the owner worked in the business and didn’t record a salary. Add or subtract any other appropriate items to arrive at a realistic net profit. Let’s say the normalized earnings turned out to be $10,000.

Third, subtract the normal earnings of $4,800 from the normalized earnings of $10,000 to determine excess earnings.

$10,000 – $4,800 = $5,200

Fourth, determine a capitalization rate (cap rate). This also can be complex to develop. However, the idea behind a cap rate is this: The lower the risk, the lower the return on investment. The higher the risk, the higher the return on investment. For example, if you invest your money in your local bank, the risk of losing your investment is relatively low. Therefore, you only earn about 2%. Invest in the stock market and you can expect to earn up to 10% or higher in some cases, because it is a more risky investment. A small business can be a very risky investment, and a rule of thumb says you should at least expect to earn 20%. But, if the small business has factors that indicate less stability, then an even higher rate of return should be expected, perhaps 30% or 40%. Determining an appropriate and accurate cap rate is probably the hardest part of valuing a business.

However, let’s say our cap rate is 20%.

Fifth, divide the cap rate into the excess earnings to determine Goodwill.

$5,200 / 20% = $26,000

Sixth, add the net assets value and the Goodwill to determine the full value of the business.

$60,000 + $26,000 = $86,000

Our seller wanted $100,000 for the business. Now you can go to him and say, “Gee, I just don’t see it that way, take a look at my analysis”. Usually, the seller will back down when presented with a formula approach. If the seller hires his own accountant to provide a formula approach and his value of the business is higher than yours, (you can bet on it) then a common approach is to settle on a price that is the difference between the two.

How could the seller’s accountant come up with a different figure than yours? It’s in those rates and all the variables that go into developing them. It doesn’t take much to skew the percentage points one way or another. Here is a “what if”:

What if the seller’s accountant came up with a rate of return for net assets of 6% instead of 8%?

$60,000 x .06 = $3,600 Normal earnings

$10,000 – $3,600 = $6,400 Excess earnings

And, what if the seller’s accountant came up with a cap rate of 18% instead of 20%?

$6,400 / .18 = $35,556

$60,000 + $35,556 = $95,556

This is very close to the seller’s original asking price of $100,000.

The name of this formula of valuing a business is called the Net Assets plus Excess Earnings method. It does not work on all businesses and there are other methods that can be used. The main point is to inform you that formulae do exist and not simply to accept the rationalizations of the seller.

Does Goodwill even exist?

This is a quick and dirty method to see if you want to waste your time negotiating a business offering. When the seller provides financial statements for your perusal, look at the bottom line. Take the time to normalize the earnings as mentioned above. Is there a profit? If not, you know there is not going to be any goodwill. What are the assets worth that you will be buying? Are they less than the asking price? If so, you can pretty much bank on the fact that the asking price is too high. Look at alternatives. Could you buy new assets for the amount the seller is asking and start your own business from scratch? Why pay for something that doesn’t exist?

What happens if the seller has two sets of books?

Business owners who keep two sets of books are not altogether uncommon. They keep one set of books for the government and another set for internal purposes. There is nothing wrong with this practice unless it is for the purpose of hiding income in order to pay lower taxes. The problem for these people arises when it comes time to sell their business. They want you (the buyer) to accept their internal books because they reflect more profit. However, you have no way of verifying that these books are accurate. That is why it is important to make sure that the tax returns of the business support the financial statements. Business owners who follow this practice of deception want it both ways. What they don’t realize is that any wise and astute buyer is not going to go along with it. If a business owner is going to lie and cheat the government, surely that person is capable of lying to a potential buyer. My recommendation is to walk away or only pay a price based on information from the tax return.

Good financial records

If you are buying or selling your business, good records are a must. Buyers are going to want an historical average of profits so they can develop trends. Trends speak volumes. Good financial records are indicators of how the business was managed. A strong prospective buyer will expect nothing less than Balance Sheets and Profit and Loss Statements that tie directly to the business tax returns. I’ve witnessed solid buyers walking away from deals because of sloppy books. Sloppy books are a “pig-in-a-poke” to a prudent buyer.

Buy

When you buy an item you either pay cash for it all at once, or, you sign an agreement, called a promissory note, to pay for it over time. When you buy and make installment payments, you are considered to have entered into a “contract of sale”. From an accounting and tax standpoint, you have purchased an asset and incurred a liability. The asset cost is deducted over a period of time through an expense category called depreciation. Usually, a down payment of a certain amount is required to consummate the purchase. Note how this transaction is set up on the books using the following journal entry:

When payments are made on the note there are two components to consider, i.e., principal and interest. Principal is the original amount borrowed and interest is the cost of borrowing the money. Since interest is a cost, it is a deductible expense and has its own category. For instance:

Do you see that in a “contract of sale” the expense deduction comes from two sources, depreciation and interest?

Lease

A lease is an agreement under which the owner of property permits someone else to use it for a fee. The owner is the lessor and the user is the lessee. There are two types of leases from the standpoint of the lessee: a “dirty” lease and a “true” lease. The “dirty” lease is called a “capital lease” or a “lease obligation” in accounting circles, and, a “true” lease is called an “operating lease”.

A capital lease is one in which the rights and risks of ownership of the property will be transferred to the lessee. Therefore, the lessee must evaluate the provisions of a lease in order to determine if the lease should be classified as a capital lease or an operating lease.

How does the lessee do this? This is the tough part. There are four criteria to use and, if any one of them fit, the lease should be treated as a capital lease:

1. The lease transfers ownership of the property to the lessee by the end of the lease term.
2. The lease contains a bargain purchase option (like a $1.00 buyout).
3. The lease term is equal to 75% or more of the estimated economic life of the leased property.
4. The present value of the minimum lease payments, at the beginning of the lease term, is at least equal to 90% of the fair value of the leased property.

I recognize that at this point I may have left many of you scratching your heads. But, don’t give up just yet. Look, most of the lease contracts you are going to enter into contain the first two criteria. If the lease contracts do, don’t worry about the last two criteria. If they don’t and the lease doesn’t appear to have the characteristics of an operating lease (see below), then you should check with your accountant to make sure you are giving the lease proper accounting treatment.

In the United States, the Internal Revenue Service (IRS) and the Financial Accounting Standards Board (FASB) feel that a capital lease type of contract is so similar to a “contract of sale” that it should be given the same accounting and tax treatment as a normal purchase.

The cost of leasing is built into the lease payment but is not stated separately (like interest on a note). However, the IRS considers it to be the same. Therefore, a Capital Lease is set up the same as a Notes Payable.

Note here that the cash down payment is less than the contract of sale above. This is one advantage of buying through a lease. Normally, the down payment includes only the first and last payment of the lease ($550 + $550 = $1,100).

Depreciation occurs just as in a contract of sale.

Often you will find that the leasing company does not give you the actual cost of the asset you are buying. What they will do is give you the total cost of the lease. For instance, if your lease payments are $550 per month for twenty months then the total lease contract will be stated as $11,000. You must remember to find out the actual value of the asset ($10,000) in order to record it accurately on your balance sheet and depreciation schedule.

The rule is that the cost of the asset can never exceed its fair market value. There may be other costs called “executory costs” included in the lease payments. These are items such as insurance, maintenance, and property tax. These items can be expensed in each payment as they are incurred.

The $550 lease payment is split up in the same manner as the principal and interest payment of the notes payable except that you may have to include the executory costs.

The only difference between a Capital Lease and a Contract of Sale purchase is that the down payment on the lease may be less. The deductible expense is the same.

An operating lease (or “true lease”) is one in which the lessor retains the rights and risks of ownership. The lessee is simply obtaining the right to use the property for the term of the lease and no more. If the four criteria above are not met then the lessee should treat the lease as an operating lease.

If, at the end of the term of an operating lease, you decide to keep the property, then, technically you should be required to pay the fair market value of the item at that time. However, many lessors offer the leased property at 10% of its original fair market value. This practice of using a 10% buyout at the end of the lease term does not constitute a “bargain purchase option”. In addition, the bookkeeping is simpler, because the full cost of the lease payments is treated as a rent expense each month. There is no asset recorded on the books, no Capital Lease Payable or Interest Expense. Here is how the journal entry looks each month:

Unless you can write off the equipment all in one year using the IRS 179 Election, you can probably expense this property faster than a “contract of sale” which uses depreciation and interest. In twelve months, using my example, you could deduct $6,600 ($550 x 12 mo = $6,600) assuming you bought the property on January 1.

What about automobile leasing vs. buying? This is a whole different ball game. The politicians have tinkered with the auto deduction over the years and made it very complicated. However, the bottom line in the U.S. is: There are statutory limitations as to how much you can depreciate an automobile in one year, depending on the cost of the auto and when you bought it. If you lease an auto, there may be an advantage; however, it depends on the lease terms. You can write off the payments (modified by the business use percentage) each month, which could very well exceed the allowable depreciation amounts.

In an effort to find parity between the lease payments and the allowable depreciation amounts, the IRS constructed Lease Inclusion Tables. The idea is to modify the amount of the deductible lease payments by the amount found in the Lease Inclusion Tables. However, the amount you have to include from these tables is astoundingly small. Understandably, no one is complaining about the higher write off.

Calculation

Now that you have a sense for the accounting theory of leases and loans, your next step will be to calculate the numbers associated with the equipment in mind. The Internet has many Lease or Buy calculators. For instance, http://www.lease-vs-buy.com will take you through the process step-by-step and provide explanations and definitions for unfamiliar terms. If you don’t like this one, just put “lease or buy calculator” in Google and pick one you do like. Once you are finished, it’s probably a good idea to check your results with an accounting professional.

How in the world could anyone working in accounting get along without a Detail of the General Ledger report? That would be like working with your hands tied and your eyes blindfolded. Without this report you would have a very difficult time determining how a final balance in a particular account was derived. Here is why:

Picture this: Back in the not-to-distant past (before computers really caught on) we accountants recorded each transaction of the business manually into a great big hard-bound, three-leaf binder book with yellow pre-printed ledger pages. Obviously, this was a very time-consuming, tedious process. Each page not only recorded the numbers associated with the transaction, it also recorded where the numbers came from, the date, and, when appropriate, a very brief note to the side describing additional detail. Here is an example of a general ledger account page:

Account 1010 – Cash-in-Bank

Transactions may come from a variety of journals, but they all pyramid into the General Ledger. I use the word “pyramid” because it is helpful to visualize the shape of a pyramid with all the source documents spread out at the base. The information is being summarized from each document and “migrates” upward to the General Ledger and eventually to the financial statements, which are at the top of the pyramid:

Fin State
Trial Balance
General Ledger
Gen Jour, Cash Rec, Cash Disb, Acct Rec, Acct Pay
Sales Invoices, Purchase Invoices, Bank Rec, Check Register

If I wanted to find out how a particular balance came to be, all I had to do was look at the detail on the general ledger page. That detail would then tell me which source documents contained the numbers that contributed to the final balance. I did not have search all over kingdom come to find what I was looking for.

Nowadays, your computer accounting software should give you a report of the detail in your General Ledger that is laid out as cleanly and clearly as presented above. Just like you would find in a manual general ledger. The report should not be encumbered with all kinds of other information that makes it hard to decipher. Some software programs don’t call this report a Detail of the General Ledger, they call it a transaction report or something similar.

Furthermore, you should be able to print a report for any period your heart desires, for instance: a year-to-date report; from February to July; for just one month; or whatever. You need that flexibility. If you need to see all twelve months of activity for a particular account, then you need to see all twelve months. You should not have to print out each month separately and then manually piece them together. And, if you only need to look at one month, you don’t want to have to print out the entire year.

A good report will enable you to use it as an analytic tool to find mistakes. Let’s assume that after printing your financial statements you looked at the Cash-in-Bank account and it said the balance was $3,556.38. Being the good accountant that you are, you verified that balance with the bank reconciliation balance and found that it said the balance should be $3,583.38. The difference between the two totals is $27.00. Your first step should be to run a Detail of the General Ledger report for the month, which you do and it is our example above. The first thing you notice is a $27.00 credit entry. This is suspicious and worth investigating. You can see that this entry came from the General Journal so you turn to page 4. Let’s hypothesize and assume that you really meant for this credit entry to go to Employee Advance, which is 1110. You simply wrote the wrong GL Account number.

We used to call this procedure “smoking out the error”. Sometimes the errors are easy to find, sometimes not so easy. The process consists of verifying the final balances that are on the financial statements. What is in the General Ledger should be what is on the financial statements. Therefore, you must use another document as a means of verifying the account balance. In our example above, we used the Bank Reconciliation. Other documents used to verify balances could be the Accounts Payable Ledger, Accounts Receivable Ledger, Sales Tax Report, Payroll History Report, Inventory Control Report, Notes Payable Amortization Schedule, and so on.

Just like a carpenter who uses a level before nailing up a board, you will want to verify your balances with these other control reports before accepting the financial statements as being correct. If the board isn’t level, the carpenter must figure out why. If an account balance is different than the balance found on the control document, then use your analytical tool called the Detail of the General Ledger Report to discover why.

If you have a set of business financial statements, take a quick look at them. First look at the Net Profit or Loss line on your P&L statement. Let’s say it reads $48,567.32. Now look at your Balance Sheet and find the Equity section. You should see that same number $48,567.32 on a line called Net Profit or Loss or something similar.

Why is this? Net Profit means an increase (credit) in Equity and Net Loss means a decrease (debit) in Equity. (Review the Accounting Model found in my last article to verify this.) Remember, Equity is what is yours. Therefore, if you have an increase in Equity (credit) then it makes sense to think that you have an increase in Assets (debit), probably in the form of cash, receivables, inventory or property. Or, you might have a decrease in Liabilities (debit) indicating an increase in Equity since you now no longer owe as much to creditors.

Similarly, it stands to reason that if you have a loss, indicating a decrease in Equity, that you will be showing a decrease (credit) in your Assets. In other words, you now own less.

It may help to think of the Balance Sheet as working the same way as a reservoir of water. At any point in time you can measure how much water a reservoir contains. In addition, there is always a river that flows into and fills the reservoir and an outlet, such as a dam, where the reservoir is drained. The reservoir level always reflects whatever water came in and went out.

The Balance Sheet, like the reservoir, is a reflection of the financial activity of your business at a given point in time. This is usually measured at the end of an accounting period, i.e., month, quarter, and year-end. The P&L statement can be thought of as the river that flows into and out of the reservoir. The P&L statement is a measure of the revenue and expense activity that occurred during an accounting period, such as at the beginning of a month to the end of the month, etc. The point to remember is that a Balance Sheet always reflects the activity of revenue and expense that has occurred in the past and current accounting periods.

Now that we have that concept established, here is a tip: When your business is a sole proprietorship, the way you pay yourself is through an account called “Owner’s Draw”. This account is located in the Equity section of the Balance Sheet and represents a decrease in Equity when you take a personal draw. However, sometimes owners get mixed up as to whether they are taxed on the draw amount or net profit so let’s clear up the confusion.

When a draw is taken, cash is being decreased, but where did the cash come from in the first place? Here are a couple of possibilities:

• Maybe you borrowed some money and put it in the business, but then decided to use some of the money for personal purposes. You don’t have to pay tax on borrowed money.
• Or maybe a while ago, you contributed some personal money that had previously been taxed and are now paying back. You certainly wouldn’t have to pay taxes on the same money twice.

Because the money withdrawn from the business may include previously taxed money, the rule is that you pay tax on Net Profit because Net Profit relates to newly earned income not previously taxed. If you keep your books on an accrual basis, then Net Profit may be quite different than your cash draws. This is because your revenue may include sales that haven’t yet been paid (Accounts Receivable) and expenses you haven’t yet paid (Accounts Payable).

Even if your books are recorded on a cash basis, your Net Profit may not relate directly to cash. For instance, usually a business has some depreciation that is a non-cash deduction. Or, you may have expenses charged on credit cards that have not yet been paid.

Perhaps you can now see that there are several reasons why the Owner’s Draw is something different than Net Profit even though there is a loose relationship between the amount of money available to the owner and Net Profit.