The key to understanding these accounts is having a working knowledge of how debits and credits are recorded depending on whether a transaction calls for an increase or a decrease. Use the Accounting Model link in the article if you need brusing up.

For example, if you are a sole proprietor and you take money out of your business for personal purposes then you would record an entry on the debit side of the general ledger account “Owner’s Draw”. Increases to Equity require a credit entry, while decreases to Equity require a debit entry.

In the example, if you wrote yourself a check you would be decreasing Cash, which is an asset. Since you wrote the check to yourself, it makes sense that you decreased your Equity. Here is the tricky part and why you need to “think out” what you are doing using the Accounting Model:

You decreased your Equity by making a debit entry to Owner’s Draw and you decreased cash in your bank account when you withdrew money for personal reasons and made a credit entry to CASH. Seems straightforward doesn’t it?

But you increased the Owner’s Draw account while at the same time decreasing your equity. Sometimes this concept is hard for people to grasp. You just have to remember that Owner’s Draw is a general ledger account found within the Equity Section.

It is useful to remember the fundamental accounting equation:

ASSETS = LIABILITIES + EQUITY

When Cash, an asset, was decreased then either Liabilities or Equity would also have to be decreased in order to stay in balance. In this case, the decrease was in Equity.

The rule is that in any transaction recorded the DEBIT SIDE MUST EQUAL THE CREDIT SIDE of the ledger.

Any questions?

For a definition and general understanding of Goodwill, be sure to read my blog article titled, “Valuing Goodwill: Avoid buying a Pig-in-a-Poke”. Let’s assume you’ve done that and you now know that 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.

Let’s also assume that you have just purchased a sole proprietorship small business for $150,000. You paid for it by making a down payment of $50,000 from personal funds and acquired a bank loan for the remaining $100,000. The purchase consists of $70,000 in Fixed Assets, and $80,000 in Goodwill. The journal entry would be:

Account Debit Credit

Fixed Assets $70,000

Goodwill $80,000

Notes Payable $100,000

Capital Contributions $ 50,000

You know you can depreciate the Fixed Assets, but can you write off Goodwill? According to the Internal Revenue Service, under the MACRS system, Goodwill can be amortized over a fifteen year period.

If you bought the business on July 1, the first year’s amortization would be $2,666.67. Each full year would be $5,333.33. Simply divide $80,000 by 15 to get $5,333.33. Divide that amount by 2 to arrive at $2,666.67. Depending on what month of the year you purchased the business determines the amount amortization expense. The journal entry to record amortization for Goodwill would look like this:

Account Debit Credit

Amortization Expense $2,666.67

Accumulated Amortization $2,666.67

Pretty straightforward, wouldn’t you say?

It seems reasonable doesn’t it? After all, your time is worth money and you are giving it to a worthy cause. What’s the matter with that? First, read my October article titled, “The Historical Cost Concept Accounting Principle”. It explains that money must exchange hands, or a promise to pay money, before an amount can be recorded on the books because there needs to be an objective way to determine the value of a transaction. Was there any money or promise of money exchanged in the example? No, there was only a contribution of labor.

Second, from a debits and credits perspective, how would you record a contribution of labor? If you recorded a debit to an expense account called Contributions, what would be the credit entry? Not Cash. Not Payables. Maybe Equity? Let’s look at that. If you write a credit entry to increase Equity, then the expense entry lowers Net Profit as washes out the increase in Equity. Sound pretty good? Not really, because you just violated the accounting principle of Historical Cost. No money was actually paid, so there was no objective way to value the transaction.

What if you decided that your time was worth $1000 an hour? You worked eight hours so you recorded an expense of $8,000. That might be a big hit on the old Net Profit. Plus, it looks like you contributed a substantial amount to the business. More likely, someone who charged $75 an hour might be inclined to up it to $125 an hour if they felt they could. You can see why the Internal Revenue Service (IRS) would take a dim view of this. If left up to the discretion of millions of taxpayers the potential for abuse would be staggering.

Therefore, this practice is not allowed. The integrity of financial statement reporting must be protected, and the IRS doesn’t want to be cheated.

After explaining all this to clients, often they still don’t get it. Or, they don’t want to get it. They feel they gave up something so they should get something back, i.e., the write off. The IRS says that if you performed a service for someone then record that service as income on your books, then you can deduct it as a legitimate Contribution expense. I say, why bother, since they both wash each other out. It’s just extra accounting work.

I welcome your comments or questions on this sometimes confusing concept.

If so, you should have treated that lease the same way you would have treated a normal purchase of equipment in your accounting records. In other words, the lease should have been capitaized. The equipment item should have been recorded in the Fixed Assets section of the Balance Sheet as a debit, and the down payment a credit to Cash, and the remaining balance owed set up as a Capital Lease or Lease Obligation in the liability section of the Balance Sheet. Interest and depreciation should be expensed as with any other purchase of an asset that has an installment loan associated with it.

It is important to understand what constitutes a “true” lease from a “dirty” lease (a capital lease). The accounting requirements are very different. Read the article and let me know if you have any questions.

John Day

Full accrual accounting can be tedious and time consuming so many people use a hybrid system. This means using a combination of accrual and cash basis methods when preparing financial statements. Most often, a business will record only Accounts Receivable and Accounts Payable accrual items. In addition, the only Accounts Payable items recorded will be Inventory purchases, since most of the other expenses of the business are paid within 30 days. The value of using the hybrid system is that your financial statements reflect all Revenue and all Inventory purchases. Plus, it is fairly straightforward when adjusting for a cash basis tax return at the end of the year.

Yes, it is possible to have it both ways, i.e., using accrual for your books and cash for your taxes? However, you must remember to adjust your accruals to cash at the end of the year. If you are using a full accrual system, then it may not be practical to have to change over everything from accrual to cash. If you are using a hybrid system (explained above) then all you have to do is adjust your Accounts Receivable and Accounts Payable balances at the end of the year.

For example, let’s say you generated $75,000 in Revenue during the previous year and your Accounts Receivable balance was $25,000 on December 31 of that year. The logical conclusion is that you had $50,000 in cash receipts that are reportable on your tax return. ($75,000 less $25,000 not yet collected)

In the current year you had $100,000 in Revenue but your Accounts Receivable balance was only $10,000. In this case, your reportable cash receipts would be $115,000. Why? Twenty-five thousand in cash was received in the current year but was generated in the prior year (last year’s A/R) and $90,000 ($100,000 less $10,000 not yet collected) was received in the current year and generated in the current year.

When adjusting Accounts Payable for a cash basis tax return, you have a choice. You can remove all the expense items that relate to Accounts Payable such as:

Or, you can do this by setting up a special account:

Either way, the point is that you can do it and there may be good reason to do so. You may have high receivables and low payables. This means you could be in for a double-whammy. You will have to report high income and low deductions. This means your taxes will be higher while not having received the cash to pay those taxes. Keep in mind though that you can’t switch back and forth each year from accrual to cash. Once you select the method of accounting for your tax return, you have to stick with it. Otherwise, you will have to have permission from the IRS and a very good reason for requesting a change in accounting method.

Essentially, you must determine if there is a gain or loss on the disposition. See my article, “Disposing of Assets – Figuring Gain or Loss” in the articles section of the blog as to the steps involved.

Recently, I was asked whether an asset that is fully depreciated could continue to be depreciated because the asset was still in service. The answer is “no” because once an asset is fully depreciated there is nothing left to depreciate. The accounting concept of “book value” needs to be understood in order to appreciate why the answer is “no”. An asset is purchased at a given price and recorded as such. At that moment in time, the purchase price is the “book value” of the asset.

When depreciation is applied to the asset, the book value of the asset is decreased. The process of depreciation is to remove a portion of the book value of the asset and expense it via depreciation. At a given time, you can figure the book value of an asset by subtracting the depreciation that had been accumulated up to that point in time.

If you sell a fully depreciated asset, or an asset with a zero book value, then the sales price is all gain. If you discard an asset that still had a book value, then there is a loss on the discard. If you have a gain or loss on a trade, the gain or loss is deferred by rolling the gain or loss into the book value of the new asset.

Keeping a good depreciation schedule is the key to easily figuring gain or loss when you dispose of an asset. You may want to keep a manila folder on each asset sold. On the right side of the folder, attach the original purchase invoice of the asset. On the left side, use a columar page to figure the accumulated depreciation and the corresponding book value. This serves as documentation for your adjusting journal entry for the disposition. When the auditor visits, you’ll be glad did this.

It is always best to use the card exclusively for business if you can. Each month when you receive your statement from the credit card company you should code or categorize each charge item on the statement. Include the finance charge to an account called Interest Expense or Credit Card Fees. Using your general journal you should record the activity. Here is an example:

Credit Card Payable is obviously a liability account on your balance sheet because you owe this money. If you were to make a payment on your credit card for $200, the transaction would look like this:

However, since a payment would most likely be coming out of your check register, you would not have to write a general journal entry. The category called Credit Card Payable would simply be coded next to the check and entered via a cash disbursements journal into your computer, or, automatically entered if you use computer checks.

The beauty of this simple method it that the Credit Card Payable account balance should always equal the balance on your credit card statement. In addition, all the charges get allocated into the proper categories in their correct amounts.

Sole Proprietor

Choice One: Write a reimbursement check to yourself, code it to the appropriate expense categories.

Choice Two: Write a general journal entry debiting the appropriate expense accounts and crediting the Owner’s Draw account.

If you have been taking personal draws (debiting Owner’s Draw) then it only makes sense that when you spend your personal funds for business expenses you should credit (offset) the Owner’s Draw account.

Partnership

Choice One: When the partner turns in receipts for business purchases made from personal funds, write a check to the partner and code the check to the appropriate expense accounts.

Choice Two: A working partner receives money for services rendered to the partnership through an account called, “Guaranteed Payments“. If the partner uses personal funds for business purchases and turns in receipts, write a general journal entry that debits the expenses and credits that partner’s guaranteed payments account.

All you are doing is “netting“ increases and decreases to the partner’s account.

Note: You must include in the Partnership Agreement that it is okay to reimburse a partner for out-of-pocket expenses, otherwise those expenses are not deductible on the partnership tax return.

Corporation

Choice One: Reimbuse the officer/stockholder for out-of-pocket expenses by writing a check and coding the appropriate expense accounts.

Choice Two: Write a general journal entry debiting the out-of-pocket expenses and crediting the Officer Advance account.

In a corporation, there is no “draw“ account for officer/stockholders because they must receive compensation through a formal payroll system. Often, in a business that has a single officer/stockholder, that person writes checks to him or herself on the fly. He/she doesn’t want to wait for payday. In order to accomodate this practice, you can use an account called “Officer Advance”. When payday rolls around, subtract the advances from officer/stockholder’s paycheck. Or, better yet, wait until the end of the year to do it. It might be best to do it at the end of the year, because any out-of-pocket expenses can be recorded to offset the advances taken.

If, at the end of the year, there is a credit balance in the Officer Advance account, simply write a reimbursement check to the officer/stockholder. If there is a debit balance that is greater than the regular payroll net check, then gross up the amount of the excess advance and add it into the last payroll of the year. To “gross up” a check, means that you know what the net amount is, but you must figure out the gross amount in such a way that when the payroll taxes are subtracted from the gross amount, the net amount comes out to the amount the individual has already received.

Avoid using Stockholder Loans for Due To or Due From Stockholder transactions. Shareholder Loans should only be used for real loans that have a note instrument, an interest rate assigned, and regular payments made.

Keep it Simple

I am a sole proprietor. At the end of the day, I may have three or four receipts all crumpled up in my pockets. Usually, I’m not in the mood to sit down and enter these into my books. I have an accordian file, organized by month that I accumulate those receipts into. At the end of the year, I sort them out by category, and staple a calculator tape to the stack with the total. When I write my year end general journal entries, I include all those totals. I debit the expense accounts and credit the Owner’s Draw account.

If you belong to a larger organization you will probably want to journal your out-of-pocket expenses monthly.

Read my article titled, “Recording Credit Card Expenses on Your Books”, in the articles section of this blog. It tells you how to record credit card charges when using a combination of business and personal transactions.

John Day

See my new article titled Miscellaneous Suspense – The Handy-Dandy GL Account, in the articles section of the blog for a more detailed description of how the account can be used.

In the Post section of the blog under Debits & Credits, I’ve had a running commentary with a fellow named Mark. His case is a perfect example of how the Miscellaneous Suspense account can be of use. He is accumulating costs related to his new business that will officially start in a couple of weeks. He has been working on it for almost one year. Instead of recording a number of small amounts into GL accounts for fixed assets or start-up costs, I have recommended that he accumulate these costs into the Suspense account. Once he and his accountant have determined the nature of the costs, he can reclassify and group like costs so that the entry into the final account will be one or two entries instead of a series of small entries.

I use the Miscellaneous Suspense account all the time. Sometimes a client forgets to code a check to a GL account. Instead of stopping what I’m doing, I put it in the Suspense account. I may have a dozen entries by the time I’m done. I make sure I have written a good description for each item, then I simply print out the Suspense account ledger page and call or fax the sheet to the client. The client provides the answers, and I write the journal entries to reclassify the amounts.

Sometimes a figure will sit in the Suspense account until the end of the year. I must clear the account one way or the other at year end, unless I specifically know that it must wait until the following year. At year end, when I print the Suspense account page, I may have quite of few entries of debits and credits. I go through the list and cross out the debits and credits entries I have already dealt with. This leaves the ones I still need to resolve. Some items may require more detective work. Hopefully, I’ve kept good notes in the past records. What may have seemed so clear to you four months ago, can grow cold awfully fast.

John Day

First, think about what you are doing. You take a certain amount of money out of the bank; let’s say $100, and put it into a cash box. Remember, that the general ledger account, Cash-in-Bank, is an asset. An asset, you may recall, if you have taken my Accounting for Non-Accountants course, is an unused economic resource that your business owns (has possession or controf of). All you have done, is shift $100 from Cash-in Bank to another asset account called Petty Cash. You deplete the cash in the box when you purchase such items as postage, office supplies, meals, gas for an auto, etc. When most of the cash is gone, you must replenish the fund. You do that by withdrawing more cash from the bank for the amount that has been depleted; let’s say $92.50. You should have $92.50 in receipts for expenses in the box. Those expenses are posted to their respective categories and the offset is, of course, Cash. Here is the journal entry:

DESCRIPTION                  DEBIT              CREDIT

Postage                      37.00

Office                       14.50

Meals                        36.50

Auto                         15.00

   Cash                                         92.50

The mistake occurs when you try to do this:

DESCRIPTION                 DEBIT              CREDIT

Petty Cash                   92.50

   Cash                                         92.50
                                                      

If you went with this second journal entry, you would end up with $192.50 in the Petty Cash account, which is an asset on your balance sheet, and zero in the expense accounts for postage, office, meals, and auto. This doesn’t seem right, does it? If you audited the petty cash box you would not find $192.50 in cash, vouchers and receipts. You would only find $100.00. The Petty Cash amount remains the same as originally established, unless you purposefully decide to increase it. Otherwise, petty cash expenditures must be recorded to their appropriate expense categories.

Go to the articles section of the blog to read my article, “Why Petty Cash” to find out why using a petty cash fund is a good accounting practice.