Real Life Accounting Blog

The accrual method of accounting is the method by which revenues are recorded when earned, and expenses are recorded when they are incurred. A cash-basis method of accounting measures revenue when cash is received and expenses when they are paid. The accrual method must be used for financial statements to be considered prepared according to Generally Accepted Accounting Principles (GAAP). See my blog article Accrual vs. Cash for a detail explanation with sample journal entries.

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.

If you are a small business owner or manager, there will come a time when you have to dispose of an asset. You may sell, trade, or discard the asset but regardless how you dispose of it you must account for it on the company’s books.

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.

There are several ways to record “out-of-pocket” expenses for the owner of a business on your books. How you do this depends of what type of business organization is being used. For example: Sole proprietor; Partnership; or Corporation.

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

Anyone who works in accounting will soon come across an item where it is not clear to which general ledger account it should be posted. When this happens, you can use a general ledger (GL) account called Miscellaneous Suspense. This account is normally located in the Other Assets section of the Balance Sheet. It serves as a temporary holding place until adequate research can be done to determine the nature of the amount. Once that determination is made, you simply reclassify the amount to the appropriate GL account.

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