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Replenishing Petty Cash

30-Jan-05

How to properly replenish petty cash has been a surce of confusion for many small business owners. As a practicing accountant, I find clients making the same mistake constantly, and it come from not understanding the full concept of petty cash. The concept is not difficult to understand; you just need to make sure you understand it.

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.

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Detail of the General Ledger Report

04-Jan-05

The Detail of the General Ledger Report:
Your most valuable analytic tool

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

Date Source Debit Credit Balance
12/31 Balance Forward 3,450.21
01/05 General Journal pg 2 54.00 3,504.21
01/17 General Journal pg 4 27.00 3,477.21
01/31 Cash Receipts pg1 8,025.34 11,502.55
01/31 Cash Disbursements pg 4 7,945.87 3,556.68

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.

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Detecting Accounting Errors

04-Jan-05

The beauty of using double-entry accounting is that your books are designed to be “in-balance”. If they are not in balance there is an error. Therefore, after running a set of financial statements, it is important to check the general ledger (GL) account balances on the Balance Sheet.

There are some “at-a-glance“ figures to check first. Do the Assets equal the Liabilities plus Equity? Does the Cash GL account balance with the Bank Reconciliation? Is the Net Profit or Loss figure on the Income Statement the same as the Net Profit or Loss figure found in the Equity Section of the Balance Sheet.

Next, on a monthly basis, make sure that the Accounts Receivable GL balance ties to the Accounts Receivable Ageing Report, and that the Accounts Payable GL balance ties to the Accounts Payable Ageing Report.

The frequency of checking the GL balances of Inventory, Fixed Assets, Accumulated Depreciation, Current and Long-Term Notes, Sales Tax Payable, Payroll Tax Payable is up to you and the demands of your business. Some do it monthly, quarterly, semi-annually, and annually.

What happens if you find an error? You must trace back the series of entries that were recorded to the particular GL account that is out of balance. Your best analytical tool for this is a report called “The Detail of the General Ledger”. Review my latest article posted on this blog titled, “The Detail of the General Ledger Report: Your Most Valuable Analytic Tool”. I give examples of how you use this report to find the origin of an error.

There are all kinds of errors that can occur during the accounting process. With experience, you will become familiar with these errors and it won’t take long to figure out what happened. Some errors are easy to spot, but occassionally you will find one that is really insidious. You have to put on your detective’s hat, look for clues, and be very thorough as you work your way through the problem. Being organized helps a great deal. Making sure to review all the material in front of you is essential. The mind is an amazing thing. When you review material, it gets stored in the brain. As you are looking for the missing link when solving a mystery, your mind will make a connection with some item of information that you reviewed earlier. Accountants learn to trust their minds when that little voice way in the background says, “Hmmm, I wonder if ….” More often than not, it proves to be valuable.

I avoid taking short-cuts because I have learned that what may seems like a time-saving step might prove to be the longer route. I don’t like to “net” figures together. I will take the extra time to write each part of a transaction so that I can trace back and remember what I was doing. One of the most annoying things you can do to yourself is write a journal entry with no explanation. Sure enough, if there is an error, it will be related to the journal entry you wrote with no explanation. There you sit, unable to remember why in the world you wrote that entry. Do that a few times and you will learn quickly the error of your ways.

Big Tip: Searching for that error and can’t find it? Take a break. Come back the next morning and miraculously you will find the error within a few minutes. The mind works in mysterious ways. Here are a few common errors found in accounting:

  1. Transpostion error – Instead of writing 72 you wrote 27. If the error amount is divisable by 9, it is most likely a transpostion error.
  2. You wrote a 3 for and 8 or vice versa. You wrote a 4 for a 9 or vice versa.
  3. You wrote 300 instead of 30, etc.
  4. Your beginning balance or balance forward was incorrect. You’ll have to go back to a previous period to find the error.
  5. The GL account number or amount was entered incorrectly into the computer when posting.
  6. You reversed a debit entry for a credit entry or vice versa.
  7. The general journal entry debits did not equal the credits. (Calculation error)
  8. The GL code was written incorrectly when writing the journal entries or coding the cash disbursements journal.

Can you think of any more?

John

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Journalizing Payroll

20-Dec-04

If you are a business owner or manager, chances are you have had to deal with payroll and all of its complexities. If you haven’t dealt with payroll yet, you may have to in the future. There are many parts to payroll. First you have to learn how to calculate withholding taxes for employees and understand all the federal and state rules associated with those taxes. If you don’t stay on top of the rules, which can change from year to year, you risk miscalculating the taxes and/or missing reporting deadlines. The price for not conforming to the rules can be severe penalties.

Faced with these hurdles, many small businesses opt for a payroll tax service. This is usually a good idea, as these services tend to be inexpensive and can lift a heavy burden from the shoulders of an owner or manager. However, the information provided by the payroll service company has to be entered into the company’s books. There is a simple way to do this, but first, you must have an understanding of what you are trying to accomplish.

It is imperative to understand the difference between “employee withholding taxes” and “employer payroll taxes”. In the U. S., it works like this:

Employee Taxes Employer Taxes
Federal:
FIT (Federal Income Tax)
FICA Tax (Social Security)
Medicare Tax
State:
SIT (State Income Tax)
SDI (State Disability Insurance)		 Federal:
FICA Tax
Medicare Tax
FUTA Tax (Federal Unemployment)
State:
SUTA Tax (State Unemployment)

The state I use in the example is California. The state, in which you live may have different withholdings, so be sure to find out what they are, if any. Either way, you will have to follow the same accounting procedures.

Many of the larger payroll service companies provide a ton of information in the form of payroll reports. Unfortunately, the payroll information you need for your general ledger is often not easily discernable. I have had a payroll service business in Santa Barbara for 20 years, and even I have a hard time deciphering the large payroll service companies’ reports.

The larger payroll companies insist that you pay your payroll taxes “the day” of payroll. Therefore, you must set up an agreement between your bank and the payroll company so that the payroll company can automatically withdraw funds from your account to their account. They pay the taxing agencies directly. Your taxes may not be due on that exact date, so the payroll company has use of your money until the time the taxes are paid. It has been reported that they make millions on the interest alone from the float. (Well, anyway they used to).

If you use a smaller, perhaps local, payroll service company, they may simply process your payroll data and then provide you with the information you need to write your own checks to employees and the federal and state taxing authorities.

The challenge for you is to record the gross wages and withholdings in the proper accounts, and to reconcile what you actually owe for each tax against what has been paid. It’s a bit of pain, but once you get the hang of it, it’s not too difficult. Here’s how I do it:

One of your reports should be a payroll history that lists each employee, his/ her gross wages, FIT, FICA, Medicare, SIT, SDI, and net wages. For instance:

Gross Wages FIT FICA Medicare SIT SDI Other Net Wages
10,000.00 2,600.00 620.00 145.00 400.00 80.00 20.00 6135.00

There should be another report that clearly shows the employer payroll taxes.

FICA Medicare FUTA SUTA
620.00 145.00 80.00 350.00

This is the information you need to write your payroll journal entry. Here is an example of a journal entry for the employee side:

A.

DESCRIPTION DEBIT CREDIT
Gross Wages 10,000.00
FIT, FICA, Medicare 3,365.00
SIT, SDI 480.00
Employee Advance 20.00
Payroll Clearing 6,135.00
To record payroll for xx/xx/xx

Here is the example for employer payroll taxes:

B.

DESCRIPTION DEBIT CREDIT
Employer Payroll Tax 1,195.00
Accrued Employer P/R Tax 1,195.00
To record employer payroll taxes: FICA, Med, FUTA, SUTA

Look at what you have accomplished with these journal entries. In the first journal entry (A), you recorded your gross wages to the appropriate expense account. You set up the liability for the employee taxes payable. You recorded a credit in the employee advance account, assuming an employee was given a $20.00 advance earlier. You recorded a credit to the Payroll Clearing account for the correct amount of net checks that were paid out. This amount should clear out all the individual checks posted to the Payroll Clearing account that were paid to employees via your cash disbursements system.

For those unfamiliar with a payroll clearing account, it is a general ledger account that is normally set up in the asset section of the balance sheet. The purpose it serves is to reconcile all the net payroll checks paid to employees during an accounting period with a general journal entry that summarizes the total of all the net payroll checks. If an error occurs, the difference will remain in the payroll clearing account. This difference can then be researched to find the cause of the error.

If you write your payroll checks directly out of your cash disbursements system, along with all your other checks, then I recommend using a payroll clearing account. If you use a separate bank account just for payroll, then you probably don’t need a payroll clearing account.

In the second journal entry (B), you recorded all the employer payroll taxes to the expense account and set up the liability for those payroll taxes. When the taxes are actually paid, the amounts will be recorded as a debit to Accrued Employer Payroll Taxes, and the employee FIT, FICA, Medicare, SIT, SDI tax liability accounts, which will zero out those accounts. For instance:

DESCRIPTION DEBIT CREDIT
FIT, FICA, Medicare 3,365.00
SIT, SDI 480.00
Employer P/R Taxes 1,195.00
Cash 5,040.00

An advantage of using a smaller payroll service company or using your own payroll software program in your business is that you have the use of your money until the taxes become due. This can be critical if you happen to be suffering from a cash flow shortage. In addition, small payroll service companies tend to be more flexible when it comes to reversing mistakes, running a special payroll, researching tax inquiries, handling worker’s compensation audits, etc.

Whether you use an outside payroll service or buy your own payroll software, I would make sure that the reports you receive are simple to read and clearly display the critical information you need to record your payroll activity quickly and accurately. A payroll software program should post all the information automatically. However, you should be able to verify and prove that the information is correct, as mistakes do happen. This requires good reports and a solid understanding of how recording payroll works.

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Payroll: In-house or out-source?

20-Dec-04

Payroll is one of the most vexing parts of bookkeeping. This is because the rules keep changing and there are many parts to understand. Some brave souls tackle it head-on and master the beast. Others think the software programs will do it all for them. Many shy away from the whole process and turn it over to either an in-house employee or out-source to a payroll processing company.

What’s best? Depends on you. In today’s world, if you are a small business, I wonder why anyone would try to do the whole thing in-house. As I mention in the latest article posted on this blog, “Journalizing Payroll“, the large payroll processing firms such as ADP and Paychecks lack flexibility and their reports are hard to read. Somehow you have to get the payroll information they are providing into your books, so you have to decifer their reports. That’s what my article is about.

Are there any alternatives? There are small payroll processing companies that are flexible. They are fine for small payrolls. If you have cafeteria plans, pension plans, and other plans, sometimes those complexities are too much for the smaller payroll firms.

Recently I have been hearing about a new concept, (To be honest, I haven’t tried this out and don’t know anybody who has, but it seems like a idea worth investigating.) but I believe it is restricted to accountants and bookkeepers. Accountant’s World (http://www.accountantsworld.com) and a few others and suggesting that they will process your payroll clients in partnership with you. You enter the employee hours through their Internet site and they do everything else, including reports and checks. They claim that you do 20% of the work and receive 80% of the profit. This frees you up to take on more payroll clients or do other accounting work. Most important it allows you to retain your own payroll clients. .

I had a payroll business as part of my accounting practice for twenty years. I never made any money from the payroll but it provided important side benefits. First, I was able to design the payroll reports so they fit nicely into the client’s journal entry process. Second, there was consistent, and constant contact with the client that always helps cement the relationship. And, third, the clients love to have one firm do all their work, such as payroll, financial statements, and tax returns. It was a good deal for them and also for me. Clients are more likely to stay loyal when all their needs are being serviced by one firm.

So check out the payroll article and let me know if you have any questions or comments.

John

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Undertanding Depreciation – It’s not as hard as you might think

30-Nov-04

Depreciation is defined as a portion of the cost that reflects the use of a fixed asset during an accounting period. A fixed asset is an item that has a useful life of over one year. An accounting period is usually a month, quarter, six months or one year. Let’s say you bought a desk for your office on January 1, for $1000 and it was determined that the desk had a useful life of seven years. Using a one year accounting period and the “straight-line” method of depreciation, the portion of the cost to be depreciated would be one-seventh of $1000, or $142.86.

Most non-accountants roll their eyes and shudder when the topic of “depreciation” comes up. This is where the line in the sand is drawn. Depreciation is far too complicated to try and figure out, or so it seems to many. But is it really? Surely the definition of depreciation mentioned above is not that difficult to comprehend. If you look closely you will see that there are five pieces of information you must have in order to determine the amount of depreciation you can deduct in one year. They are:

  • The nature of the item purchased (the desk).
  • The date the item was placed in service (Jan 1)
  • The cost of the item ($1000).
  • The useful life of the item (seven years).
  • The method of depreciation to be used (straight-line)

The first three are easy to figure out, the second two are also easy but require a little research. How do you figure out the useful life of an item? Let me regress for a moment. There is “book depreciation” which is based on the real useful life of an item, and there is the IRS version of what constitutes the useful life of an item. A business that is concerned with accurately allocating its costs so that it can get a true picture of net profit will use book depreciation on its financial statements.

However, for tax purposes the business is required to use the IRS method. The IRS may have shorter or longer useful lives for fixed assets causing a higher or lower depreciation write-off. The higher the write-off, the less tax a business pays. The long and short of it is that you end up having to create a book financial statement and a tax financial statement. So, most small businesses that aren’t concerned with a precise measurement of their net profit use the IRS method on their books. This means that all you have to do is look in IRS Publication 946 to find the useful life of a particular item.

The last piece of information you need is found by determining the method of depreciation to use. Most often it will be one of two methods: the “straight-line” method or an accelerated method called the “double-declining balance” method. Let’s briefly discuss these two methods:

-Straight-line – This is the simple method mentioned in the definition above. Just take the cost of the item, divide it by the useful life and you’ve got the answer. Yes, you will have to adjust the depreciation for the first year you placed the item in service and for the last year when you removed the item from service. For instance, if your depreciation for one year was $150 and you placed the item in service on April 1 then divide $150 by 12 (months) and multiply $12.50 by 9 (months) to get $112.50. If you removed the item on February 28 then your deduction will only be $25.00 (2 x $12.50).

-Double-declining balance – The idea behind this method is that when an item is purchased new, you will use up more of it in the earlier years of its life, therefore, justifying a higher depreciation deduction in the earlier years. With this method, simply divide the cost of the item by the useful life years as in the straight-line method. Then, multiply that result by 2 (double) in the first year. The second year, take the cost of the item and subtract the accumulated depreciation. Next, divide that result by the useful life and multiply that result by 2, and so on for each remaining year.

But, wait! You don’t have to do this. The IRS provides tables that have the percentages worked out for each year of the two different methods. Not only that, they have set up special first year “conventions” that assume you purchased your depreciable fixed assets on June 30. This is called the one-half year convention. The idea behind this is that you may have bought some items earlier than June 30 and some after that date. So, to make it easy to figure out, they assume the higher and lower depreciation amounts will all average out.

Actually, the IRS doesn’t even call it depreciation anymore. They call it “cost recovery”. Let’s face it. This is a political tool. Congress giveth and taketh away. They have been playing with this system for years. If they want to stimulate growth in business they will shorten the useful life of assets so businesses can attain a higher write-off. If they are not in the mood, they will extend the useful life of an item. A good example is the 39 years set for the useful life of commercial property. This means that if you lease a building for your business and make improvements, those improvements have to be depreciated over 39 years. The House has just approved a bill to drop that down to 15 years for leasehold improvements, but the Senate hasn’t yet approved it.

Before December 31, 1986 we had ACRS or Accelerated Cost Recovery System. Currently, we have MACRS or Modified Accelerated Cost Recovery System. Every time congress tweaks the rules they give it a different name.

Keep in mind there are different schedules for different properties. For instance, residential real property is depreciated over twenty-seven and one-half years and non-residential real property is depreciated over thirty-nine years. In addition, if more than forty percent of your total fixed asset purchases occurred in the last quarter of the year, then, you must use a mid-quarter convention. This convention assumes that your purchases made in the last quarter of the year were made on November 15. This prevents you from buying a big expensive piece of equipment on December 31 and treating it as though it were purchased on June 30 and gaining a larger depreciation expense.

Understanding how basic depreciation works can be valuable to the small business owner because it helps to know the tax implications when planning for capital equipment purchases.

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Journalizing Depreciation

30-Nov-04

One of the students taking my Real Life Accounting for Non-Accountants online accounting course e-mailed me with a question about “Accumulated Depreciation”. He was having a real hard time comprehending why that account existed. To me, it was clear as a bell. To him, he simply could not see it. I tried explaining it from several different angles and after many e-mails it started to dawn on him. Perhaps there are more people like him who haven’t yet grasped the full concept of depreciation. So let’s discuss how depreciation is journalized. You can review how to understand the process of depreciation using the “straight-line and double-declining methods” in my latest article, “Understanding Depreciation – It’s not as hard as you might think”.

In the article, I explain how a portion of the cost of a fixed asset is allocated to the Depreciation Expense general ledger account each accounting period. The method of doing that requires a debit entry to Depreciation Expense because that general ledger account is being increased (therefore a debit entry) by the allocated cost of the fixed asset. As you know, the rule of double-entry accounting is that the debit entries must equal the credit entries when all is said and done. This means a credit entry must be made for the amount equal to the Depreciation Expense entry.

The credit entry is recorded in an account called “Accumulated Depreciation”. This account is located in the Asset section of the Balance Sheet under Fixed Assets. It can be one account that contains all the accumulated depreciation for various categories of fixed assets such as, Office Equipment, Furniture & Fixtures, Machinery & Equipment, Vehicles, Leasehold Improvements, etc. Or, it can be set up as a separate account located below the fixed asset account it relates to. For example:

Furniture & Fixtures

Accumulated Depreciation – Furniture & Fixtures

It doesn’t matter as it’s up to you.

The main concept to understand here is that the Accumulated Depreciation account is an offset to the Fixed Asset accounts. You could call it a “contra” account. Remember that even though the Accumulated Depreciation account is located in the Asset section it maintains a credit balance. Fixed Assets when purchased are posted as a debit balance because an increase is being recorded. When a portion of the fixed asset is removed and recorded in the Depreciation Expense account then that decrease is recorded in the Accumulated Depreciation account as a credit. This makes sense because the Accumulated Depreciation account’s purpose is to reflect how much of the fixed assets that have been expensed.

Looking at it a different way, we could have simply recorded a credit to the fixed asset account directly. So instead of seeing a fixed asset balance of $500 we might see $450. The problem with this method is that it would be difficult to know at a glance how much we purchased the fixed assets for originally and how much depreciation we have expensed. Using an Accumulated Depreciation account provides us with more information.

Let me know if you have any questions about how this works.

John

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Understanding ‘The Bottom Line’

15-Nov-04

What’s there to understand? The bottom line is the last line on the Profit & Loss (P&L) statement and it is either a profit or a loss. That’s all you need to know, isn’t it? Yes, it is important to know whether you are making a profit or losing money, but understanding how financial statements work is knowing the nature of each account and how it fits into the scheme of things. In other words, did you know that the entire P&L statement is just an extension of one number in the Equity section of your Balance Sheet?

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.

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The Difference between Owner’s Draw and Net Profit

15-Nov-04

For some sole proprietors, there is confusion between the money taken out for personal use (Owner’s Draw) and the Net Profit earned by the business. One is taxable and the other is not. Let’s clear it up now. First, read my article, “Understanding the Bottom Line”. As I mention in the article, there is a loose correlation between the two. However, the Internal Revenue Service is only interested in your current year earnings (Net Profit), not how much money you withdrew from the company. You may have been able to draw the money out of the business because most of the money came from net profit, but some of that money may have come from other sources.

The other concept the article addresses is the fact that the Profit and Loss Statement is an extension of one line item in the equity section of the Balance Sheet. Net Profit usually means and increase in Equity, and Net Loss means a decrease in Equity. That seems to stand to reason. Perhaps you hadn’t yet made this connection. If so, then you have just increased your knowledge base of how accounting works.

Let me know if you have any questions or need any clarification.

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The General Journal – Your Most Versatile Accounting Tool

01-Nov-04

A journal is a record of transactions that shows the accounts and amounts of both the debit side and credit side of the entry. A General Journal is the primary journal or place to record transactions that do not fit into any other journal.

The General Journal (GJ) serves a major purpose. In many small business situations, the Cash Disbursements (CD) Journal is the only journal used in conjunction with the GJ. The CD journal you may recall is essentially your checkbook register. That being the case, one side of the transactions always results in a credit (decrease) to Cash. Your computer system automatically decreases cash and you decide which GL accounts to debit the checks. This is pretty straightforward. If you can’t remember how debits and credits work, type the following link to review the “accounting Model”:

http://www.reallifeaccounting.com/accounting_model.asp

But, how do you enter information into your computer that is not related to the checks you wrote? Consider for instance, items such as: bank charges; correction of mistakes; deposits to the bank; sales; sales tax; non-sufficient funds (NSF) from customer checks that bounce; depreciation expense; gain or losses from the sale or trade of fixed assets; notes payable; inventory adjustments; accounts receivable and accounts payable entries; payroll; and, any other unusual transactions that might occur.

Use of the General Journal sets apart the person who knows how accounting works from those who don’t. Why? Because one must understand how debits and credits work in order to write the adjusting journal entries. This simple knowledge is what gives power to the user. This ability allows a person to solve problems, straighten out messes, bring order to disorder, and not be fooled or intimidated by anyone. I remember one day I was in a client’s office and was getting ready to leave for another client appointment. I mentioned I was working on organizing a corporation’s books that were in chaos, and the principals had no idea what they were doing. I was a little surprised when the client I was with said, “Wow, I would love to have that kind of power”. I had never thought about it that way before, but she was right. There is power with knowledge and it feels good.

The people who “know they know” how accounting works can explain or communicate information confidently to those that need to know, such as the boss, board of directors, partners, CPA or staff. The General Journal is one of the most versatile tools found in the accountant’s toolbox.

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