Comment on Loans vs. Leases: What’s it all about? by Loan Finder Observer

One of the most frequent questions I get asked is “Shall I lease or buy?” Most likely the lease vs. buy choice for a business would arise when considering the acquisition of a company automobile or delivery truck, but it could be any expensive piece of equipment. This decision is usually predicated by the desire to obtain the highest deduction or tax savings. The first step in answering the “lease or buy” question is to clarify the difference between these two purchasing options.

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:

The lease transfers ownership of the property to the lessee by the end of the lease term.The lease contains a bargain purchase option (like a $1.00 buyout).The lease term is equal to 75% or more of the estimated economic life of the leased property.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.

View the original article here

What is the difference between equity financing and debt financing?

Equity financing often means issuing additional shares of common stock to an investor. With more shares of common stock issued and outstanding, the previous stockholders’ percentage of ownership decreases.

Debt financing means borrowing money and not giving up ownership. Debt financing often comes with strict conditions or covenants in addition to having to pay interest and principal at specified dates. Failure to meet the debt requirements will result in severe consequences. In the U.S. the interest on debt is a deductible expense when computing taxable income. This means that the effective interest cost is less than the stated interest if the company is profitable. Adding too much debt will increase the company’s future cost of borrowing money and it adds risk for the company.

You can learn more about equity financing under Stockholders’ Equity. You can learn more about debt financing under Bonds Payable.

About the Author: Harold Averkamp (CPA) has worked as an accountant, consultant, and university accounting instructor for more than 25 years.

He is the author of the 2010 Master Accounting Download Package which has been praised for it's ability to simplify accounting in a way that anybody can understand.

View the original article here

Is the depreciation of delivery trucks a period cost or is it manufacturing overhead?

The depreciation on the trucks used to deliver products to customers is a period cost. The depreciation on delivery trucks will be reported as an expense on the income statement in the period in which it occurs. It might be reported as part of Selling Expenses or as part of Selling, General and Administrative (SG&A) Expenses.

The depreciation on the trucks used to transport materials or work-in-process between the facilities of a manufacturer is a component of manufacturing overhead. In other words, the depreciation on trucks used in the manufacturing process is assigned to the goods produced rather than being expensed directly.

Learn more about Manufacturing Overhead.

About the Author: Harold Averkamp (CPA) has worked as an accountant, consultant, and university accounting instructor for more than 25 years.

He is the author of the 2010 Master Accounting Download Package which has been praised for it's ability to simplify accounting in a way that anybody can understand.

View the original article here

What is an impairment?

The term impairment is usually associated with a long-lived asset that has a market which has decreased significantly. For example, a meat packing plant may have recently spent large amounts for capital expenditures and then experienced a dramatic drop in the plant’s value due to business and community conditions.

If the undiscounted future cash flows from the asset (including the sale amount) are less than the asset’s carrying amount, an impairment loss must be reported.

If the impairment loss must be reported, the amount of the impairment loss is measured by subtracting the asset’s fair value from its carrying value.

About the Author: Harold Averkamp (CPA) has worked as an accountant, consultant, and university accounting instructor for more than 25 years.

He is the author of the 2010 Master Accounting Download Package which has been praised for it's ability to simplify accounting in a way that anybody can understand.

View the original article here

What is the difference between a deferred expense and a prepaid expense?

Often the term deferred expense indicates that a payment was made more than one year before the cost is expensed. This deferred expense will be reported on the balance sheet as a noncurrent or long-term asset.

Often the term prepaid expense indicates that a payment was made less than one year before the cost is expensed.  This prepaid expense is reported as a current asset.

Sometimes an accountant does not intend for there to be a difference.  For example, an accountant might say that part of a company’s six-month insurance premium should be deferred to the current asset account Prepaid Insurance. Accountants also state that any prepayment of a future expense will result in an adjusting entry known as a deferral.

Learn more about Adjusting Entries.

About the Author: Harold Averkamp (CPA) has worked as an accountant, consultant, and university accounting instructor for more than 25 years.

He is the author of the 2010 Master Accounting Download Package which has been praised for it's ability to simplify accounting in a way that anybody can understand.

View the original article here

What is the difference between the cash basis and the accrual basis of accounting?

Under the cash basis of accounting…

1. Revenues are reported on the income statement in the period in which the cash is received from customers.

2. Expenses are reported on the income statement when the cash is paid out.

Under the accrual basis of accounting…

1. Revenues are reported on the income statement when they are earned—which often occurs before the cash is received from the customers.

2. Expenses are reported on the income statement in the period when they occur or when they expire—which is often in a period different from when the payment is made.

The accrual basis of accounting provides a better picture of a company’s profits during an accounting period. The reason is that the income statement prepared under the accrual basis will report all of the revenues actually earned during the period and all of the expenses incurred in order to earn the revenues.

The accrual basis of accounting also provides a better picture of a company’s financial position at a moment or point in time. The reason is that all assets that were earned are reported and all liabilities that were incurred will be reported.

The accrual basis of accounting is required because of the matching principle.

Learn more about Accounting Principles.

About the Author: Harold Averkamp (CPA) has worked as an accountant, consultant, and university accounting instructor for more than 25 years.

He is the author of the 2010 Master Accounting Download Package which has been praised for it's ability to simplify accounting in a way that anybody can understand.

View the original article here

What is a comparative balance sheet?

A comparative balance sheet usually has two columns of amounts that appear to the right of the account titles or other descriptions such as Cash and Cash Equivalents, Accounts Receivable, Accounts Payable, etc. The first column of amounts contains the amounts as of a recent moment or point in time, say December 31, 2009. To the right will be a column containing corresponding amounts from an earlier date, such as December 31, 2008. The older amounts appear further from the account titles or descriptions as the older amounts are less important.

Providing the amounts from an earlier date gives the reader of the balance sheet a point of reference—something to which the recent amounts can be compared.

Learn more about the Balance Sheet.

About the Author: Harold Averkamp (CPA) has worked as an accountant, consultant, and university accounting instructor for more than 25 years.

He is the author of the 2010 Master Accounting Download Package which has been praised for it's ability to simplify accounting in a way that anybody can understand.

View the original article here

What is a cost driver?

Ideally, a cost driver is an activity that is the root cause of why a cost occurs.

In the past century, the root cause of indirect manufacturing costs has changed from a single cost driver (such as direct labor hours) to several cost drivers. Due to sophisticated manufacturing and increased demands from customers, direct labor is no longer the main cost driver of indirect manufacturing overhead.

In addition to direct labor, today’s drivers of indirect manufacturing costs include the number of machine setups required, the number of engineering change orders, the demands from customers for special inspections, handling and storage, the number of components in the units produced, and the number of production machine hours.

Manufacturers that want to know the true costs of their products need to know what is driving their indirect manufacturing costs. For these companies it is not sufficient to merely spread overhead costs to products by using a single factor such as direct labor hours or production machine hours.

Learn more about Manufacturing Overhead.

About the Author: Harold Averkamp (CPA) has worked as an accountant, consultant, and university accounting instructor for more than 25 years.

He is the author of the 2010 Master Accounting Download Package which has been praised for it's ability to simplify accounting in a way that anybody can understand.

View the original article here

What is the difference between Rent Receivable and Rent Payable?

The asset account Rent Receivable is used by the landlord to report the amount of rent that has been earned by the landlord but has not been received from the tenant as of the balance sheet date. The liability account Rent Payable is used by the tenant to report the amount of rent that the tenant owes for rent but has not been paid as of the balance sheet date.

If the rent is to be paid on the first day of each month, and if the rent is paid on time, the landlord will have a zero balance in Rent Receivable. Similarly, the tenant will have a zero balance in Rent Payable. It is only if the tenant falls behind in making the rent payments that amounts will be entered into the Rent Receivable and Rent Payable accounts.

Learn more about Adjusting Entries.

About the Author: Harold Averkamp (CPA) has worked as an accountant, consultant, and university accounting instructor for more than 25 years.

He is the author of the 2010 Master Accounting Download Package which has been praised for it's ability to simplify accounting in a way that anybody can understand.

View the original article here

Comment on T-Accounts: A Great Tool for Solving Accounting Transactions by Bookkeeping Services

A T-Account is a template or format shaped like a “T” that represents a particular general ledger account. Debit entries are recorded on the left side of the “T” and credit entries are recorded on the right side of the “T”. It is a tool for organizing journal entries and analyzing accounting transactions.

There are a few business owners or managers who have a fantastic ability to remember details, but I would venture to say that most of us find our memory diminishing over time. T-Accounts come in handy when a series of journal entries are required and it becomes too difficult to keep all of them in your head.

When solving accounting problems, you have to think of accounting transactions in terms of the “accounting model”. Click this link if you need to refresh your memory regarding the accounting model:

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

The “accounting model” is a template you can use to remember how debits and credits work. The two most common scenarios for using T-Accounts are: 1) determining why certain transactions were previously posted to the general ledger; or, 2) working out the most appropriate place to post certain accounting
transactions.

T-Accounts work because they are visually effective. This means they are simple to understand and usually it is possible to portray all the T-Accounts on one page. Let’s look at a basic accounting transaction and then translate it into T-Account form. Assume you sold an accessory to one of your rental inventory assets for $35 cash and deposited the money into the bank. You originally bought the accessory for $20 and put it into inventory until it was sold. The journal entries for the transaction would look like this:

The T-Accounts would look like this:

You can easily see that the debits equal the credits. Let’s look at a more complex accounting transaction. You bought a company van to delivery your rental inventory for $25,000 and you did this by putting $5,000 down and setting up a liability (Notes Payable) for $20,000. You made your first payment of $380, of which $80 was interest, and your first month’s depreciation was $833. To the unfamiliar, these transactions might appear confusing until T-Accounts are used.

A critical step is to make sure that the debits equal the credits. If not, you have made a mistake that must be solved. Next, simply put these T-Accounts in journal entry form:

View the original article here

What is the difference between an implicit cost and an explicit cost?

An implicit cost is a cost that has occurred but it is not initially shown or reported as a separate cost. On the other hand, an explicit cost is one that has occurred and is clearly reported as a separate cost. Below are some examples to illustrate the difference between an implicit cost and an explicit cost.

Let’s assume that a company gives a promissory note for $10,000 to someone in exchange for a unique used machine for which the fair value is not known. The note will come due in three years and it does not specify any interest. Due to the company’s weak financial position it will have to pay a high interest rate if it were to borrow money. In this example, there is no explicit interest cost. However, due to the issuer’s financial difficulty and the seller having to wait three years to collect the money, there has to be some interest cost. In other words, there is some interest and it is implicit. To properly record the note and the machine, the accountant must determine the amount of the interest, which is known as imputing the interest. In effect the accountant must convert the implicit interest to explicit interest. This is done by discounting the $10,000 by using the interest rate that the issuer of the note would have to pay to another lender. If the rate is 12% per year, the interest that was implicit in the note is $2,880 and the principal portion of the note is the remaining $7,120.

If another company with the same financial condition purchased this unique machine by issuing a $7,120 note with a stated interest rate of 12% per year, the interest cost of $2,880 would be explicit. In this situation, there is no need to impute the interest.

Another example of an implicit cost is the opportunity cost of a sole proprietor working in her own business. For example, Gina works as a sole proprietor and her business reported a net income of $30,000 for the year. Since a sole proprietor does not receive a salary or wages, there is no explicit cost reported for Gina’s work in her business. However, if Gina is foregoing a salary of $40,000 from another company, that is an implicit cost for her business. After considering this implicit cost, Gina is losing $10,000 by working in her proprietorship.

If Gina operates her business as a corporation, Gina will be an employee of the corporation. If her annual salary is $40,000 the corporation’s income statement would report the $40,000 salary as an explicit cost for Gina’s work.

About the Author: Harold Averkamp (CPA) has worked as an accountant, consultant, and university accounting instructor for more than 25 years.

He is the author of the 2010 Master Accounting Download Package which has been praised for it's ability to simplify accounting in a way that anybody can understand.

View the original article here

Comment on Equity Accounts – It’s Your Money by LaReina

Equity is the difference between assets and liabilities as shown on a balance sheet. In other words, equity represents the portion of assets that are fully owned by the owners (stockholders, partners, or proprietor) of a business.

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.

View the original article here

Comment on Equity Accounts – It’s Your Money by Mostafa

Equity is the difference between assets and liabilities as shown on a balance sheet. In other words, equity represents the portion of assets that are fully owned by the owners (stockholders, partners, or proprietor) of a business.

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.

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What is a dividend and why is it needed?

A dividend paid by a corporation is a distribution of profits to the owners of the corporation. The owners of a corporation are known as stockholders or shareholders. (In a sole proprietorship, the distribution of profits to the owner is referred to as a draw.)

A corporation’s board of directors, which is elected by the stockholders, decides if a cash dividend is needed. The considerations for paying or not paying a dividend include the stockholders’ wishes, the stock market’s reaction, and the corporation’s needs and opportunities for cash in the present and in the future.

Learn more about Stockholders’ Equity.

About the Author: Harold Averkamp (CPA) has worked as an accountant, consultant, and university accounting instructor for more than 25 years.

He is the author of the 2010 Master Accounting Download Package which has been praised for it's ability to simplify accounting in a way that anybody can understand.

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What is benchmarking?

Benchmarking is a process for improving some activity within an organization. We will illustrate benchmarking with the following example.

Company Q has identified one of its activities that needs improvement. The company conducts a search to find another organization that is considered to have mastered the activity. Perhaps it is Corporation J that is recognized as having the best practice for this activity. Corporation J’s performance is viewed as the benchmark or standard or best practice.

Company Q will study Corporation J’s performance and procedures in depth and will identify the differences between the organizations. Company Q will likely modify its procedures in order to bring its performance of the activity up to the level attained by Corporation J.

About the Author: Harold Averkamp (CPA) has worked as an accountant, consultant, and university accounting instructor for more than 25 years.

He is the author of the 2010 Master Accounting Download Package which has been praised for it's ability to simplify accounting in a way that anybody can understand.

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understand-accounting.net Named Among Top 50 Accounting Web Sites

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If a mortgage payment is due on January 1, should the payment be accrued at December 31?

If the interest portion of the January 1 loan payment is for the month of December, then the interest portion should be accrued as of December 31.

To illustrate, let’s assume that the amount of the mortgage loan payment due on January 1 is $1,000 and it consists of $300 of interest from December 1 through 31, and a principal payment of $700. Since the $300 of interest has occurred during December and since the company has an obligation as of December 31 to the lender for that interest, the company must accrue the interest. This is accomplished with an adjusting entry dated December 31 in which Interest Expense is debited for $300 and Interest Payable is credited for $300.

There is no accrual for the principal portion of the loan payment. The principal balance of the loan is not reduced until the actual principal payment occurs.

Learn more about Adjusting Entries.

About the Author: Harold Averkamp (CPA) has worked as an accountant, consultant, and university accounting instructor for more than 25 years.

He is the author of the 2010 Master Accounting Download Package which has been praised for it's ability to simplify accounting in a way that anybody can understand.

View the original article here

Are bonds payable reported as a current liability if they mature in six months?

Bonds payable that mature (or come due) within one year of the balance sheet date will be reported as a current liability if the issuer of the bonds must use a current asset or will create a current liability in order to pay the bondholders when the bonds mature.

However, the bonds could be reported as a long-term liability right up to the maturity date if:

1. The company has a sufficient, long-term investment that is restricted for the purpose of paying the bondholders when the bonds mature. This type of investment is known as a bond sinking fund.

2. The company has a binding agreement that guarantees that the existing bonds will be refinanced by issuing new bonds or by issuing shares of stock.

Learn more about Bonds Payable.

About the Author: Harold Averkamp (CPA) has worked as an accountant, consultant, and university accounting instructor for more than 25 years.

He is the author of the 2010 Master Accounting Download Package which has been praised for it's ability to simplify accounting in a way that anybody can understand.

View the original article here

Where is the discount on the purchase of office furniture recorded?

The discount received on the purchase of office furniture that will be used by a company is recorded in the same asset account in which the office furniture is recorded. That account might be Furniture and Fixtures or Office Furniture. (The discount is not recorded in Purchase Discounts as this account is only for the discounts on the purchase of merchandise that will be sold.)

To illustrate, let’s assume that a company purchases furniture for the office of a newly appointed executive. The cost of the furniture is $10,000 and the invoice allows a discount of 1% if it is paid within 10 days. If the company pays the invoice within 10 days, the Furniture and Fixtures account will increase by $9,900 ($10,000 minus the discount of $100). The depreciation calculations will be based on the cost of $9,900.

Learn more about Accounting Principles.

About the Author: Harold Averkamp (CPA) has worked as an accountant, consultant, and university accounting instructor for more than 25 years.

He is the author of the 2010 Master Accounting Download Package which has been praised for it's ability to simplify accounting in a way that anybody can understand.

View the original article here

What does understated mean?

When an accountant says that an amount is understated, it means two things:

1. The amount is not the correct amount, and

2. The amount is less than the true amount.  In other words, the amount is too small.

To illustrate the term understated, let’s assume that a company is reporting its accounts payable as $21,000. Let’s also assume that the correct or true amount of accounts payable is $23,000. An accountant will say that the reported amount of $21,000 is understated by $2,000.

Because of double-entry bookkeeping or accounting there will also be a second general ledger account with an error for the same amount.

About the Author: Harold Averkamp (CPA) has worked as an accountant, consultant, and university accounting instructor for more than 25 years.

He is the author of the 2010 Master Accounting Download Package which has been praised for it's ability to simplify accounting in a way that anybody can understand.

View the original article here

What is a comparative income statement?

A comparative income statement will consist of two or three columns of amounts appearing to the right of the account titles or descriptions. For example, the income statement for the year 2010 will report to the right of the word Revenues the amounts for each of the years 2010, 2009, and 2008. As a courtesy to the reader, the amounts from the most recent period are in the column closest to the titles. The older amounts are deemed to be less significant and thus appear furthest from the titles.

A comparative income statement gives the reader a frame of reference for comparing the current year amounts.

Learn more about the Income Statement.

About the Author: Harold Averkamp (CPA) has worked as an accountant, consultant, and university accounting instructor for more than 25 years.

He is the author of the 2010 Master Accounting Download Package which has been praised for it's ability to simplify accounting in a way that anybody can understand.

View the original article here

What is the difference between a balance sheet of a nonprofit organization and a for-profit business?

One difference in the balance sheets of a nonprofit or not-for-profit organization and a for-profit business is the name or title shown in its heading. In a nonprofit, the name of this financial statement is the statement of financial position. In the for-profit business this financial statement is the balance sheet.

Another difference is the section that presents the difference between the total assets and total liabilities. The nonprofit’s statement of financial position refers to this section as net assets, whereas the for-profit business will refer to this section as owner’s equity or stockholders’ equity. The reason for this difference is the nonprofit does not have owners. This means that the nonprofit organization’s statement of financial position will reflect this equation: assets - liabilities = net assets.

The net assets section will consist of the following parts: unrestricted net assets, temporarily restricted net assets, and permanently restricted net assets. The amounts reported in each of these parts are based on the donor’s stipulations.

About the Author: Harold Averkamp (CPA) has worked as an accountant, consultant, and university accounting instructor for more than 25 years.

He is the author of the 2010 Master Accounting Download Package which has been praised for it's ability to simplify accounting in a way that anybody can understand.

View the original article here

What is the statement of activities?

The statement of activities is one of the main financial statements of a nonprofit or not-for-profit organization.

A nonprofit’s statement of activities is issued instead of the income statement which is issued by a for-profit business.

The statement of activities focuses on the total organization (as opposed to focusing on funds within the organization) and reports the following:

1. Revenues such as contributions, program fees, membership dues, grants, investment income, and amounts released from restrictions.

2. Expenses reported in categories such as major programs, fundraising, and management and general.

3. The change in net assets resulting from items 1 and 2.

The statement of activities will have multiple columns in order to report the amounts for each of the following classes of net assets: unrestricted, temporarily restricted, permanently restricted, and total.

About the Author: Harold Averkamp (CPA) has worked as an accountant, consultant, and university accounting instructor for more than 25 years.

He is the author of the 2010 Master Accounting Download Package which has been praised for it's ability to simplify accounting in a way that anybody can understand.

View the original article here

How do you balance a checkbook?

You balance a checkbook by comparing the amounts on your bank statement or in your bank account to the amounts you have in your checkbook or check register. Accountants refer to this as reconciling the bank statement or doing a bank reconciliation or bank rec (pronounced as “wreck”).

You can find a free explanation and a complete illustration of how to balance your checkbook at Bank Reconciliation.

If you would like a form with instructions to guide you, AccountingCoach.com offers a bank reconciliation form (both blank and completed) as part of its Master Set of 80 Business Forms.

About the Author: Harold Averkamp (CPA) has worked as an accountant, consultant, and university accounting instructor for more than 25 years.

He is the author of the 2010 Master Accounting Download Package which has been praised for it's ability to simplify accounting in a way that anybody can understand.

View the original article here

How do you calculate the payroll accrual?

The payroll accrual is the amount that needs to be entered into a liability account in order for the credit balance in the liability account to be the amount owed to employees. The amount owed is the amount the employees have earned from working, but as of the date of the balance sheet this amount has not been paid to the employees.

To illustrate the payroll accrual, assume that a company’s employees were paid on September 30 for their work through September 25. The credit balance needed in the liability account as of September 30 is the amount that the employees earned for the days of September 26 through September 30.

Learn more about Adjusting Entries.

About the Author: Harold Averkamp (CPA) has worked as an accountant, consultant, and university accounting instructor for more than 25 years.

He is the author of the 2010 Master Accounting Download Package which has been praised for it's ability to simplify accounting in a way that anybody can understand.

View the original article here

How do you compute a selling price if you know the cost and the required gross margin?

To compute the selling price, let’s assume that a product has a cost of $100 and the seller wants to have a 30% gross margin on its selling price, or 30% of SP. The relationship between a selling price, cost, and gross margin or gross profit is: SP - cost = gross profit or gross margin. If the gross margin is 30% of SP, the cost of $100 will be 70% of SP.

Algebra allows us to compute the selling price as follows:

SP - cost = gross margin

SP - $100 = 30% of SP

1SP - $100 = 0.3SP

1SP - 0.3SP = $100

0.7 SP = $100

0.7SP/0.7 = $100/0.7

SP = $142.85.

To verify that a selling price of $142.85 will give us the correct gross margin, we subtract the cost of $100 from the $142.85 selling price. The result is a gross profit of $42.85 which when divided by the selling price gives us the required gross margin of 30% ($42.85/$142.85 ).

About the Author: Harold Averkamp (CPA) has worked as an accountant, consultant, and university accounting instructor for more than 25 years.

He is the author of the 2010 Master Accounting Download Package which has been praised for it's ability to simplify accounting in a way that anybody can understand.

View the original article here

How is petty cash reported on the financial statements?

The Petty Cash account and its balance could be listed separately as one of the first assets in the current asset section of the balance sheet. This is likely the case at smaller companies.

At larger companies, the balance in the Petty Cash account is often combined with the balances in the other cash accounts and the total of the cash accounts will be reported as Cash or as Cash and Cash Equivalents. You will find Cash and Cash Equivalents as the first item in the current asset section of the balance sheet.

Learn more about the Balance Sheet.

About the Author: Harold Averkamp (CPA) has worked as an accountant, consultant, and university accounting instructor for more than 25 years.

He is the author of the 2010 Master Accounting Download Package which has been praised for it's ability to simplify accounting in a way that anybody can understand.

View the original article here

What does it mean to report expenses by function?

To report expenses by function means to report them according to the activity for which the expenses were incurred.

For a business, the reporting of expenses by function means the income statement will report expenses according to the following functional classifications: manufacturing, selling, general administrative, and financing.

For a not-for-profit organization, the reporting of expenses by function means the statement of activities will report expenses according to the following functional classifications: 1) each of its major programs, and 2) the supporting services which are a) management and general, b) fund-raising, and c) membership development.

(Classifying expenses according to salaries, electricity, repairs, etc. is referred to as natural classifications, or classifyng expenses by their nature.)

About the Author: Harold Averkamp (CPA) has worked as an accountant, consultant, and university accounting instructor for more than 25 years.

He is the author of the 2010 Master Accounting Download Package which has been praised for it's ability to simplify accounting in a way that anybody can understand.

View the original article here

Comment on Replenishing Petty Cash by John

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 CREDITPostage 37.00Office 14.50Meals 36.50Auto 15.00 Cash 92.50

The mistake occurs when you try to do this:

DESCRIPTION DEBIT CREDITPetty 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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Is a manufacturer’s product warranty part of its manufacturing overhead or is it part of its SG&A expense?

The costs associated with a manufacturer’s product warranty are part of its selling expenses and therefore part of its SG&A expenses.

If the future costs of the warranty coverage are probable and can be estimated, they are recorded at the time of the sale. The accounting entry will debit Warranty Expense and will credit Warranty Liability. If the estimated warranty costs are recorded at  the time of the sale, the actual costs of the repair work or the replacement of the product during the warranty period will be debited to the Warranty Liability account—thereby reducing the liability balance.

About the Author: Harold Averkamp (CPA) has worked as an accountant, consultant, and university accounting instructor for more than 25 years.

He is the author of the 2010 Master Accounting Download Package which has been praised for it's ability to simplify accounting in a way that anybody can understand.

View the original article here

What is a fringe benefit rate?

A fringe benefit rate is the cost of an employee’s benefits divided by the wages paid to an employee for the hours working on the job. The following is a sample calculation of the fringe benefit rate for a hypothetical, full-time employee with a wage rate of $20 per hour.

Let’s begin by assuming that a company operates 5 days per week for 8 hours per day for 52 weeks per year—a total of 2,080 hours per year. Let’s also assume that each year the employee is entitled to 15 days of paid vacation, 8 paid holidays, and 5 paid sick days. This amounts to 28 days of 8 hours each, or 224 hours per year that the employee is paid when not on the job. Therefore, the employee’s wages for working on the job will be 1,856 hours per year (2,080 hours minus 224 hours) times $20 per hour = $37,120 for a year.

Next let’s compute the cost of the hypothetical fringe benefits earned by the employee. For the paid vacation, holidays and sick days the annual cost is $4,480 (224 hours not on the job times $20 per hour). Let’s also assume that the employer pays the following annual costs for the employee: $7,200 of the employee’s health, life and disability insurance; $2,000 for the employee’s retirement benefits; $1,100 for worker compensation insurance; $210 for unemployment insurance; and $3,182 (2,080 hours X $20 X 7.65%) for the employer’s portion of the Social Security and Medicare taxes. The sum of these costs for employee benefits is $18,172 per year.

The hypothetical amounts shown above result in a fringe benefit rate of 49%. This is $18,172 of annual benefits divided by the $37,120 of wages earned while working on the job.

Learn more about fringe benefits at Payroll Accounting.

About the Author: Harold Averkamp (CPA) has worked as an accountant, consultant, and university accounting instructor for more than 25 years.

He is the author of the 2010 Master Accounting Download Package which has been praised for it's ability to simplify accounting in a way that anybody can understand.

View the original article here

What are the benefits of a revenue budget?

The main benefit of a revenue budget is that it requires looking into the future. The revenue budget should contain the assumptions made about the future and the details about the number of units to be sold, the expected selling prices, and so on.

The budgeted amount of revenue is then compared to the budgeted amount of expenses in order to determine if the revenues are adequate. Learning of a potential problem before the year begins is a huge benefit because it allows for alternative actions to be developed prior to the start of the new year.

When an annual revenue budget is detailed by month, each month’s actual revenues can be compared to the budgeted amount. Similarly, the actual year-to-date revenues can be compared to the budgeted revenues for the same period. In other words, monthly revenue budgets allow you to monitor revenues as the year progresses instead of being surprised at the end of the year.

Let’s illustrate the benefits of a church’s revenue budget. A church’s annual revenue budget should be prepared independently of the expense budget. The total of the revenue budget is then compared to the annual expense budget. If the annual revenue budget is less than the annual expense budget, action can be taken to develop additional revenues or to reduce the planned expenses before the accounting year begins.

An additional benefit occurs when the annual revenue budget is also detailed by month.  Let’s assume that the church’s monthly revenue budgets will vary by the number of days of worship in the month, the time of year, and other factors. As a result, an annual budget of $370,000 might consist of the following sequence of  monthly amounts: $26,000 + $28,000 + $35,000 + $30,000 + $30,000 + $32,000 + $27,000 + $28,000 + $30,000 + $28,000 + $30,000 + $46,000. Based on these budgeted or planned monthly revenues, the church is expecting to have revenues of $181,000 for the first six months. If the actual revenues for the first six months are only $173,000 the church officials will see that an $8,000 problem at mid-year needs to be addressed. The shortfall also raises the question of whether there will be a similar shortage in the second half of the year. Thanks to the monthly revenue budget, church officials will be alerted early enough to find a solution. The solution could include a message to members asking for additional contributions, an edict to cut expenses for the remainder of the year, and so on.

Preparing a detailed, realistic budget requires you to plan ahead. This in turn gives you insights prior to the start of the accounting year. Monthly revenue budgets allow you to monitor the receipts right from the beginning of the year.

About the Author: Harold Averkamp (CPA) has worked as an accountant, consultant, and university accounting instructor for more than 25 years.

He is the author of the 2010 Master Accounting Download Package which has been praised for it's ability to simplify accounting in a way that anybody can understand.

View the original article here

What does overstated mean?

When an accountant states that a reported amount is overstated, it means two things:

1. The reported amount is incorrect, and

2. The reported amount is more than the true or correct amount.

For example, a company reports that its prepaid insurance is $8,000. However, the true or correct amount of prepaid insurance is only $7,000. The accountant will say that the reported amount for prepaid insurance is overstated by $1,000.

Because of double-entry accounting or bookkeeping, another general ledger account will also have a reporting error. In our example, if Prepaid Insurance is overstated (too much being reported) it is likely that Insurance Expense will be understated (too little is being reported).

Learn more about Adjusting Entries.

About the Author: Harold Averkamp (CPA) has worked as an accountant, consultant, and university accounting instructor for more than 25 years.

He is the author of the 2010 Master Accounting Download Package which has been praised for it's ability to simplify accounting in a way that anybody can understand.

View the original article here

What is the difference between correlation and cause and effect?

Correlation means that two or more sets of data move in some consistent pattern. Perhaps during a 10-year period the number of cars sold in the U.S. moved in the same direction as the country’s rate of inflation. Even with a 10-year correlation between the two sets of data, it is unlikely that more inflation caused an increase in the number of cars sold. In other words, correlation does not assure that there is a cause and effect relationship.

On the other hand, if there is a cause and effect relationship, there will have to be correlation.

About the Author: Harold Averkamp (CPA) has worked as an accountant, consultant, and university accounting instructor for more than 25 years.

He is the author of the 2010 Master Accounting Download Package which has been praised for it's ability to simplify accounting in a way that anybody can understand.

View the original article here

What is a compilation?

A compilation refers to financial statements that were prepared or compiled by an organization’s outside accountant. A compilation is often the result of an accounting service known as write-up work. With compilations, or compiled financial statements, the outside accountant converts the data provided by the client into financial statements without providing any assurances or auditing services.

A compilation report should accompany the compiled financial statements and it should state that the financial statements 1) are the representation of the management of the organization, and 2) have not been reviewed or audited and that the accountant offers no opinion or assurances on them.

Compilations allow companies without an accountant to have financial statements prepared at a lower cost than reviewed or audited financial statements.

Learn more about Financial Accounting.

About the Author: Harold Averkamp (CPA) has worked as an accountant, consultant, and university accounting instructor for more than 25 years.

He is the author of the 2010 Master Accounting Download Package which has been praised for it's ability to simplify accounting in a way that anybody can understand.

View the original article here

What is accounting fraud?

Accounting fraud is a deliberate and improper manipulation of the recording of sales revenue and/or expenses in order to make a company's profit performance appear better than it actually is. Some things that companies do that can constitute fraud are:

--Not listing prepaid expenses or other incidental assets

--Not showing certain classifications of current assets and/or liabilities

--Collapsing short- and long-term debt into one amount.

Over-recording sales revenue is the most common technique of accounting fraud. A business may ship products to customers that they haven't ordered, knowing that those customers will return the products after the end of the year. Until the returns are made, the business records the shipments as if they were actual sales. Or a business may engage in channel stuffing. It delivers products to dealers or final customers that they really don't want, but business makes deals on the side that provide incentives and special privileges if the dealers or customers don't object to taking premature delivery of the products. A business may also delay recording products that have been returned by customers to avoid recognizing these offsets against sales revenue in the current year

The other way a business commits accounting fraud is by under-recording expenses, such as not recording depreciation expense. Or a business may choose not to record all of its cost of goods sold expense fore the sales made during a period. This would make the gross margin higher, but the business's inventory asset would include products that actually are not in inventory because they've been delivered to customers.

A business might also choose not to record asset losses that should be recognized, such as uncollectible accounts receivable, or it might not write down inventory under the lower of cost or market rule. A business might also not record the full amount of the liability for an expense, making that liability understated in the company's balance sheet. Its profit, therefore, would be overstated.

Managing the Bottom Line

If you don't keep track of how much money you're making, you have no idea whether your business is successful or not. You can't tell how well your marketing is working. And I don't just mean you should know the amount of your total sales or gross revenue. You need to know what your net profit is. If you don't, there's no way you can know how to increase it.

If you want your business to be successful, you need to make a financial plan and check it against the facts on a monthly basis, then take immediate action to correct any problems. Here are the steps you should take:

* Create a financial plan for your business. Estimate how much revenue you expect to bring in each month, and project what your expenses will be.

* Remember that lost profits can't be recovered. When entrepreneurs compare their projections to reality and find earnings too low or expenses too high, they often conclude, "I'll make it up later." The problem is that you really can't make it up later: every month profits are too low is a month that is gone forever.

* Make adjustments right away. If revenues are lower than expected, increase efforts in sales and marketing or look for ways to increase your rates. If overhead costs are too high, find ways to cut back. There are other businesses like yours around. What is their secret for operating profitably?

* Think before you spend. When considering any new business expense, including marketing and sales activities, evaluate the increased earnings you expect to bring in against its cost before you proceed to make a purchase.

* Evaluate the success of your business based on profit, not revenue. It doesn't matter how many thousands of dollars you are bringing in each month if your expenses are almost as high, or higher. Many high-revenue businesses have gone under for this very reason -- don't be one of them.

Inventory and expenses

Inventory is usually the largest current asset of a business that sells products. If the inventory account is greater at the end of the period than at the start of the reporting period, the amount the business actually paid in cash for that inventory is more than what the business recorded as its cost of good sold expense. When that occurs, the accountant deducts the inventory increase from net income for determining cash flow from profit.

the prepaid expenses asset account works in much the same way as the change in inventory and accounts receivable accounts. However, changes in prepaid expenses are usually much smaller than changes in those other two asset accounts.

The beginning balance of prepaid expenses is charged to expense in the current year, but the cash was actually paid out last year. this period, the business pays cash for next period's prepaid expenses, which affects this period's cash flow, but doesn't affect net income until the next period. Simple, right?

As a business grows, it needs to increase its prepaid expenses for such things as fire insurance premiums, which have to be paid in advance of the insurance coverage, and its stocks of office supplies. Increases in accounts receivable, inventory and prepaid expenses are the cash flow price a business has to pay for growth. Rarely do you find a business that can increase its sales revenue without increasing these assets.

The lagging behind effect of cash flow is the price of business growth. Managers and investors need to understand that increasing sales without increasing accounts receivable isn't a realistic scenario for growth. In the real business world, you generally can't enjoy growth in revenue without incurring additional expenses.

What is forensic accounting?

Forensic accounting is the practice of utilizing accounting, auditing, and investigative skills to assist in legal matters. It encompasses 2 main areas - litigation support, investigation, and dispute resolution. Litigation support represents the factual presentation of economic issues related to existing or pending litigation. In this capacity, the forensic accounting professional quantifies damages sustained by parties involved in legal disputes and can assist in resolving disputes, even before they reach the courtroom. If a dispute reaches the courtroom, the forensic accountant may testify as an expert witness.

Investigation is the act of determining whether criminal matters such as employee theft, securities fraud (including falsification of financial statements), identity theft, and insurance fraud have occurred. As part of the forensic accountant's work, he or she may recommend actions that can be taken to minimize future risk of loss. Investigation may also occur in civil matters. For example, the forensic accountant may search for hidden assets in divorce cases.

Forensic accounting involves looking beyond the numbers and grasping the substance of situations. It's more than accounting...more than detective work...it's a combination that will be in demand for as long as human nature exists. Who wouldn't want a career that offers such stability, excitement, and financial rewards?

In short, forensic accounting requires the most important quality a person can possess: the ability to think. Far from being an ability that is specific to success in any particular field, developing the ability to think enhances a person's chances of success in life, thus increasing a person's worth in today's society. Why not consider becoming a forensic accountant on the Forensic Accounting Masters Degree link on the left-hand navigation bar.

Types of Costs

Direct costs are those costs that cann be directly attributed to a product or product line, or to one source of sales revenue, or one business unit or operation of the business. An example of a direct cost would be the cost of tires on a new automobile.

Indirect costs are very different and can't be attached to any specific product, unit or activity. The cost of labor or benefits for an auto manufacturer is certainly a cost, but it can't be attached to any one vehicle. Each business has to devise a method of allocating indirect costs to different products, sources of sales revenue, business units, etc. Most allocation methods are less than perfect, and generally end up being arbitrary to one degree or another. Business managers and accounts should always keep an eye on the allocation methods used for indirect costs and take the cost figures produced by these methods with a grain of salt.

Fixed costs are those costs that stay the same over a relatively broad range of sales volume or production output. They're like an albatross around the neck of business and a company must sell its product at a high enough profit to at least break even.

Variable costs can increase and decrease in proportion to changes in sales or production level. Variable costs vary proportionately with changes in production/

Relevant costs are essentially future costs that could be incurred, depending on what strategic course a business takes. If an auto manufacturer decides to increase production, but the cost of tires goes up, than that cost needs to be taken into consideration.

Irrelevant costs are those that should be disregarded when deciding on a future course of action. They're costs that could cause you to make a wrong decision. Whereas relevant costs are future costs, irrelevant costs are those costs that were incurred in the past. The money's gone.

Gains and Losses

It would probably be ideal if business and life were as simple as producing goods, selling them and recording the profits. But there are often circumstances that disrupt the cycle, and it's part of the accountants job to report these as well. Changes in the business climate, or cost of goods or any number of things can lead to exceptional or extraordinary gains and losses in a business. Some things that can alter the income statement can include downsizing or restructuring the business. This used to be a rare thing in the business environment, but is now fairly commonplace. Usually it's done to offset losses in other areas and to decrease the cost of employees' salaries and benefits. However, there are costs involved with this as well, such as severance pay, outplacement services, and retirement costs.

In other circumstances, a business might decide to discontinue certain product lines. Western Union, for example, recently delivered its very last telegram. The nature of communication has changed so drastically, with email, cell phones and other forms, that telegrams have been rendered obsolete. When you no longer sell enough of a product at a high enough profit to make the costs of manufacturing it worthwhile, then it's time to change your product mix.

Lawsuits and other legal actions can cause extraordinary losses or gains as well. If you win damages in a lawsuit against others, then you've incurred an extraordinary gain. Likewise if your own legal fees and damages or fines are excessive, then these can significantly impact the income statement.

Occasionally a business will change accounting methods or need to correct any errors that had been made in previous financial reports. Generally Accepted Accounting Procedures (GAAP) require that businesses make any one-time losses or gains very visible in their income statement.

Sunk Costs and Loss Aversion

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Accountant: Integrity

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What does an audit do?

If a business breaks the rules of accounting and ethics, it can be liable for legal sanctions against it. It can deliberately deceive its investors and lenders with false or misleading numbers in its financial report. That's where audits come in. Audits are one means of keeping misleading financial reporting to a minimum. CPA auditors are like highway patrol officers who enforce traffic laws and issue tickets to keep speeding to a minimum. An audit exam can uncover problems that the business was not aware of.

After completing an audit examination, the CPA prepares a short report stating that the business has prepared its financial statements, according to generally accepted accounting principles (GAAP), or where it has not. All businesses that are publicly traded are required to have annual audits by independent CPAs. Those companies whose stocks are listed on the New York Stock Exchange or Nasdaq must be audited by outside CPA firms. For a publicly traded company, the expense of conducting an annual audit is the cost of doing business; it's the price a company pays for going into public markets for its capital and for having its shares traded in the public venue.

Although federal law doesn't require audits for private businesses, banks and other lenders to private businesses may insist on audited financial statements. If the lenders don't require audited statements, a business's owners have to decide whether an audit is a good investment. Instead of an audit, which they can't really afford, many smaller businesses have an outside CPA come in on a regular basis to look over their accounting methods and give advice on their financial reporting. But unless a CPA has done an audit, he or she has to be very careful not to express an opinion of the external financial statements. Without a careful examination of the evidence supporting the amounts reported in the financial statements, the CPA is in no position to give an opinion on the financial statements prepared from the accounts of the business.

Profit and Loss

It might seem like a no-brainer to define just exactly what profit and loss are. But of course these have definitions like everything else. Profit can be called different things, for a start. It's sometimes called net income or net earnings. Businesses that sell products and services generate profit from the sales of those products or services and from controlling the attendant costs of running the business. Profit can also be referred to as Return on Investment, or ROI. While some definitions limit ROI to profit on investments in such securities as stocks or bonds, many companies use this term to refer to short-term and long-term business results. Profit is also sometimes called taxable income.

It's the job of the accounting and finance professionals to assess the profits and losses of a company. They have to know what created both and what the results of both sides of the business equation are. They determine what the net worth of a company is. Net worth is the resulting dollar amount from deducting a company's liabilities from its assets. In a privately held company, this is also called owner's equity, since anything that's left over after all the bills are paid, to put it simply, belongs to the owners. In a publicly held company, this profit is returned to the shareholders in the form of dividends. In other words, all liabilities have the first claim on any money the company makes. Anything that's left over is profit. It's not derived from one element or another. Net worth is determined after all the liabilities are deducted from all the assets, including cash and property.

Showing a profit, or a positive figure on the balance sheet, is of course the aim of every business. It's what our economy and society are built on. It doesn't always work out that way. Economic trends and consumer behaviors change and it's not always possible to predict these and what income they'll have on a company's performance.

What are other ratios used in financial reporting

The dividend yield ratio tells investors how much cash income they're receiving on their stock investment in a business. This is calculated by dividing the annual cash dividend per share by the current market price of the stock. This can be compared with the interest rate on high-grade debt securities that pay interest, such as Treasure bonds and Treasury notes, which are the safest.

Book value per share is calculated by dividing total owners' equity by the total number of stock shares that are outstanding. While EPS is more important to determine the market value of a stock, book value per share is the measure of the recorded value of the company's assets less its liabilities, the net assets backing up the business's stock shares. It's possible that the market value of a stock could be less than the book value per share.

The return on equity (ROE) ratio tells how much profit a bus8iness earned in comparison to the book value of its stockholders' equity. This ratio is especially useful for privately owned businesses, which have no way of determining the current value of owners' equity. ROE is also calculated for public corporations, but it plays a secondary role to other ratios. ROE is calculated by dividing net income by owners' equity.

The current ratio is a measure of a business's short-term solvency, in other words, its ability to pay it liabilities that come due in the near future. This ratio is a rough indicator of whether cash on hand plus the cash to be collected from accounts receivable and from selling inventory will be enough to pay off the liabilities that will come due in the next period. It is calculated by dividing the current assets by the current liabilities. Businesses are expected to maintain a minimum 2:1 current ratio, which means its current assets should be twice its current liabilities.

Depreciation

Depreciation is a term we hear about frequently, but don't really understand. It's an essential component of accounting however. Depreciation is an expense that's recorded at the same time and in the same period as other accounts. Long-term operating assets that are not held for sale in the course of business are called fixed assets. Fixed assets include buildings, machinery, office equipment, vehicles, computers and other equipment. It can also include items such as shelves and cabinets. Depreciation refers to spreading out the cost of a fixed asset over the years of its useful life to a business, instead of charging the entire cost to expense in the year the asset was purchased. That way, each year that the equipment or asset is used bears a share of the total cost. As an example, cars and trucks are typically depreciated over five years. The idea is to charge a fraction of the total cost to depreciation expense during each of the five years, rather than just the first year.

Depreciation applies only to fixed assets that you actually buy, not those you rent or lease. Depreciation is a real expense, but not necessarily a cash outlay expense in the year it's recorded. The cash outlay does actually occur when the fixed asset is acquired, but is recorded over a period of time.

Depreciation is different from other expenses. It is deducted from sales revenue to determine profit, but the depreciation expense recorded in a reporting period doesn't require any true cash outlay during that period. Depreciation expense is that portion of the total cost of a business's fixed assets that is allocated to the period to record the cost of using the assets during period. The higher the total cost of a business's fixed assets, then the higher its depreciation expense.

What is the Sarbanes-Oxley Act?

The Sarbanes-Oxley Act of 2002 is a United States federal law passed in response to the recent major corporate and accounting scandals including those at Enron, Tyco International, and WorldCom (now MCI). These scandals resulted in a decline of public trust in accounting and reporting practices. Named after sponsors Senator Paul Sarbanes (D-Md.) and Representative Michael G. Oxley (R-Oh.), the Act was approved by the House by a vote of 423-3 and by the Senate 99-0. The legislation is wide-ranging and establishes new or enhanced standards for all U.S. public company Boards, Management, and public accounting firms. The first and most important part of the Act establishes a new quasi-public agency, the Public Company Accounting Oversight Board, which is charged with overseeing and disciplining accounting firms in their roles as auditors of public companies. Some of the major provisions of the Sarbanes-Oxley Act's include:

--Certification of financial reports by chief executive officers and chief financial officers

--Auditor independence, including outright bans on certain types of work for audit clients and pre-certification by the company's Audit Committee of all other non-audit work

--A requirement that companies listed on stock exchanges have fully independent audit committees that oversee the relationship between the company and its auditor

--Significantly longer maximum jail sentences and larger fines for corporate executives who knowingly and willfully misstate financial statements, although maximum sentences are largely irrelevant because judges generally follow the Federal Sentencing Guidelines in setting actual sentences

--Employee protections allowing those corporate fraud whistleblowers who file complaints with OSHA within 90 days, to win reinstatement, back pay and benefits, compensatory damages, abatement orders, and reasonable attorney fees and costs.

Accountant: Integrity

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Corporate Restructurings: Ordinary or Not So Ordinary?

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About GAAP

While many businesses assume that accountants are bound by generally accepted accounting practices and that these are inviolate, nothing could be further from the truth. Everything is subject to interpretation, and GAAP is no different. For one thing, GAAP themselves permit alternative accounting methods to be used for certain expenses and for revenue in certain specialized types of businesses. For another, GAAP methods require that decisions be made about the timing for recording revenue and expenses, or they require that key factors be quantified. Deciding on the timing of revenue and expenses and putting definite values on these factors require judgments, estimates and interpretations.

The mission of GAAP over the years has been to standardize accounting methods in order to bring about uniformity across all businesses. But alternative methods are still permitted for certain basic business expenses. No tests are required to determine whether one method is more preferable than another. A business is free to select whichever method it wants. But it must choose which cost of good sold expense method to use and which depreciation expense method to use.

For other expenses and for sales revenue, one general accounting method has been established; there are no alternative methods. However, a business has a fair amount of latitude in actually implementing the methods. One business applies the accounting methods in a conservative manner, and another business applies the methods in a more liberal manner. The end result is more diversity between businesses in their profit measure and financial statements than one might expect, considering that GAAP have been evolving since 1930.

The pronouncement on GAAP prepared by the Financial Accounting Standards Board (FASB) is now more than 1000 pages long. And that doesn't even include the rules and regulations issued by the federal regulatory agency that jurisdiction over the financial reporting and accounting methods of publicly owned businesses - the Securities and Exchange Commission (SEC).

Research and Development Costs

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How is accounting used in business?

It might seem obvious, but in managing a business, it's important to understand how the business makes a profit. A company needs a good business model and a good profit model. A business sells products or services and earns a certain amount of margin on each unit sold. The number of units sold is the sales volume during the reporting period. The business subtracts the amount of fixed expenses for the period, which gives them the operating profit before interest and income tax.

It's important not to confuse profit with cash flow. Profit equals sales revenue minus expenses. A business manager shouldn't assume that sales revenue equals cash inflow and that expenses equal cash outflows. In recording sales revenue, cash or another asset is increased. The asset accounts receivable is increased in recording revenue for sales made on credit. Many expenses are recorded by decreasing an asset other than cash. For example, cost of goods sold is recorded with a decrease to the inventory asset and depreciation expense is recorded with a decrease to the book value of fixed assets. Also, some expenses are recorded with an increase in the accounts payable liability or an increase in the accrued expenses payable liability.

Remember that some budgeting is better than none. Budgeting provides important advantages, like understanding the profit dynamics and the financial structure of the business. It also helps for planning for changes in the upcoming reporting period. Budgeting forces a business manager to focus on the factors that need to be improved to increase profit. A well-designed management profit and loss report provides the essential framework for budgeting profit. It's always a good idea to look ahead to the coming year. If nothing else, at least plug the numbers in your profit report for sales volume, sales prices, product costs and other expense and see how your projected profit looks for the coming year.