accounting advice

8/3/2019 Accounting Advice

http://slidepdf.com/reader/full/accounting-advice 1/61



challenged the accountants for practicing law without a license, income tax preparation had beenso thoroughly identified with accountants that they lost the case.

The Great Depression rocked the integrity of the accounting profession. The British SteamshipCompany was just one of the large world giants that went bankrupt just after posting large

profits. “How could profitable companies go bankrupt?” Investors asked. Court cases showedthat the economic reality was that the companies weren’t profitable after all. The profits were theresult of bookkeeping tricks. Moreover the reserve funds that were on the books were non-existent.

So far, these events could be chalked up as individuals' fraud (albeit widespread fraud) andhandled through the ordinary course of justice. What made the events historic was when theaccountants testified in court that the bookkeeping practices were “generally accepted accounting principles” and then proceeded to prove that they were. This was more serious than justindividual malfeasance. If the basic rules of accounting gave false information, then somethingwas wrong with the basic rules of accounting.

Worse, followed. Corporate accounting was anything goes. There were no rules, per se. Therewere just “generally accepted accounting principles”. They were generally accepted becausemost accountants did certain things. Since accountants were hired by and answered to corporatemanagement, they served the needs of management, not the public. That meant that in practice,the primary function of accounting was to make management look good.

Things had to change. While the profession managed to escape the full New Deal governmenttakeover, rules, standards and legal responsibility had to be shouldered. The American Instituteof Certified Public Accountants (AICPA) created their own rule-making body, the Committee onAccounting Procedure. They accepted government licensure. Most importantly, auditing

financial statements was limited to CPA’s and they were made personally liable for their auditreports. The new Securities and Exchange Commission (SEC) required audit reports for allpublicly traded companies.

With these measures, accountants contributed to restoring public trust in the stock market and theeconomy during the depression years.

Time passed by. Criticism mounted that the AICPA’s rulemaking was not keeping pace with theneeds of the expanding economy. Around 1960 the American Institute of Certified PublicAccountants scrapped the Principles Committee and set up the Accounting Principles Board(APB) in 1959. Still the cry for more uniformity and consistency in accounting continued.

In 1973 the Financial Accounting Standards Board (FASB) replaced the APB. It brought twomajor changes over the previous rules-setting bodies. First it was independent of the AICPA.Second, previous procedural impediments to rule making were overhauled. In short, it wasgeared to crank out rules – lots of rules.



In the next several decades, it did. And for those accounting areas where it did not want to go,other bodies were set up. There was the Cost Accounting Standards Board and The GovernmentAccounting Standards Board.

In addition to the statements from these Boards, the accountant had to contend with new rules

from such sources as Statements of Position, and Accounting and Auditing Guides from theAICPA, and Technical Bulletins and Interpretations from FASB.

By the 1990’s the complaint was “standards overload”. Rule making continued apace.

Ronald Reagan set an historic precedent in 1982 by killing an accounting board (the CostAccounting Standards Board). The idea that society has enough accounting rules in an arearemains a unique event in the history of accounting.

The auditing standards mirrored the accounting standards. Small business was deeply impactedby new auditing requirements. More audit rules meant more audit work and hence more costs to

businesses.

In the 1980’s the AICPA announced the Statements on Standards for Accounting and ReviewServices (SSARS). Henceforth, CPA’s provided three levels of accounting services: 1)Compilation, 2) Reviews and 3) Audits. Auditing: The Expectation Gap covers these.Responding to public pressure, they okayed plain paper “management only” statements in 1998.

Other countries had their own rule-making activities. As the gray areas in accounting came to becovered by rules the flexibility of accountants to accommodate the differing practices of differentcountries disappeared. What to do?

More rules, of course! The International Accounting Standards Commission promulgated therules for international accounting. This was set up in Britain just before the turn of the century.

With the corporate scandals directly involving misleading accounting in the early years of the2000’s, accounting has come back to the days of 1930’s. This time it did not escape directgovernment oversight.

And they are not living happily ever after.

GAAP vs. OCBOA

GAAP stands for “Generally Accepted Accounting Principles”. OCBOA stands for “Other Comprehensive Basis of Accounting”. As the terms imply one is the standard accounting and theother is – other.

The backbone of GAAP accounting is the concept of the matching principle. This means thatrevenues should be matched with expenses and vice versa. Accountants record transactions wheneconomic events occur in addition to when cash is transferred.



ExampleAssume you bill a customer $1,000 for services.When you send the bill, you credit revenues $1,000 and debit accounts receivable for $1,000.When you produce the financial statements, they show $1,000 of revenue even though youhaven’t yet got the money. Later the customer pays up. You credit accounts receivable and debit

cash for $1,000.

Use the same principle for expenses.

Who makes these rules?

The main rule making body is the Financial Accounting Standards Board (FASB). TheGovernment Accounting Standards Board (GASB) uses FASB statements as their base.International Accounting rules comes from the International Accounting Standards Commission(IASC).

The Cost Accounting Standards Board went defunct in 1982. Their standards applied to FederalGovernment Contractors that were big businesses. Even though that board no longer exists, theirstandards still apply. (See Code of Federal Regulations, Title 4 of the General AccountingOffice.)

The main OCBOA accounting principles are cash basis and tax basis.

Cash basis accounting means that transactions are only recorded when cash exchanges hands.

ExperienceOver the years we’ve encountered hardly any cases of pure cash accounting. Accountants usually

slip in some accrual accounting. Accounts receivable and payable are not cash basis transactionsyet they frequently pop up in financial statements labeled “cash basis”. Cash basis statementsshould have no liabilities at all except for loans of cash.

Practical needs of business seem to constantly impinge on the cash basis accountants’ world.Management wants to know how much money they “really” owe the bank. What about thosepesky payroll deductions? And what happened to their depreciation deduction? So accountants inpractice usually let some non-cash transactions slip onto their books.

What “Cash Basis” financial statements usually means is that not all the required accrual entrieshave been made.

Tax basis accounting means that the financial statements use the same methods that will apply tothe tax return. There should be differences between book and tax amounts when this accountingbasis is used.

TipOn the income statement use the term “taxable income”. Below that have a section titled “Other Revenues and Expenses”. Put non-deductable expenses and excludable revenues here.



ExampleAssume the salesman buys lunch for some prospects. The cost is $50.Only ½ of meals and entertainment is deductable. Therefore the only expense that should berecognized should be $25. What about the other $25 that the salesman spent? Code that to non-deductable expenses in the “Other” category.

ExperienceTax basis is the most popular form of “Certified” financial statements. There are two reasons.1)Managers like these kind of statements because they tell them what their taxable income islooking like.2) CPA’s like them because the rules aren’t as sticky as for GAAP basis statements.

Knowing what accounting basis were used to produce the financials is critical to understandingthem. OCBOA statements may not show all the liabilities and assets. GAAP statements mayshow income that substantially differs from taxable income.

TYPES OF ACCOUNTANTS

What’s the difference between a bookkeeper and an accountant? Oh, about $10 an hour.

That’s an old joke Jack first heard when he took his first accounting class way back in 1974. It’s point is that there is a blur. Here’s a list of the different jobs in this line of work and what theymean.

BookkeeperTheoretically these people are at the bottom of the accounting food chain. Theoretically. Inreality, good bookkeepers are the most valuable of the accounting team. The basis of all thefinancial reporting system rests upon their data input.

In theory bookkeepers record transactions from main sources like invoices and checks.Accountants make accruals and adjustments. Full Charge bookkeepers, however, can do thewhole accounting process complete through final financial statements. Many of these peoplecommand considerable salaries.

AccountantThese people can take the basic data and adjust it to final status. In large companies accountantsmay specialize in one area such as payroll or accounts payable.

Controller (also Comptroller)

This is the head of an accounting department. It’s a fancy word for “chief accountant”.

Chief Financial Officer (CFO)The CFO is head of sever finance related departments. Accounting is only one. Others might be“financial management”, “collections”, and “fixed assets”.

If a company has an internal auditing staff, this department should report to the CFO. This is sothat the CFO can receive independent opinions about accounting operations.



Enrolled agent (EA)These are usually but not necessarily accountants. EA’s may represent taxpayers before the IRS.They must pass an exam administered by the IRS. Accountants who offer their services to thepublic usually try for the EA status.

Certified Public Accountant (CPA)CPA’s can attest to the validity of financial information. This means that they can audit financialstatements and report on whether they are accurate or not. This authority is licensed by law.

CPA’s receive a license to practice from a state board of accountancy. They must pass exams toachieve this. Current requirements include two years of experience and five years of college.

The IRS grants CPA’s and attorneys automatic authority to practice before it.

Other designationsAccounting titles have sprung up like weeds in the last few decades. Some of the main ones are:

CMA stands for “Certified Management Accountant”. This is great for cost accountants.

CIA stands for “Certified Internal Auditor”. In addition for the internal auditors, governmentauditors of contractors have found this designation to be useful.

INTERNATIONAL ACCOUNTING

The two main problems with accounting for companies that are either partially or wholly outsideof the United States are:

1. Different countries have different accounting rules and2. Different currencies.

The problem for the former are being settled by the promulgation of International AccountingStandards. The second issue cannot be addressed by simply issuing a regulation.

ExampleAssume: You’re recording a checks from a US bank account in the accounting books. You finishwith that task and now go on to the next checkbook. This is for a French bank account and all theamounts are in francs. What do you do?If you record the checks as written then you will have a general ledger with amounts meaning

different things.

You must convert all foreign currencies to one single currency. That means you've got todetermine the exchange rates of each transaction and then multiply them out.

ExampleAssume: Supplies has 2,000 chalked up to it. If 1,000 are from the US bank and 1,000 are fromthe French bank, how much has been spent on supplies?



trend in the direction of concentration. The internet pushes it in the opposite direction.

Today the accountant can operate on a truly global scale. Next day air, long distancetelephones, video conferencing, faxes, and e-mail can partially offset the lack of a localpresence. Customers who are smart will value reliability and personal attention over corporate

bigness in their accountants.

Computer software are reaching the limits of their potential. This may seem like we are reallysticking our necks out on this one.

The small businesses packages will acquire the more of the features of the big, expensivepackages. However, bookkeepers must still use judgment on the treatment of transactions. Thatmeans that accountants must still manipulate the data in accounting programs. Internet bankingis increasingly taking over the data entry function. That only can cover deposits and checks.Other business transactions still have to be entered in by hand.

Many public accounting firms are turning to consulting as their revenue generators of thefuture. Many predict the demise of the staples of public accounting – write up work and taxreturn preparation. Unfortunately for the public but fortunately for the accountants, increasingcomplexity of accounting rules and tax laws will increase demand for public accountant’s help.

Last, accountants are going to be increasingly affected by the trends towards the paperlessoffice. Already, tax returns can be filed on disk along with workbooks. Source documents canbe scanned into such programs as Adobe Acrobat and saved on disk with the tax return file.The IRS has been encouraging e-filing for some years now.

For all the glitz about equipment, rules, and globalization, accounting still depends on human

beings. The age old qualities of reliability, caring, and honesty will remain the basis of theprofession.

THE FINANCIAL STATEMENTS

The Balance Sheets

This shows the assets and liabilities of the company. The difference between the two is theequity.

Traditionally, assets were listed on the left side of the page. Liabilities and equity were listed

on the right. This is significant in understanding debits and credits.

Liabilities and equity are always shown together. This means that if liabilities are greaterthan assets, then equity is negative.

The balance shows the position of the company at a single point in time. Its heading alwayscontains a single date. The statement tells you that at the moment the business closed for the



day on the date in the heading, those were the amounts for assets such as cash in bank,liabilities such as taxes due, and equity.

The Income Statement

This shows the revenues and expenses of the company. The difference between the two isnet income.

Revenues and expenses are self explanatory. Many income statements just show those twocategories with net income at the bottom. However, many situations call for a furtherbreakdown.

Companies that buy and sell inventory need to know how much they are making on it. Thisis gross profit. To do this expenses are broken into two parts: Cost of Goods Sold andOperating Expenses.

ExampleAssume: A furniture store sells $10,000 worth of furniture. It banks $30,000. Expensesother than the cost of the furniture was $15,000. The Income Statement would look like this:

Revenue $30,000Cost of Goods Sold 10,000Gross Profit $20,000Operating Expenses 15,000

Net Income$ 5,000

======

Companies have costs that are not operating costs. Costs from discontinued operations, gains

and losses from sale of assets are examples of non-operating amounts. For corporations,income tax expenses gets a “below the line” (non-operating expense) category.

Income statements show the result of activity over a period of them. That is why the dates inthe heading will always say something like “For the month ended . . .” or “For the Year Ended . . .”

These are placed in Other Income and Expense listings below Income from Operations.

The Balance Sheet and the Income Statement are the two primary statements because theiramounts come straight from the Trial Balance. Net income connects the two. It shows up as

an item in Equity on the balance sheet and at the bottom of the income statement.

The Cash Flow Statement

This compares net income to changes in cash. FASB Statement 95 allows two methods; thedirect and the indirect method.



ExperienceThe statement recommends that everybody use the direct method. Almost everybody usesthe indirect method because it is easier.

Both methods require a reconciliation between net income and net changes in cash.

Net income is at the top of the page. Cash is at the bottom. All those things that account forthe difference between the two amounts are listed in between.

ExampleDepreciation is an expense that reduces net income. However, no cash actually goes out of the bank account when it is recorded. Therefore it has to be added back to net income as partof the process of reconciling it to cash.

The items are broken out into three categories: Operating Activities, Financing Activities,and Investment Activities.

Statement of Changes in Retained Earnings

This can be changes in capital depending on the type of company.

It starts with the beginning balance and then shows the major elements that increased anddecreased the equity during the period.

Footnotes complete the required financial reporting package.

Tip Note the word “required” in the above sentence. A Financial Statement Report can containsupplemental information depending on what the company needs it for. It can be packagedtogether with “Management Reports”, graphs, charts, tables and other information.Management can use the supplemental reports to “put its best foot forward”.

ASSETS, LIABILITIES, AND EQUITY

Assets are what you own. Liabilities are what you owe. Equity is what’s left over. It is your net

worth.

Assets always equal your liabilities plus equity. If assets are less than liabilities then your equityis negative.

Assets are on the left of the balance sheet; liabilities and equity are on the right. This directlycorresponds to debits and credits. Debits mean left; credits mean right.

http://www.lemoineandjames.com/gaap/15future.html



Assets and liabilities are grouped into two main categories: current and non-current.

Current assets are those assets that can readily be converted to cash. Bank accounts are of coursemost readily convertible, but any assets that can be converted to cash within a short time arecurrent assets.

Current liabilities are those liabilities that have to be paid off within a short time.

Short time for both current assets and current liabilities usually means one year or less. For somecompanies, it may be “the normal business cycle”.

Non-current assets are further divided into fixed assets and other assets.

Even though items of machinery and other assets may be sold in less than one year, fixed assetsare still non-current. This is because they are intended to help operate the business for periods of greater than a year. If an asset is bought with the intent to sell for a profit, then it is inventory and

is a current asset.

Equity consists of money invested in the company by the owners, money taken out of thecompany by the owners (i.e. their return on their investment), and net income.

DEBITS AND CREDITS

Warning: think of this page as accounting boot camp! This is basic training and I am your drill

sergeant.

Attention!

Alright recruits, here’s the acid torture test of accounting. If you have trouble understandingaccounting it is because of this one concept. It is the hardest task in all of accounting. After youunderstand this one concept everything else accounting-wise will be a piece of cake. But beforeyou can go anywhere else, you must first get past this point.

There are no fancy icons on this page! Uh, uh! If you want to leave you’re going to first have toget by me!

Alright recruits! Suck in that gut! Straighten out those shoulders! Forward march!

Debits

Here is all you need to know about debits:

Debits are on the left.

Got that? Alright! Next:



Credits

Here is all you need to know about credits.

Credits are on the right.

Got that? Alright!

Now some of you recruits are still having trouble with this concept, so let me explain it to youagain.

Debits are on the LEFT. Credits are on the RIGHT.

And I will repeat: that is ALL you need to know about debits and credits.

Generations of accounting students get blocked by this concept. They don’t get blocked because

it is so difficult. They get blocked because they insist that there must be more to it than this.

They bring to accounting the preconception that debits are something that are bad or credits aresomething that are good. Or they think that credits will increase financial position in some way --or that debits will hurt.

Accounting teachers and professors in countless classes over the centuries have tried to get people to remove this excess mental baggage. They’ve tried reason. They’ve tried persuasion.They tried torture. Still people struggle with this concept.

Listen to me! I am your drill sergeant! You WILL remove all other thoughts about debits and

credits from your mind except for what I tell you!

Debits are on the left! Credits are on the right! Period!

Fall in! Move out!

Welcome to the obstacle course. Here’s where we’re going to put this concept to work. (Grin!)

Assets are on the left. Got that? Debits are on the left. Got that? Do any of you meatheads see a

connection?

Whenever you code an entry to an asset account that increases the amount, you put the amount inthe debit column.

And yes, you over there, those assets include cash. If money is received, cash is debited. Notcredited, DEBITED!



Why? Because cash is an asset. Assets are on the left. Debits are on the left. Increases to assetsare debited. I am your drill sergeant. So there!

Over here are the liabilities and the equity. Right face! Over here!

The same thing goes for them. They are on the right. Credits are on the right.

If you take out a loan, you will credit your liability. That is because loans increase liabilities.Liabilities are on the right. Credits are on the right. And I am your drill sergeant!

Now what about the reverse? What about when assets or other stuff goes down? Well, thereverse is (drum roll) the reverse!

Credit assets to remove value. Debit liabilities and equity to make them go down.

When you write a check, you credit cash. Checks reduce cash. Cash is an asset. Assets are on the

left. Credits are on the right. Credits make assets go down. They are the reverse of debits.

When you pay off a loan, you debit liabilities. Liabilities are on the right. Debits are on the left.Debits make liabilities go down. They are the reverse of credits.

Now hear this!

Assets are on the left. Liabilities and Equities are on the right! I will say this again. Debits are onthe left. Credits are on the right. Period!

Next!

Equity consists of (1) money owners have invested in the company and (2) the results of operations. That’s net income to you.

Net income comes from where? The Income Statement. Revenues minus expenses are netincome. And as I just said, net income is an item in Equity. I am your drill sergeant!

Rely on this!

Equity is on the Right. The Income Statement accounts all result in net income. Net income is inequity. Which is on the right.

This means that anything that increases net income will increase equity. Which is on the right.

Revenues increase net income. They are credited. Because they are on the right!

Expenses decrease net income. They are debited. Because they are on the left!

Period!



You now know all you need to know about debits and credits. Back to the home page! Forwardmarch! Hup two, three, four. Left, right. Left, right. . . . .

DOUBLE ENTRY BOOKKEEPING

Every debit must have a credit and vice versa.

ExampleAssume you write a check for your monthly rent.You reduce cash and increase expenses. Credit cash; debit rent expense.

Every transaction has to be analyzed with its impact on at least two accounts.

Sometimes a transaction involves more than two accounts.

Example

You make a loan payment.Part of any loan payment is for interest and part is for principle. So one part of your check isdebited to interest expense and the principal reduction is debited to loans payable. The twoamounts added together equals the amount of your check which is credited to your asset accountfor cash in bank.

None of this will make sense unless you understand the basic concept of debits and credits.

What if you can only see just one account that would relate to a transaction? Punt!

Sorry for this flip answer. If it is any comfort to you, this is like solving a puzzle when you know

what the answer must be even though you may not see it right away. There ALWAYS is anotheraccount.

For every entry, for every credit there is a debit – ALWAYS!

ACCOUNTING SOFTWARE

What Microsoft is to office software Intuit is to accounting programs for small business. Intuitproduces Quickbooks. This has the biggest market share of small accounting programs.

Peachtree is the main competitor. One-Write Plus split off from Safeguard Business Systems in

1994, had a rocky transition to Windows from DOS, and has never recovered its former marketposition.

Dac Easy and MYOB are also-rans. There are, of course, a whole lot of others.

These programs service the bottom tier of small business. They can handle most general businessaccounting needs.



ExperienceWe can negotiate with the IRS regarding income taxes due. They will grant payment plans. Withthe right reason and the right approach, Offers in Compromise can even reduce the amount of income taxes due. With payroll taxes due, however, the IRS plays hardball. This is because thismoney was never the employer’s money to begin with. They deducted it from the employee’s

paychecks for the IRS. Therefore there should be no reason for a company to be unable to pay.Thus the IRS view.

In practice, even with the best attorneys and CPA’s in the world, it is very bad to mess withpayroll taxes.

Since this such a big issue, many of even the smallest businesses want to see their payroll taxliability on the Balance Sheet.

Payroll tax liabilities come in three flavors: Federal Form 941 Taxes, State Income Taxes,Unemployment Taxes.

The 941 Taxes are the income taxes and the social security/medicare taxes. Income Taxes arewholly deducted from the employee. The social security/medicare family of taxes are deductedand then matched by the employer. This means that you deduct a total of 7.35% from theemployee’s paycheck but you pay 15.3% to the IRS. The differ ence between the two is PayrollTax Expense but the total is Current Liability.

State income taxes, like federal income taxes are deducted from the employee’s paycheck. Keepstate income taxes in a separate account because it is a separate tax.

Separate unemployment taxes into federal and state accounts, too. These accounts are paid on

separate forms. Use the Federal Form 940 for Federal Unemployment Tax. The amount due willdepend on the amount paid for the state unemployment in certain circumstances.

To sum up, you need the following payroll tax payable accounts: Federal 941 Taxes, StateIncome Taxes, Federal Unemployment, and State Unemployment.

Generally Accepted Accounting Principles (GAAP) requires other payroll related liabilities.

Anything else that the company deducts from an employee’s paycheck is a liability. The moneyby law must be paid to the party for which it was deducted.

On any date the company will owe wages. This liability is the difference from the date on thecalendar and payday.

ExampleImagine if an employee just quits. You still owe him for the time he worked even though hischeck is not due until payday.

Not just wages, but the rest of the employee’s deductions have to be accrued, too.



of the business must loan the company money to get by. These loans are Current Liabilitiesregardless of the owner’s intent. This is be the owner by definition is in control. To beconservative, accounting rules assume that the owner can pull his money out of the company atany time.

The very last thing in the Current Liabilities section is “Current Part of Long Term Debt.” Thiswill be covered in the next section.

ACCOUNTS RECEIVABLE AND ACCOUNTS PAYABLE

Accounts Receivable is an asset. It represents money that customers owe you.

Accounts Payable is a liability. It represents money that you owe for being a customer of somebody else.

Both these accounts serve the same function. They allow you to put money into the income

statement without cash actually moving.

When invoices are sent or received, then transactions are recognized.

ExampleAssume: You get an invoice from the phone company.Book the amount as a debit to Telephone Expense and the credit to Accounts Payable.When you finally get around to paying the bill, book the debit to Accounts Payable instead of Telephone Expense. You don’t want the same bill expensed twice!

Many accountants record Accounts Payable even though they may pay a bill right away. This is

because they want the software program to keep track of each vendor’s activity. The same is truefor keeping track of customers in Accounts Receivable.

Key reports for management from this area are Aging Reports. These list the amounts bycustomer/vendor and by how old they are.

ExampleAssume your Accounts Receivable totals to $10,000.The Aging Report will show you how much of it is current, how much is 30 days past due, howmuch is 60 days past due, and etc. It will also show the amounts for each customer in eachcategory. Management can use this to analyze their credit policies and, most importantly, to

collect the money.

GAAP requires that an allowance must be made for bad debts. An estimate must be made onsome kind of percentage basis. Credit a contra-account “Allowance for Bad Debts” on theBalance Sheet. Debit Bad Debt Expense.

A contra-account is a balance sheet account whose purpose is to reduce the amount of anotheraccount. That is why asset contra-accounts have credit balances while liability contra-accounts



have debit balances. “Contra” is a latin word that means “against”.

Professional firms like Law Firms or even us Accounting firms may use an account called“Unbilled Accounts Receivable’. This is for work they’ve racked up but aren’t ready to bill theclients yet. The offset account is a liability account “Unearned Revenue”.

DEPRECIATION

(in which Office Manager Judi Baker offers a dissenting point of view.)

You know that when you take a brand new computer out of its box it is no longer as valuable asthe price you paid for it. Fixed assets depreciate in value. The difference between what youbought an asset for and what is is now worth is depreciation.

Depreciation is an expense. It is also a contra-account against fixed assets.

ExampleThis is what the Fixed Assets section of aBalance Sheet might look like: The journal entry for this might have beenMachinery andEquipment $ 50,000Buildings 100,000Less: Accum. Dep. (20,000)

Total Fixes Assets$130,000=======

Depreciation Expense (debit) 5,000Accumulated Depreciation

(credit)5,000

Tip - Jack’s Make only one journal entry for all your assets. Use only one Depreciation Expense amount in

your Income Statement and one Accumulated Depreciation amount in your Balance Sheet.These amounts should be the total of all your depreciation calculations.This is easier on both the accountant and the readers of the financial statements. Few peoplewant to go into all the details of depreciation and it just makes them look more complicated thanthey need to be.Ignore Kathy’s tip below. (Grin!)

Tip - Judi'sIgnore Jack’s tip above. (Grin!)Separate listings of Depreciation Expense and Accumulated Depreciation should be in thefinancial statements for each category of assets. This gives the user valuable information on theaging of a company’s plant and equipment. Together with the Cash Flow Statement’s section on

which assets have been bought and sold, an analyst can form useful conclusions about acompany’s present and future capital needs.

Jack’s Rebuttal Most users couldn’t be bothered. If a user wants to know all that, then provide them thedepreciation schedule that gives them even more information. Otherwise why assault users withadditional information when financial statements are complicated enough?

Judi’s Rebuttal



Breaking out depreciation isn’t all that complicated to do or to read. Aw, come on Jack!

Okay, so even partners like us can have our professional disagreements! (Grin!)

What about the other $15,000 in Accumulated depreciation (the 20,000 less the 5,000)?

Accumulated depreciation is the total of all depreciation for the current period and all priorperiods.

Not all of the amount of an asset is depreciated at one time. The idea of depreciation is thatdepreciation goes up as the asset’s value goes down.

So how are the amounts determined? There are a variety of methods. Here are the two mostcommon.

The Straight Line Method

Take the total cost of an asset. Estimate how much it will be worth when you dispose it. Thedifference between its starting amount and the ending amount is going to have to be depreciated.

Now estimate its total useful life. Divide the total difference by the total life. That is the amountto depreciate this period.

ExampleAssume a widget that costs $10,500. Its useful life is 10 years. Its value at the end will be $500.Over the next 10 years you will need to adjust this widget’s book value from $10,500 down to$500. In other words, you’ve got to decrease it by $10,000 over 10 years. This works out to anaverage of $1,000 per year.

The straight line method is to just use the average.

The IRS Method

This is not generally accepted accounting principles (GAAP). It is for accounting on the TaxBasis of accounting which is an Other Comprehensive Basis of Accounting (OCBOA). More onGAAP vs. OCBOA here.

The IRS has tables that you use to look up the deductable depreciation amounts. Remember thatthese tables like all IRS rules are the result of politics not any accounting theory.

For example there is the Section 179 Expense election. This allows you to deduct all of the valueof new assets up to a certain amount.

Peachtree has a module to track fixed assets and depreciation. Quickbooks does not. Aspreadsheet can also track depreciation.

http://www.lemoineandjames.com/gaap/12gaap.html






With a spreadsheet like Excel, each row is for individual assets. Columns are for the Asset’sname, Class, Date Purchased, Amount, Depreciation Method, Accumulated Depreciation -Beginning of Year, Depreciation Expense, Accumulated Depreciation - End of Year. The class isthe Balance Sheet line description.

Then sort by class (Judi’s tip) and sub-total for your series of journal entries. Use theDepreciation Expense column subtotals for your series of journal entries. Otherwise, just use thetotal at the bottom for Jack’s one comprehensive journal entry.

INVENTORY

Assets whose purpose is for sale to customers are inventory. In a grocery store, food is inventory.Books and magazines are inventory. Cash registers are not inventory.

ExampleA developer builds a tract of homes and puts them up for sale. Are those buildings fixed assets

or inventory?Answer: inventory because their purpose is for sale to customers.For people live in those homes, they are fixed assets. Even though a homeowner may hope tosell it sometime down the road, he’s using the asset, not just holding it for sale.

Inventory accounting shows up in two places in the financial statements. It is a current asset inthe Balance Sheet. It is also a part of Cost of Goods Sold in the Income Statement.

ExperienceFew software packages handle the Cost of Goods Sold accounting properly. While in theoryCost of Goods Sold should show Beginning Inventory, Purchases, and Ending Inventory, we

lump them all into just one account.This is where you may want to consult your particular accounting program’s limitations, to see if you need to do this, too.

At the end of the year each company should physically count its inventory. The accountantshould price this merchandise at cost and then adjust the books to the inventory that is actuallyon hand. Both GAAP and IRS rules require a physical count once a year.

But how do you count for inventory in the meantime?

One method is the percent of sales method. First, you should code all inventory purchases to

Inventory (the Balance Sheet account). Next, figure your average markup. This can be based onthe ratio of Cost of Goods Sold to Sales in previous years. Then at the end of the period (usuallya month or a quarter) make an adjusting entry to credit this amount out of inventory and debit itinto Cost of Goods Sold.

ExampleAssume markup of 20%. August Sales were $10,000.Cost of Goods Sold should be $8,000.



Don’t try to be too exact with these estimates. They are, after all, estimates. Use rounding. Don’timply accuracy that is not there and is not possible to achieve. Note that this is why a physicalcount is so important. That should be calculated to the last penny!

How do you cost inventory?

So the clerks have gone all around the plant and you now have a whole bunch of count sheets.The amounts of each item should be multiplied by how much these items cost to get your cost.But how can you know? What if the prices were different at different times of the year? Whichprices should you use?

This is where you go to work!

First, you’ve got to have records of how much units were bought at what prices. Next, you haveseveral options: First in First Out (FIFO), Average, and Last in First Out (LIFO). As the names

imply, you go through your lists, crossing out items as sold until you get to the number of unitsthat match your count. Those are the prices you use to cost the items on your count sheets.

Easy for us to say! Now, go to work!

LEASES

When the Financial Accounting Standards Board issued their statement on leases, this hailed asthe most complicated accounting standard issued to date. What a long time ago that was!

The basic concepts are really simple. Lease is another word for rent. They mean the same thing.

All the rental arrangements come in just two flavors for accounting: Operating and CapitalLeases. Just those two flavors.

How to determine what category a lease falls into? The magic number is 90%. If the lease is 90%of almost any aspect of the asset, then it is a Capital Lease. Otherwise it is an Operating Lease.

If the total lease cost is 90% of the asset’s value, then it is a Capital Lease. If the length of thelease agreement is 90% of the total life of the asset, then it is a Capital Lease. Even if there is abargain purchase option that affects that 90% of cost figure, the lease is a Capital Lease.

Operating Leases go on the Income Statement as Rent Expense. The accounting is the simplestfor these leases. You write your monthly check to the leasing company and then record it to RentExpense and you’re done.

A Capital Lease is a Fixed Asset for the Lessee. The amount is the net present value of the leasepayments. This means that an interest rate has to be imputed and expensed. Since it is treated asan asset, depreciation is taken.



Lessor’s books get the opposite treatment as you might expect. The imputed interest is incomeinstead of expense. The capitalized part of the lease is a liability instead of an asset.

This the guts of accounting for leases. There is much more in the details of how to do this. Thisis where a professional accountant needs to be consulted.

PAYROLL

Payroll would be easy if it weren’t for all of those pesky deductions.

On a cash basis of accounting (see GAAP vs. OCBOA), the net amount of the paycheck would be debited to Wages Expense and Cash in Bank credited. When payments are made tothe IRS and the various state tax and employment departments, debits are made to PayrollTax Expense and credits again to Cash in Bank. Oh, the accounting is so simple!

One problem here is that the payroll tax expense is higher than reality. What about all of those amounts that were deducted from the paycheck? Those weren’t expenses to thecompany. They come our of the employee’s money.

The other problem is that Wages Expense is too small. The gross not the net pay is the trueamount that is the expense to the company!

Okay, so the cash basis accountant will just add up all the differences in all the paychecksand make an adjusting journal entry to bring the two amounts to the correct balances. Thecash basis accountant is now done.

There is still a problem for everybody else. What about all those monies that are owed to the

IRS, the State, the Union, ex-wives, and maybe some retirement fund, health insurance fund,savings plan, and who knows what else? Those are liabilities.

And speaking of liabilities what about employer taxes? All of these have to be accountedfor.

For this reason, most people (yes, even otherwise pure cash basis accountants) recordliabilities for payroll.

A typical journal entry for a paycheck might look like this:

Gross Pay (debit) 1,000.00Social Security Payable (credit) 62.00Medicare Payable (credit) 13.50State Income Tax Payable (credit) 60.00Union Dues Payable (credit) 50.50Child Support Payable (credit) 100.00Cash in Bank (credit) 714.00







Total debits and credits1,000.00=======

1,000.00=======

Notice that none of the deductions hit any expense account. They reduce the employee’sfinances, not the company’s. Also notice that the amount credited to cash exactly equals the

amount of net pay.

Employment tax liability is created for every paycheck. Here’s how that journal entry looks:

Payroll Tax Expense (debit) 75.50Social Security Payable (credit) 62.00Medicare Payable (credit) 13.50

Total debits and credits-----75.50=====

-----75.50

=====

The payroll tax liabilities are reduced like any other liability when payments are made. Debitthe liability and credit Cash in Bank.

TipThis applies to liability accounts for Federal Form 941 taxes (income, social security, andmedicare taxes).Use a contra-liability account for tax deposits. Debit this account for tax payments here.This will make it easier to adjust the accounts at the end of each quarter when the form isfiled.

TipAnother idea is to just have one liability account for all Form 941 taxes. Activity in this

account will consist of deposits (debits), paycheck deductions (credits) and tax accruals(credits). With everything in one place, it is easier to check the amounts against the taxreturns.

The first tip is if you wish to break out your taxes separately; the second is if you just wantthe totals to be right.

ExperienceIt is important to check the accounting against the taxes when payroll tax returns are sentout. Many embarrassing mistakes can be caught IRS notices prevented.

All accounting software has a payroll feature to it. Payroll services like us also will do this.Companies with specialized or complicated payroll may want to use an outside service.

ExampleRestaurants should use a payroll service because of the special IRS rules on tips.

http://www.lemoineandjames.com/gaap/34leases.html



CASH

By far, the single most sensitive item in the financial statements is cash. This is what it’s allabout. Even Net Income means nothing until it results in cold, hard cash. Cash is so important

that it is even on two different financial statements. It is in the Assets section of the BalanceSheet and at the bottom of the Cash Flows Statement.

So, let’s account for that cash!

Cash in Bank

Each bank account should have a separate account in the Chart of Accounts. The activity and thebalances in each of these accounts should be reconciled to its bank statement each and everymonth. The bank reconciliations should be printed and saved.

TipAccounting software has bank reconciliation features in their program. Use them!

ExperienceMore mistakes get caught with bank reconciliations that with any other kind of error trappingactivity.

Petty Cash

Cash kept in a drawer or a cash register for small expenses needs to be tracked, too. The personin charge should keep receipts (or vouchers if none) for each disbursement. This paperwork istotaled and turned in to the accountant for recording. Take a check made out to cash to replenishthe petty cash fund.

ExampleAssume 3 receipts: $10 for paperboy, $5 for coffee, $7 for box of pens.Here are the journal entries.

First to record the outgo:Dues and Subscriptions (debit) 10.00Breakroom Supplies (debit) 5.00Office Supplies (debit) 7.00Petty Cash (credit) 22.00

Total debits and credits------

22.00=====

------22.00

=====

Second to record the influx from the check:Petty Cash (debit) 22.00Cash in Bank (credit) 22.00

Total debits and credits-----

22.00=====

-----22.00

=====

Coins






















































Many businesses have vending machines. They have a supply of coins on hand to make changefor customers.

So while you’re reconciling the bank statement, you see a withdrawal for a role of quarters.Where do you post that?

The journal entries needs to follow the flow of the cash. What happened to the paper dollars thatwere exchanged for the quarters? Let’s follow an assumed cycle from the beginning.

A fund is set up for coins:Coin Fund (debit) 20.00Cash in Bank (credit) 20.00

Dollars are turned in:Cash in Bank (debit) 20.00Coin Fund (credit) 20.00

More coins needed:Coin Fund (debit) 20.00Cash in Bank (credit) 20.00

If dollar bills are making it into the bank via the Petty Cash Fund, then journal entries shouldtrack that.

ExperienceMany times they might not make it into the bank at all. They just stay in Petty Cash. This is whythese funds should be physically counted and the accountant should record the receipts.

The dollar bills to not hit revenue. The quarters that come out of the vending machines hit it,instead. After all, that’s the best source of scoring how much the machines are really producing.

Cash needs to be carefully watched. The same person who handles the money should not beaccounting for it. Cash funds should be counted often and by at least two people. Differentpeople should handle checks and deposits from those who record them in the books.

OTHER CURRENT ASSETS

Current assets are those assets that are expected be converted into cash within a year (or the

normal business cycle).

Accounts Receivable and Inventory are discussed elsewhere. These are always current assets.

Investments such as stocks, bonds, loan receivables are discussed elsewhere, too. A particularitem may be current if it is expected to be converted into cash within a year.

Example

































http://www.lemoineandjames.com/gaap/31ar_ap.html


http://www.lemoineandjames.com/gaap/33inventory.html







List a 90 day note receivable among the current assets because it will become due in less than ayear.

Prepaid Expenses

Use this to record paid expenses that apply to future periods.

ExampleAssume: You pay a 1 year insurance policy for $2,000. You prepare financial statements eachmonth.Code the check to Prepaid Expenses. Each month credit this account for 1/12th of the paymentand debit Insurance Expense.

TipDon’t use this account unless the amounts are substantial. The amounts are timing differencesonly. They are seldom worth the trouble.

Lower of Cost or Market

This is a principle that applies to almost all assets. It applies to inventory, to investments, andeven to Accounts Receivable (through the Allowance for Bad Debts account). It means theamounts on the Balance Sheet should reflect reality. If the true value of the item is less than itscost, then the true value must be the one used.

The reverse is NOT true. If the true value is greater than cost, cost is still used. That is why therule is called “LOWER of Cost or Market”.

Credit the assets and debit “Unrealized Losses” in the Income Statement.

FIXED ASSETS

These are physically tangible property. They should be substantial in amount. They should beused in the business. Items purchased for resale are inventory no matter how large it is.

ExampleYour company builds a giant $1 billion fighter jet for the Air Force. That aircraft is inventory,not a fixed asset.

ExperienceMany accountants will not capitalize anything under $1,000. They expense it, instead.

Here are some common categories of fixed assets:

Automobiles and Trucks Buildings Computers and Electronics



Furniture and Fixtures Land Machinery and Equipment

All of these items should be depreciated except for land. Land never depreciates. IRS rules

require that at a reasonable part of the purchase cost of real property be allocated to land.

Assets under construction are in a separate account. They do not start depreciating until they arefinished and placed in service.

All direct costs get coded to this account while the asset is under construction. Direct materials(such as lumber and paint) go into the cost of the asset. Other direct costs to include: direct labor,direct travel, meals, expendable tools, and so on. Even capitalize associated interest costs.

Trade-ins are a special case of asset valuation. The new asset’s value is the market value of theasset you give up plus any money you pay. Accountants call this money “boot”. If you talk the

other party to pay you money instead, then subtract that from the value. If the market value of theasset received is more readily determinable, then use that as the basis, adding or subtracting bootas the facts determine.

All of this is pretty simple. Special cases make it more complex. Gains and losses are recognizedon exchanges of assets in some cases. An asset cannot have a value less than 0.

The IRS has special auto trade-in rules.

Donated assets are valued at their market value.

Assets purchased on credit are valued at the present value of the loan payments.

Add the cost of major repairs to an asset to its cost. Expense minor repairs.

ExperienceOnce upon a time Jack was auditing a federal laboratory for the government. As he was lookingdown the listing of assets, he spotted a suspicious item. It was a camera. It was valued at some$21,000. “I’d like to see this wiz- bang camera,” Jack said to himself. So he put it on his list of things to spot check.When the asset manager got to that item on the list, he directed Jack to the Security Department.The laboratory’s Chief of Security said that it was one of the special security cameras. So, they

trotted off to find it. When they arrived at the designated location, it wasn’t there! Since this was a very public area, people started to congregate. “What’s going on?” someone inthe crowd asked. Another said, “Security lost one of their cameras!” People started to chuckle.The chief’s face got redder and redder still.Finally, with much relief all around the camera was located. Its location had been improperlystated on the asset sheets.No big deal but boy was it fun to see those security guys who are always hassling people gettinga little payback!



Moral of the story: don’t hassle the auditor or if you are the auditor and you hassle the Chief of Security, don’t go back – but that’s for another story.

INVESTMENTS

Investments can be short term or held for the long haul. Short term assets must be readilymarketable for them to be classed as Current Assets. Otherwise, they are long term.

We’re discussing loans receivable here, because like bonds they are creditor/debtor instruments.

The main issue to be concerned with in investments is to be sure to carry them at lower of Costor Market. This rule is treated elsewhere.

Don’t make direct write-offs to investments for unrealized losses. When the market is lower thanits cost but you’re still holding on to the investment then this is an UNREALIZED loss. Yourealize the loss when you sell the investment. But what if you hang onto it and the market goes

back up?

Use a contra-account. Call it “Allowance to Reduce to Market”: Post unrealized gains and lossesto it so that you can keep track of the actual costs of the investment.

Where there is no market for an investment, then there can be no such calculation.

ExampleAssume you own 10% of your dad’s dry cleaning store. What happens when your dad retires andthe family sells it? You’ll find out when it happens. Since there is no way to readily determinethe market value of your share, you don’t need to worry about unrealized losses.

Accounting for investments when they comprise a substantial portion of the investee company isdiscussed elsewhere.

INTANGIBLE ASSETS

Patent rights, copyrights, goodwill, organization and startup costs, are examples of IntangibleAssets. These are assets that you can’t touch or feel but still have economic reality.

Intangible assets have four major characteristics:

1. They have no physical substance2. They have future economic benefits but the value of those benefits are difficult to

determine3. Their useful life can’t be readily determined, either 4. They generally have operational use vs. investment use in the business.

Amortization costs works like depreciation does for fixed assets. A life is calculated for each



asset and a percentage is amortized each year. Just like an allowance account is used foraccumulated depreciation, one should be used for accumulated amortization.

Unlike fixed assets, one does not have to wait for it to literally be scrapped or sold in order towrite it off. Write it off as soon as its value is zero.

Classify intangible assets as “Other Assets” on the Balance Sheet. This is the last of the major asset categories.

Other assets besides intangibles go here, deposits for example.

TipList intangibles separately from the rest of the items in “Other Assets” so that the readers of thefinancials don’t confuse them.

CURRENT LIABILITIES

Current Liabilities are those debts the company owes that come due within one year. LikeCurrent Assets, the operating cycle can be different. In that case, use that to classify debts intocurrent and non-current.

ExperienceThe most commonly seen Current Liabilities are those items that affect expenses.Many cases the only items in this section are Accounts Payable and the payroll related items.

Accounts Payable, like Accounts Receivable warrant a page all of their own. So does payroll.However, this area affects so much of the Current Liabilities section, that we say more about

payroll liabilities here.

Payroll Taxes Payable is a big issue with companies. Even cash basis companies need to keeptrack of their payroll tax liability.

ExperienceWe can negotiate with the IRS regarding income taxes due. They will grant payment plans. Withthe right reason and the right approach, Offers in Compromise can even reduce the amount of income taxes due. With payroll taxes due, however, the IRS plays hardball. This is because thismoney was never the employer’s money to begin with. They deducted it from the employee’spaychecks for the IRS. Therefore there should be no reason for a company to be unable to pay.

Thus the IRS view.

In practice, even with the best attorneys and CPA’s in the world, it is very bad to mess withpayroll taxes.

Since this such a big issue, many of even the smallest businesses want to see their payroll taxliability on the Balance Sheet.



Payroll tax liabilities come in three flavors: Federal Form 941 Taxes, State Income Taxes,Unemployment Taxes.

The 941 Taxes are the income taxes and the social security/medicare taxes. Income Taxes arewholly deducted from the employee. The social security/medicare family of taxes are deducted

and then matched by the employer. This means that you deduct a total of 7.35% from theemployee’s paycheck but you pay 15.3% to the IRS. The difference between the two is PayrollTax Expense but the total is Current Liability.

State income taxes, like federal income taxes are deducted from the employee’s paycheck. Keepstate income taxes in a separate account because it is a separate tax.

Separate unemployment taxes into federal and state accounts, too. These accounts are paid onseparate forms. Use the Federal Form 940 for Federal Unemployment Tax. The amount due willdepend on the amount paid for the state unemployment in certain circumstances.

To sum up, you need the following payroll tax payable accounts: Federal 941 Taxes, StateIncome Taxes, Federal Unemployment, and State Unemployment.

Generally Accepted Accounting Principles (GAAP) requires other payroll related liabilities.

Anything else that the company deducts from an employee’s paycheck is a liability. The moneyby law must be paid to the party for which it was deducted.

On any date the company will owe wages. This liability is the difference from the date on thecalendar and payday.

ExampleImagine if an employee just quits. You still owe him for the time he worked even though hischeck is not due until payday.

Not just wages, but the rest of the employee’s deductions have to be accrued, too.

ExperienceMost of the time OCBOA financials don’t report these. Life is complicated enough.

Employee benefits are current liabilities. These may include retirement plans, health insurance,bonuses and so on.

Short term debt are current liabilities. This means any debt that is due within one year. If a multi-year loan is on its last year, it needs to be reclassified out of Long Term Debt to CurrentLiabilities.

A very important item that many accountants miss is overdrawn bank accounts. If Cash in Bank has a negative balance then it is no longer an asset. It is a liability and it is a current liability. Itmust be reclassified from Current Assets to Current Liabilities. Title the liability account “ Bank



Overdrafts”.

TipUse a reversing entry to do this. This means debit and credit the accounts so that the creditbalance is in the Current Liabilities. Then in the following month do another entry that reverses

this. Most software accounting programs have an automatic reversing entry feature for situationslike this.

Unearned Revenue is a Current Liability.

ExampleLet’s say you engage our firm Le Moine and James as your accountants. You pay us $1,000 as aretainer. This means that we owe you $1,000 worth of work. If you weren’t expecting us toprovide you $1,000 worth of services, you would never have forked over the cash to us.

Of course, if you want to just give us $1,000 smackers gratis and we don’t have to do anything

for it, then this accounting rule doesn’t apply. (Grin!)

Another kind of circumstance where unearned revenue comes up is when the end of the periodcomes before the end of the job.

ExampleWe check into your hotel and pay five days in advance. The end of the month comes two dayslater. The accountant closes your books to provide you your monthly financials. At that pointyou still owe us three days because you have our money.

Unearned Revenue differs from the other liabilities in that the liability gets taken care of by time

rather than payments. In the hotel example above, you wait three days, our time is up, we check out, and the liability is done.

The account Customer Deposits is a form of Unearned Revenue.

An important area of Current Liabilities is owner loans. Many times the Owner or Shareholdersof the business must loan the company money to get by. These loans are Current Liabilitiesregardless of the owner’s intent. This is be the owner by definition is in control. To beconservative, accounting rules assume that the owner can pull his money out of the company atany time.

The very last thing in the Current Liabilities section is “Current Part of Long Term Debt.” Thiswill be covered in the next section.

LONG TERM DEBT

Loans that will be paid off for periods greater than one year are Long Term Debt. In theaccounting for them we have found it best to list each loan separately in the Balance Sheet. Thismeans a new account for each loan in the Chart of Accounts.



Recording a loan is easy.

ExampleAssume you took out a loan of $10,000 for the bank. You will pay it off in 5 years.Debit cash for $10,000 and credit Long Term Loans Payable.

Recording a payment for a loan is not.

Each payment consists of two parts. Part of your payment goes to Interest Expense. The otherpart reduces the amount you owe. This part is the Principal.

Each payment should properly show both interest and principal.

ExampleAssume your payment is $500. Of this $500, $150 is interest and $350 is principal.Here is the journal entry to record it.

Interest Expense 150Long Term Loans Payable 350

Cash in Bank 500

This method of recording payments is applicable to both short term and long term loans. If interest expense is not taken out of the payment and the entire amount is debited to the loanpayable, then the financials will show the liability to be less than it really is.

Now for the really big question. How do you figure these amounts?

The tool that accountants use to figure out the payments is the Amortization Schedule. It lists out

the payments and shows the different parts of each payment. Here is what one looks like. Itassumes an interest rate of 5%.

Calculate interest by dividing the annual rate by the portion of the year that your payment covers.If payments are monthly, then divide by 12. If quarterly, then divide by 4.

ExperienceLenders will provide these schedules. Write your account codes on them and keep them handy.Then check each line off when you code the payments.

It’s a good idea to check with the lender periodically. Get the account balance and sync it up

with the balance in your accounting. It’s a good reality check.

Only a part of a long term loan is non-current. If you have to make payments within a year, thenpart of the loan is really current.

A reader of financial statements needs to know how much of the liabilities are due within a yearand how much is due in later years. Here’s how to do this.

http://www.lemoineandjames.com/gaap/Amort.htm






At the end of your Long Term Debt section, have an account called “Less: Current Part of LongTerm Debt”. From the amortization schedules of all your long term loans, add up all theprincipal parts of the payments that are due within one year. Take the grand total of all that anddebit the Current Part account.

Don’t touch the loan accounts themselves. The reader will want to know how much money isowed to XYZ Bank.

The Current Part account reduces the total amount of Long Term Debt to its proper, non-currentamount. It is like Accumulated Depreciation in this regard. It is an account that reduces itssection’s total.

The credit goes to another “Current Part of Long Term Debt” account. This one is at the end of the Current Liabilities. This increases Current Liabilities to its true total.

Mastering amortization schedules is the key to mastering long term debt.

EQUITY

Look at equity from two different angles. From one point of view, equity is what is left over aftersubtracting liabilities from assets. From another, equity is the result of investment activity andoperations.

The last line in the section is Retained Earnings. This is usually seen in corporation balancesheets. It represents the sum total of all profits and losses for the current period and all priorperiods. Dividend distributions to shareholders reduce Retained Earnings. Partnerships andProprietorships fold this amount into the capital accounts (see below).

Corporations also have Treasury Stock. When a corporation buys back its own stock, the debitgoes to this account. Treasury Stock reduces equity. Reducing outstanding stock is the same aspaying off a loan. If a company buys back a piece of its equity then it has reduced the amountthat investors have put into the company. That is why a company’s holdings of its own stock reduces equity rather than increases investments in the asset section.

Withdrawals of money are a key factor in equity accounting. Investors put their money into thecompany to make a profit on their investment. That means that at some point money has to betaken out of the company. There is a line in the equity section for this. Proprietorships and partnerships call it “draws”. Corporations call it “Dividends”. In all cases, this is a temporary

account. At the end of the year a journal entry moves the debit balance elsewhere. Corporationsmove this to the Retained Earnings account. The other companies move it to the capital accounts.

The capital accounts show equity at the owner level.

For Sole Proprietorships, there is only one capital account. Partnerships have separate capitalaccounts for each partner. If a partnership has many partners, then it may lump all of themtogether into one line item for financial statement purposes. A subsidiary ledger keeps track of



each partner’s capital account. At the end of the year, all other equity accounts are folded into theproprietor and partner accounts. This includes draws and earnings. The idea is that the balanceshould be each partner’s ownership position in the company. This is how much a partner cantheoretically withdraw.

ExperienceWe are continually surprised at how owners of companies fail to do the most basic things insetting up their companies. Corporations should have shares of stock. Even if there is only oneowner, he should know how many shares of stock the corporation has issued and how much eachshare was issued for. How can an owner know his investment without knowing that?

Investments consist of the amounts originally contributed into the enterprise, any additionalamounts put in, and the amounts withdrawn. The equity section of the balance sheet can tell theuser much about the organization of the company.

KINDS OF COMPANIES

The type of entity forms the basis of equity accounting. This section covers the major forms acompany can take.

Proprietorships

If a company has only one owner and has done nothing else to organize his company, than it is aproprietorship (P). For many companies, this is the best form for them to take.

There are three accounts in the Equity Section for P's:

1. Owner's Capital2. Draws3. Current Profit (Loss)

Current Profit (Loss) comes from the Income Statement. This is year to date net income.

Draws are the money the owner takes out of the company. Owners do not take out wages. It is agood idea, however, for owners to budget themselves periodic payments in lieu of wages.

Both of these accounts are closed to the Capital account at the end of the year. Any money thatowners invest in the company can go to two areas: capital or loans payable. For P's there are little

tax consequences for investing money either way.

P's get hit with two taxes: the income tax and the selfemployment tax.

P's taxes are determined on the Schedule C on the personal 1040 tax return. Net income isadjusted for allowable expense deductions. Taxable net income from the business is transferredto the front page of the 1040 and included in the rest of personal income from other sources. If the business lost money, then that amount gets transferred, too.



Self-employment taxes correspond to the payroll taxes (social security and medicare) onemployees. In payroll accounting, the business pays half and the employee pays half of thesetaxes. But for P's the owner is both. Hence, the self-employment tax. This is the combination of employer and employee payments.

The rate is 15.3%. This rate is computed on Schedule SE. The amount is transferred to page 2 of the 1040.

Partnerships

Partnerships (Ptnr) are like Proprietorships. Ptnr's have more than one owner. Partners shouldalways have a partner agreement to form a business. This is a practical requirement, notnecessarily a legal one.

ExperienceJack once had a car repair outfit for a client. The partners insisted on not having an agreement.

One man said, "A handshake is all I need. If I need a signature to trust his word, then I don'twant to do business with him." The two men were best friends and had known each other foryears.Within a few months they split amid much acrimony. We believe that the two were honest. Theproblems were misunderstandings of the basis of the business and each partner's obligations to it.An agreement would have dealt with those.Failure to do an agreement cost them not only their business but also their friendship.P.S. They talked Jack out of not doing an agreement for his accounting services, too.Misunderstandings rose from that. (Their own emotional break-up probably contributed.)Anyway, he ended up having to sue them to get his accounting fees.

Moral: always do business in writing!

Each partner needs his own capital and drawing accounts. These accounts represent hisownership position in the company.

Partners may take wages from the company. These enter the Partnership tax return as"Guaranteed Payments". They are deductible to the partnership company and income to theindividual partner. The partner pays self employment tax on these.

The partners also pay self employment taxes on their portion of the total net income of thepartnership.

Income tax returns are filed thru Form 1065. This form is similar to the tax return for the Sub SCorporation discussed below. Part of this return is a Schedule K. This shows the total incometaxes, credits, and other taxable items that flow out to the partner's individual income tax returns.Each partner gets a Schedule K-1. This shows his/hers' share of the Schedule K items.

There is a special kind of partnerships called limited partnerships. These have to have at leastone general partner. General partners are fully liable for the business. Limited partners can only



registration beyond the normal corporate licensing for Subchapter S Corporations.

Subchapter S was adopted by Congress in the 1950's to help small businesses. To qualify for SubS status with the IRS, the corporation must file Form 2553, have only one class of stock, andonly 75 or fewer shareholders. Distribution of profits must be based on ownership.

Further, at least some of the owners must be active in the business. That means the IRS will look for "Officers' Wages" on the 1120S tax return. There had better be some and it had better bereasonable. It there is not, then that can be a huge audit flag.

Small businesses jump through all of these hoops to gain one big advantage: dividenddistributions are not taxable!

Shareholders of regular corporations end up having to pay taxes twice:

at the corporate level, when their corporation pays taxes on its annual net income and

at the personal level, when they have to pay taxes on the part of net income is distributedto them

Shareholders of Sub S corporations pay taxes only once: when they have to transfer the netincome amounts of their K1's into the Schedule E of their 1040's.

Shareholders do not pay self-employment taxes. Very important point!

The payroll taxes are paid through deductions on "Officers' Wages". The corporation pays theemployer's share. This substitutes for self-employment taxes.

This is why shareholders want their wages to be as low as possible and their dividenddistributions to be as high as possible. The IRS wants the reverse. The question reduces to whatis reasonable.

Limited Liability Company

Limited Liability Companies appeared in the 1990's. They are like Sub S Corporations but withmore flexibility. They file Form 1065 (or Schedule C if only one owner). They can elect to betaxed as a corporation. They then file Form 1120.

Income can be distributed on a different basis than ownership. For example, if two partners own

50-50 of the business but agree that one partner should get 60% of the profits, they can agree todo that.

Owners are referred to as "members".

The choice of what kind of entity the company will be is one of the most crucial choicesentrepreneurs can make.



REVENUES

Revenues are not net income. Revenues are all the money that the company earned during theperiod. Income is what is left after subtracting expenses.

The two sources of revenues are cash sales and sales on account (i.e. Accounts Receivable).

Statements on the cash basis do not report receivables in their balance sheet. Hence, they do notinclude them in revenues. Sales for cash basis accounting is all the cash sales for the period plusall cash taken in for sales from prior periods.

Customer deposits are not cash. They are liabilities. When the service is performed, or when thegoods are delivered, then they can be reclassified into revenue.

Unearned revenue is a similar animal. Both of these topics are covered in Current Liabilities.

Like expenses it is okay to list major sales categories.

Revenues can be checked against bank deposits and accounts receivable. New receivables, anddeposits (less those deposits for sales made in prior periods) equal revenues.

Sales taxes are not revenues. Sales taxes are collected from customers and then paid to the state.The credit for sales taxes should go to current liabilities.

Some states (such as Georgia) give discounts for prompt payment of sales taxes. This discount isrevenue.

At the end of a period a company may have several NSF checks that it is trying to collect. Since NSF’s reduces cash they reduce revenues, too. This is why it helps to have a separate account inthe revenues.

Revenues are generally pretty easy on accountants. But wait for what’s coming next!

EXPENSES

We have one rule for accounting for expenses: don’t get fancy.

Refunds or returns of purchased items should be credited direct to the expense account. We

discourage contra accounts in the expense area.

ExceptionCash Short (Over). This is where the difference between the book amount of cash on hand andthe physically counted cash goes. For simplicity’s sake, the account stays in expenses even whenthere is more cash counted than there should have been.

Don’t use too many categories. This confuses both the bookkeeper and the reader of the

http://www.lemoineandjames.com/gaap/41cash.html






http://www.lemoineandjames.com/gaap/51current.html#ur








financials. The goal should be to use the minimum number of expense categories thatmanagement needs.

ExperienceQuickbooks, Peachtree and other accounting software come with pre-designed accounting

templates for various industries. They all come out with huge numbers of expense categories.Over many years of receiving the output of these programs that were prepared by clients, wehave noticed some patterns therefrom. Amateurs use these pre-built categories because theythink that they are “supposed to”. The bewildering array of accounts and sub-accounts are soconfusing to them that they place the same kinds of transactions in different categories. Forexample, a gift might be coded to “charities” one month and the same gift to the same partymight be coded to “gifts” the next. The bookkeeper either forgot where it was coded before or hewanted to cover all of his bases.The programs then spew out page after page of financials. The small business manager takes onelook at the morass of numbers and is overwhelmed.

We believe that it is better to cut out redundant categories and turn out financials that managerswill use.

TipOne way to trade off lots of information versus info overload is to present an Income Statementwith just one line for expenses called “Expenses”. Then list the expenses as a supplementaryschedule behind the standard financial statements.

Present expense items in alphabetical order. Even with a minimalist approach such as werecommend, you are going to have an Expense Section with more than ten lines. Usually IncomeStatements have a lot more expense lines than that. Readers and Bookkeepers both need to find

the desired expense account quickly. Alphabetical order is simple and everybody can pick up onit.

Some companies may want major areas of expenses grouped together. We usually break our ownrule and group all labor costs together. Officer Salaries, Wages, Contractors, Fringe Benefits, andPayroll Taxes are all costs of having people work in your company. It’s handy to know howmuch the total labor costs are.

One should look very hard at further grouping of expense accounts. The governing questionshould be, “Will management use this grouping?”

Many owners and employees are called upon to pay company expenses out of their own pockets.The company then reimburses them.

We recommend that companies have a policy of requiring expense reports with receipts attachedfor reimbursed expenses. This helps control abuses. It also helps the bookkeeper code the itemsin the report to the proper expense category.

COST OF GOODS SOLD



Cost of Sales (COS) is similar to Cost of Goods Sold (CGS). They both break out large expensesand subtract them separately from the rest. The result is gross profit.

The other expenses are then subtracted from that to get net income.

So, why go through all of this?

Tax regulations require Cost of Goods Sold whenever a company carries inventory. Beyond thatcosts that directly drive sales and are substantial should be broken out.

ExampleConstruction companies may have costs for materials that go into what they build. Other coststhat directly go into a construction project might be the labor of the workers, subcontractors, andtravel costs. These kinds of costs would go into COS.

Today’s software (Quickbooks and Peachtree) does not handle Cost of Goods Sold correctly.

That is why most financial statements present this section on a “close enough” basis.

Here’s how this section should really look.

Start the Cost of Goods Sold with Beginning Inventory. Add Purchases. The total of these two isTotal Goods Available for Sale. Subtract Inventory. The result is Cost of Goods Sold. Why? Thelogic of this comes from simple algebra. If a – b = c, then a – c = b. Beginning Inventory (at cost)plus Purchases (the cost of additional inventory) gives us the Total Goods Available for Sale (atcost, of course). If we subtract the Cost of Goods Sold we will get Ending Inventory (at cost).

The presentation on the Income Statement switches CGS and Ending Inventory as per the

equations. Neat, huh?

Purchases may be modified by Purchase Discounts and Purchase Returns and Allowances.

We have more on Purchases on our Inventory page. Special cases for manufacturing andconstruction companies are treated in their pages.

The software has problems with Beginning Inventory for different periods. The BeginningInventory for the first of the month is different from the Beginning Inventory for the first of theYear. This means that if you have an Income Statement that has two columns of figures, Monthactivity and Year to Date activity, software will be unable to handle the proper presentation of

Cost of Goods Sold.

PracticeIt is a wonder to us that after all these years and all of the extras that accounting programs now provide that they still can’t deliver basic accounting functions such as this.

Typically the software produces an abbreviated CGS section. They scrunch everything into oneline called “Cost of Goods Sold”. This is an area where some more detail would be helpful to







management.

AUTOMOBILE EXPENSES

Most small businesses have auto expenses. This is a tricky area because of IRS rules regarding

auto deductions for business purposes.

You may deduct auto expenses either at actual costs or on a mileage basis. This decision must bemade the first year the car is in use. For 2002, the mileage rate is 34.5 cents per mile. If you usethe actual costs method, then you may only deduct that portion of your expenses that are relatedto business. That portion is determined by mileage.

So, how do you account for this? Moreover, what if you have more than one car or truck andsome are on one method and some on the other?

Important!

Keep a driver’s log for all cars/trucks no matter what method is used. This should show the date, the

miles for each trip, and the purpose of each trip. This log will be a primary document an IRS auditor will

look for.

Further note that the tax return specifically asks whether you have evidence to support the business

mileage and if so, is this evidence in writing. You will need this log! Log books can be purchases at any

office supply store.

We recommend two auto expense accounts. Use one for mileage and the other for actual.

Mileage

For cars on the mileage method, all costs for car payments, gas, and service should be paid out of the owner’s personal account. The company may pay the costs, especially if the car has beendesignated as a company car.

Each month the driver’s log should be consulted. Multiply the miles in that log by the IRS rate.That is your auto costs for the month for that car. Debit “Autos and Trucks – Mileage.” Whereshould the credit go?

If the owner has paid the actual costs out of his own pocket, then write him a check for the costs.

The credit then goes to cash.

If the company has paid the actual costs for the car, then debit those costs to a special autoaccount in the Equity Section. (Those costs do not go to the Income Statement because they arenot deductible.) The credit for each month’s entry for autos on the mileage method then goeshere. Hence, the ending amount in the Equity Section account will be the difference betweenactual costs and mileage method costs. The auto expense account will exactly match thedeductible amount on the tax return.



Experience

An alternative place to put the offset account is “Other Expenses” on the Income Statement. This

creates another book vs. tax difference. We prefer to minimize these differences for small businesses as

much as possible. That is why we prefer to use the Equity Section. The difference then goes to draws.

The above assumes that statements are prepared on the OCBOA basis. For statements on theGAAP basis, then you must use actual costs for business use. For GAAP statements, book vs. taxdifferences goes with the territory.

Experience

Do NOT take depreciation for company cars on the mileage method. Depreciation is included in the

mileage rate.

Actual Costs

Believe it or not, you must still consult the driver’s log each month for vehicles on the ActualCost method. This is to determine business use vs. personal use.

The % of personal use must be multiplied by the total costs paid by the company. Those costsmust be credited to the expense account and debited elsewhere. But where?

Using the same logic as above, we recommend a special account in the Equity Section. Thisaccount then is added to the owner’s draws.

Other important things to watch out for

Depreciation may be limited by the IRS “luxury auto” rules.

Certain Sub S Corporations and Limited Liability Companies may be limited in how much may be

distributed. In that case, you may need to take the Schedule M-1 book vs. tax difference.

There are special trade-in rules on cars.

Final Word

Accounting for autos can be tricky. The main thing is to keep those log books!

GAINS AND LOSSES ON ASSET DISPOSALS

In a metaphysically perfect world for accountants, there would be no gains or losses whencompanies sell or otherwise dispose of fixed assets. The journal entries would all be like the onein the following example:

ExampleAssume: A machine purchased for $1,000 that has been depreciated $700 is sold for $300.



able to quickly refer to the Balance Sheet while reading the Income Statement and viceversa.

3. General Ledger. This shows the debits and credits that make up the balances on thefinancial statements.

4. General Journal. This shows the adjust entries.

5. Bank Reconciliations. Include here the copies of each bank statement as well as theschedule that shows how the ending balance relates to the General Ledger. Other papersthat contain calculations for Adjusting Journal Entries that come out the bank reconciliation process should go here, too.

6. Cash Journals. Software may kick out a number of reports here. Traditional reportsinclude the Cash Receipts Journal and the Cash Disbursements Journal.

7. Accounts Receivable (A/R) Reports. First comes an Aging Schedule. This breaks out A/Rby customer and invoice. It also shows how long each debt has been out there. This is amust-see report for management. The other major report is the Sales Journal.

8. Accounts Payable (A/P) Reports. Similar to the A/R reports, the Aging Schedule showshow much your company owes vendors and for how long. The Purchase Journal belongs

here.9. Payroll Reports. There should be a Payroll Ledger and a Payroll Journal.10. Job Cost Reports. If a company has a cost accounting system in place, these reports will

show revenues and expenses for each job that the company is working on. Managementwill turn to this section to see which jobs are making money and which aren’t. Other reports will show which jobs are over budget and which aren’t.

This is a workbook for accounting reports, only. Tax Returns including payroll tax returns,property tax returns, and sales tax returns belong in separate files. Personnel records belong in aseparate file, not behind the Payroll tab.

Accounting reports can be quite lengthy even for small companies. A binder can fill upsurprisingly rapidly. Because people will need to refer back to these reports often, a 3 ring bindercan protect the papers and keep them together.

After a year has passed, and the tax returns done, the need to refer back to these reports fallsback dramatically.

Because sturdy 3 rings are expensive, we transfer the papers out of the binder and bind thembetween cardboard covers. These covers are available from any office supply store.

IRS retention rules are three years for most cases. Some accountants insist on saving these

reports for 7 years. You may want to save them longer.

There are many other systems for organizing paperwork. Some have tabs for each month andthen put all the reports for that month behind the tab. We dislike this approach because it makesit difficult to follow transactions from one month to another.

The advise on this page is just our personal opinion. One can use whatever system of organizingyour accounting papers as one may wish. The important part of an organizational plan is that it



good to have one.

The key to controlling your accounting system is to organize your paperwork.

THE GENERAL LEDGER

Whenever we make any accounting entry we always visualize how it will affect the GeneralLedger. The General Ledger (or GL for short) is the heart of the accounting system.

The GL shows each item in the Chart of Accounts. For each item it shows:

the beginning amount, each entry whether debit or credit, and the ending amount.

We can look at the financial statements with confidence because we know that each line item in

them can be explained by the GL.

Example:

The Income Statement shows that Office Supplies was $550 for the last month. What made upthat amount?

We look at the GL. In the account for Office Supplies we find:

Balance forward: 130.35Office Max 100.00

Joe’s Supplies 330.37Charlie’s Expense Report 120.00Activity 550.37Ending Balance: 680.75.

Last month’s expenses were $550 (rounded). The Year to Date expense was $681.

Depending on the software, the GL report may not show all of the detail. It may just give you asummary with a code to tell you where to get the details. When this happens, you may have to goto the Purchase Journal, the Cash Disbursements Journal, or even the General Journal for thespecific transaction. We greatly prefer the detailed reports so that we don ’t have to go chasing

down the transactions!

Whether the report is detailed of summarized, know that where the data comes from. It comesfrom everywhere! Every transaction that gets entered into the Accounts Receivable, theAccounts Payable, Cash Receipts, Cash Disbursements, or anywhere else transactions getentered all make it into the General Ledger. This means that this is the place to look to seeeverything that has gone on.



The first thing we always look for when we examine a GL is the period it covers. Typically, areport may cover only one month at a time (as in the example above). This is because when thefinancial statements are printed, the accountant should want a copy of the GL to answerquestions about the numbers came to be. We always do this when we produce financials.

The trade-off is that we need to look at past month’s reports to get the full story about anaccount.

Example:

Continuing from the last example, it we wanted the full story on that $680.75 of Office Supplies,we will need to look at past month’s reports until we find where the $130.35 came from.

This is why in the workbook (where we keep our reports) we like all of our GL Reports togetherin one tab.

Software usually allows you to print out GL reports for the entire year.

Warning: Not all of them do. MAS90 users pay attention here!

A big problem with GL Reports occurs when the accountant makes entries to prior periods afterthe GL is printed. Unless the GL is reprinted for each month after the entry is made, they won’tmatch up to what is in the system.

Practice:

This can generate a lot of paperwork and extra trouble. Most companies discourage prior period

entries. In the real world, our experience has been that entries made in previous months of thecurrent year can’t be avoided. Management wants accurate comparisons of monthly activity.

How to resolve the trade-off between accurate accounting and accurate GL Reports?

One method is to keep a log of prior GL entries. This serves as an interim solution. Periodicallywe print year-to-date GL Reports.

Here’s a few very important things the accountant should do with the GL.

Check that the ending balances in the cash amounts equal the bank reconciliations. If they don’t

then find out what went wrong and fix them.

The GL amounts for cash always equal the reconciled amounts. Always!

Accounts Receivable and Accounts Payable always equals the totals in their aging reports. Whywould an item be on the GL account but not on the aging schedule? There is no good reason. If you do not wish it to be on the aging schedule, then reclassify it into some other account. Theseaccounts need to be managed on a monthly (if not on a weekly) basis and that means that



management needs to know what is in there.

At the end of the year, wages need to equal what is on the W-2’s (adjusted for accrued wages).We’ve faced payroll audits where they did not. We’d rather face Arnold the Terminator saying,“Big Mistake!”

Practice:

Don’t be afraid to break payroll among several GL accounts. We typically have payroll in“Officer’s Salaries” and “Wages” for the regular employees. At the end of the year, the totals of these accounts equal the totals of the W-2’s. During the year, the quarterly totals equals the totalson the payroll tax returns.

Look out for equity activity. Any entry to equity should be looked at with the darkest suspicion.We find that most entries to an equity account are wrong! Usually they should have been madeto an income statement account. IRS auditors love this stuff!

Practice:

In our firm, our rule is that no entry is made to Retained Earnings without my approval. Thiseffectively means that no entry is ever made to Retained Earnings.

In business tax returns there are specific areas that ask for the differences between book and taxRetained Earnings. This is a huge headache at tax time. We avoid it by not having any GLdifferences. (Yes, there are differences that are unavoidable and beneficial to the taxpayer, sowe’re ready with the explanations.) We just don’t have unnecessary dif ferences.

We always print out the GL before printing the financials. We go down each account and make acheck mark to show that we’ve at least looked at it. Yes, this can use a lot of paper and ink butwe catch a lot of mistakes that way. Then we print the financials, the final reports (including thefinal GL) and close out the month.

The General Ledger is the heart of the accounting system because it shows how each item of thefinancial statements came to be what it is. Know the GL and face the world with confidence!

JOURNALS

When we first heard of accounting “books” as in “we’re auditing your books” we wondered why

more than one book? After all, if H.G. Wells wrote An Outline of History in one book, why doesa small company need more than one book?

Then we took our first accounting class and we learned about the General Ledger and theGeneral Journal. Okay, so there’s two books now. One shows the activity in each account. Theother shows all of the transactions. We’re cool with that. But why do we ne ed still more books?

Theoretically, two books are all that are needed. The Journal lists the transactions that make up



the General Ledger which makes up the financial statements.

Example:

Here’s a transaction. You buy a machine for $700. The deal is $100 down and the rest in 3

months.

The Journal Entry is:

Machine 700Cash 100Loans – Short Term 600

The General Ledger will show each account. It lists each account. Then it shows the beginning balance for the account, then it’s activity, and finally the ending balance. It does this account byaccount down the balance sheet and then down the income statement.

That’s the General Ledger. More information is here.

So, there it is: a journal and a ledger. What more could you want?

More Journals, of course!

The reason for the extra journals is that they are convenient. Unlike the General Journal wheredebits and credits can be in any accounts, these special journals have common debits or creditsfor most (if not all) of the transactions in them.

Here’s a summary of the special journals.

Journal Name Debits to Credits to

Cash Receipts Journal Cash Revenues

Cash Disbursements Journal Expenses Cash

Sales Journal Accounts Receivable Revenues

Purchase Journal Expenses Accounts Payable

Payroll Journal Wages and SalariesCash and varous payroll liabilityaccounts.

.These special journals are for “normal” transactions. The General Journal is for the rest of the

transactions. There are some transactions that lie in a gray area between the two.

Credit memos, discounts, and refunds are the kinds of transactions that may make it into thespecial journals. Quickbooks and Peachtree both can handle these transactions in the specialournals.

The cash journals and the bank statements present a special problem. Bank statements come withtransactions on them such as bank charges which need to be entered into the journals. We try to

http://www.lemoineandjames.com/gaap/72ledger.html






enter as many of them as possible through the cash journals.

Journals are the accountant’s diary. They form the link between the General Ledger and thereceipts.

METHODS

Hello there! I am a widget. This is how I look on the outside.

I’m bright and shiny. I even do a good imitation of a paperweight!

But on the inside, oh that’s a different matter! On the inside I’m acomplex collection of cost accounting methods, allocations, andfinancial theorems! (This is how the accountant sees me.) I costmoney to produce - but how much money? Yes, how much money isinside me and where does it come from.

Ouch! Somebody’s pounding on me. Must be softening that roughedge. Ahh! That feels much better, now!

Somebody’s been working on me. I bet that somebody is getting paidto work on me. That means that there’s a labor cost to making me.Ooh! Here comes the money now. It tickles my insides.

Example

Suppose a workman takes 30 minutes to make a product. He earns $20 per hour.

The Direct Labor cost to the company for this product is $10.

Speaking of insides, that’s metal there guys! Somebody had to pay for that metal! That meansthat there’s a material cost to making me.

The costs of materials and the costs of labor that directly go to the product are called “PrimeCosts”.

All costs that are direct to the product are “Direct Costs”. Other Direct Costs than Prime costs

may include such items as direct travel, specific research or development costs, and bid proposalcosts.

The factory and the equipment that is used to make me also cost money, too. Some part of thatgoes to me, too.

So how do they figure all of this out? I’ll let Jack and Kathy explain how. Then I’ll come back later.



There are two main methods. Deciding which method to use will depend on what the companyneeds to track.

Job Cost Method

This method tracks costs by discreet products or by service.

ExampleA government contract is awarded your company on a cost plus fee basis. This means thegovernment will pay you all your costs for doing the job plus a fee for your trouble.

A job cost system will track your costs for the contract.

The accounting system will set up a job number. Then all direct costs for this job will need to be

tracked. Invoices for materials will need to be coded with the job number. Employees will needto keep track of what they work on and for how long and code their times with the right jobnumbers.

Overhead is then allocated to jobs by using some allocation rate.

Process Cost Method

This tracks costs by department or by production process.

Example

Jack once worked for a salmon cannery in Alaska. He (okay, I) had to decide how much the fishcost the company. The cannery had three production processes: frozen fish; canned fish; andsalmon roe. The roe was a great delicacy in Japan.

Management needed to know how much a pound of frozen fish cost; how much a can of fishcost, and how much a bag of roe cost.

(The canning costs were complicated because the company produced different sizes of cans butwe won’t go into that.)

Thousands of fish were purchased from the fishermen. We didn’t track the cost of each fish.

Indeed, we had no way of knowing if the contents of a can came from the same fish or not!

The costs for each department were divided by the total units (pounds, cans, and bags).

That example gives you the basic idea.

The main complication of process costing is what to do with units that are not completed. Thisinvolves a calculation of equivalent units. If 100 units are 60% completed then they are assumed



to be equivalent to 60 completed units.

(In the canning business, we didn’t do this. If 100 cans of fish were left without the tops on the fish rotted and that was that. 100 cans of 60% completed work = 0 completed cans.)

Activity Based Costing

This is a new system of cost accounting. It emphasizes the activities that drive costs. These arealso known as “cost drivers.”

In Activity Based Costing (ABC for short) the operation is broken down by activity. (Duh!)

Building usage is broken down to cost by square foot. Machine cost by time usage. Officemachines by paper output. And so on.

All of these activities use different methods to allocate costs to products and services. It’s more

accurate than traditional cost accounting methods but the trade-off is more work.

Standard Costs

Okay, I’m back. I’m finally a fully completed widget and I’m sitting on the loading dock readyfor shipment.

All of these systems require that the costs be finalized at the end of the year. In the meantimesome interim pricing has to be used. This is the standard cost.

This is a cost that is based on past experience, scientific analysis, time and motion studies, and/orcurrent accounting data. At the end of the year when the last adjusting entry is made, I’ll be longgone. Somewhere an accountant will make that final entry into by ledger and the last pile of money will drop into my insides (unless it reached in and took some out!) and my final cost tothe company will finally be known.

Meanwhile, I’ll just sit right here in this box and wait for the truck to arrive to pick me up. I dohope that I made a profit for the company. They seemed like nice people.

MANUFACTURING

Hello, again! I’m the widget from the last web page.

Yes, the truck finally came. It loaded me up and took me to the store. The store bought me fromthe manufacturer. I’m right now sitting on the shelf. Soon a customer will buy me (I hope) andthen I can go to work.



By-Products

These are products that have a small value relative to the main product. They don’t affect theproduction decision. Still, they make some money for the factory.

For by-products, their net revenue (revenue minus direct costs) is just deducted from the cost of the main products.

Some companies put Net Revenue from By-Products under “Other Sales” at the top of theIncome Statement or “Other Income” at the bottom of it.

Scrap

This is stuff that got thrown away. Accountants treat this the same way as (ahem!) “Shrinkage”.This is a kind term for the stuff that just disappeared. Either it got lost or it got legs and walkedaway (and ended up on our friend Billy Bob Bodine’s garage). Shrinkage.

The cost for scrap and for shrinkage may appear as a separate line in the Cost of Goods Soldsection.

Ooh! A customer is coming! She’s looking at me! Please buy me! I’m so tired just sitting here onthis shelf. All of my other widget friends have gone and left me all alone.

I don’t cost very much. Just Direct Costs, Factory Overhead, and General Overhead. Oh, no! Ididn’t explain that part yet, did I? Well, then turn to the next page – quickly. She’s still trying todecide whether to buy me!

OVERHEAD

Here’s a true story. This story occurred in Washington State in 1990 but that’s not important. Itcould have occurred anywhere; it could have occurred yesterday.

I called the relevant state department and asked this question. “What is the overhead portion of the State’s welfare budget?”

Well, I got shuffled to and fro. Eventually I got hold of the right person. At least everybody elsesaid he was the right person there to talk to. More importantly, he said he was the right person totalk to. He was a manager of some cost accounting department in the agency. They had more

than one, department that is, and lots of cost accountants so I’m sure he was very important.

Anyway, he wanted to know what I was talking about. So I explained I wanted to know howmuch of the budget actually went to help poor people and how much went to governmentoverhead. “Government overhead,” he asked, “what’s that?”

“Well, you know . . . the salaries of department directors, program administrators, managers,their deputies, their staffs, office equipment for them, buildings to house same, trips to



conferences to meet other managers, etc. You know, stuff like that.”

“Well, this is an interesting question. We had never encountered this question before.”

“What are the components of your budget then?” I asked.

“We list the various programs but we don’t track how much is direct benefits and how much isoverhead.” Despite the look of this on the page the man really was trying to be helpful. At lengthhe said, “Now come to think of it somebody did ask this question once. Somebody from thelegislature. I’ll look that up and get back to you.”

He did. He gave me the name of a state representative. Yes, if you’re wondering, he was one of those conservatives. Anyway, I called him up.

He said that yes, he remembered the question. He was only passing along a question that aconstituent had asked him. He didn’t save the answer and didn’t remember what it was. Anyway,

it was nothing elaborate. Some cost accountant had simply done a “quick and dirty” calculationfor him so he could satisfy his constituent.

Okay, so it’s now 13 years later and I’m in the opposite corner of the country. Yes, I realize Iused a lot of direct quotes up there. I don’t remember exactly what was said but I think I camepretty close to what was said.

I do know this. Very little of the money government budgets for welfare actually goes to helppoor people. I know this for sure because I know the basic principles of finance. (Okay, somaybe not the very advanced but I do know the basic ones!) One is that unless managementtakes care to control it, overhead tends to expand. The first step to control overhead is to know

what it is. I do not mean knowing academically what it consists of. I mean actually keeping tabson it on a month-to-month and a year-to-year basis.

I mean it. If the reader gets nothing else from this web site, rememberthis piece of accounting advise:

KEEP TRACK OF YOUR OVERHEAD!!

Okay, I’m done with my rant. Now let’s get back to our friend thewidget. We last saw him pining away on the store shelf.

Oh you’re back! Thank goodness! That nice lady is trying to decide tobuy me!

I’m pretty sure she’s not thinking, “How much of the cost of thiswidget is Direct Materials Cost, how much is Direct Labor Cost, orhow much is other costs?” She assumes that the store will make aprofit on the purchase. That assumes that the cost accountant has donehis job properly. No, she just wonders if she wants to pay the price to



buy me.

If the cost is going to be below the price, it’s going to have to include the overhead. But how todo that? Thereby hangs another story!

Once upon a time I (Jack again) audited a small engineering firm in western Colorado for theU.S. Department of Energy.

The owner of this firm was an independent fellow and he was (sorry!) an engineer. So when Iasked to for his documentation for the overhead part of his cost claim to the agency he produceda set of flow charts. He was an engineer, so he thought in terms of flow charts.

(Sit still, widget! The nice lady isn’t going away. I’m writing this and I just reminded her of her place. A literary device should keep quiet and not wander off! At least on this web page shewill!)

Now where was I?

I explained to him that he had to total up all of his overhead costs. That means listing them lineitem by line item and then adding the numbers up. He could understand that. In fact, he said thatthis was a good idea!

Next he had to figure that part of the overhead that should be charged to the Department of Energy. This took a little head scratching for him. So I helped him out. (This kind of attitude didnot make me very popular in certain sectors of the government.)

Overhead consists of all of those costs that are not directly attributable to projects. The

President’s salary is overhead. Interest on the building mortgage was overhead. Office equipmentwas overhead (depreciation expense).

All of these items are the overhead pool. Think of a giant swimming pool of costs. Put all of theoverhead items into this pool and add them up.

Next we need to determine the projects. Then we need to determine a proper allocation basis.

These allocation basis can vary from firm to firm. For an engineering firm, the normal base is amultiplier of direct labor.

The overhead divided by the direct labor of the project gave the amount of the overhead toallocate to the project and to charge to the government.

The overhead claim looks a lot like an Income Statement. At the top is the listing and totaling of the Overhead Pool. The next section is a listing and a totaling of the direct base. Last is theApplied Overhead. This corresponds to Net Income. Net Income is the result of subtraction(sales minus expenses). Applied Overhead is the result of division (pool divided by the base).



There are different methods for allocating overhead. There is the Job Cost Method, the ProcessCost Method, and the Activity Cost Method.

Allocation basis can include Direct Labor Hours, Direct Labor Dollars, Prime Costs, and TotalCost Input. That last one is all of the other costs that already have been allocated to projects.

A company can have more than one overhead pool. I (Jack) once worked on a laboratory thatboasted that it had the most complicated cost accounting system in the world. I decided todiagram all of its overhead pools and how they flowed into one another. Their internal auditmanager said good luck and if I succeeded to please get him a copy!

The cost accounting I described above has all of the pools flowing direct to end products (orservices in the case of the engineering firm). The laboratory had pools flowing into other pools.These were “Intermediate Cost Pools”.

The calculation of this flow is the same as for applied overhead to direct costs. The base for an

application of an intermediate cost pool is base components of the pools it is being allocated to.

WarningUncontrolled cost pools can attract cost codings from people from all over the company aspeople try to spend more than their budgets.

Alright! Enough already! This is turning into one widget with a temper! How about me? Is thatlady going to buy me or not?

Well, now there’s that labor cost to consider, widget.

Labor cost? What labor cost? This is the OVERHEAD page you idiot!

How are you supposed to compete with widgets from China where workers earn $1 per hourwhile the workers that made you earn $20 per hour?

Oh, those Chinese widgets over there. I notice they’re coming in from Latin America and fromust everywhere now.

That’s why we think of overhead.

Overhead?

Yes, overhead. American companies can’t compete with many foreign countries on labor cost.Nor should they try. But they can compete on overhead.

Hey, overhead is pretty important, then. Not just to the individual widget but to the entire futureof the world economy!

You got it, widget! Sold!



CONSTRUCTION

So you’re finally got your dream job in the construction industry! You’ll get most of construction accounting if you understand three key concepts.

1) Project Costing

If all you have to worry about, then this isn’t much of an issue. All of the costs goes to this one project. But if you have more than just one project, then you’ve got to keep track of which costs go towhich one.

It’s best to think of each construction project as a “job”. Jobcosting is the easiest and best kind of system to use.

Each cost gets two codes.

The first is the account code. This is the usual code that accounts always gets. This code takesthe transaction to the general ledger and to the trial balance. This code determines which lineitem in the financial statements the transaction will be included.

The second code is the job code. This code determines which project the cost goes to.

Of course, the construction manager may want more information than just the total amount of thecosts that has been charged to his project. He may want some kind of breakdown. Sub-codestake care of that.

Example

Your dream house may be project A-105 to the contractor. Labor costs may be code 1; materialsmay be code 2; Inspections code 3, other costs code 4.

Then $200 to the city department for a permit inspection will be coded to project A-105-3.

The A-105 tells the accounting system that it is your dream house; 3 tells it that it is forinspections.

The other cost issue is allocating overhead to projects. We have nothing spectacular to say about

overhead allocation that we haven’t already said here.

2) Revenue recognition – Completed Contract

The real problems with construction accounting is when do you show revenue? On a cash basis,then you show it when it is paid. This can present some real problems.

http://www.lemoineandjames.com/gaap/83overhead.html






Example

Your company gets a $3 million contract to make a bridge. The contract pays half down and half on completion. It takes 3 years to build this bridge.

Well, the first year you get $1.5 million. Construction costs may be minimal because you’re juststarting. The time is spent on designing it and getting permits. Your manager looks really great because he’s showing over a $million pr ofit on this bridge.

Next year you get zilch. You’ve got to spend a whole ton of money on construction costs. Yourfinancial statements post a whopping loss. Your manager looks so bad, he’s fired.

The last year, on the other hand is great! The bridge is completed on time and your companygets paid the remaining $1.5 mil. Your company looks great now.

Epilog: The fired manager goes to work for a competitor who understands construction

accounting and goes on to win bid after bid over you and brings his projects in on time and onbudget just like had done for you.

Clearly, this manner of accounting is not going to work. Some way must be found to matchrevenues with expenses. Construction accounting ties this to the completion time of the project.

Under the Completed Contract Method, the costs and revenues are shown as deferred items onthe balance sheet. They are then reclassified to the Income Statement when the project isfinished.

This is easier said than done. Somewhere a job cost schedule has to be maintained showing the

Income Statement account codes where all of the cost and revenue items will eventually end up.You won’t want all of these items showing up on the Balance Sheet; only the totals.

The Balance Sheet captions may be “Costs and Estimated Earnings in Excess of Billings” (debit balance totals) or “Billings in Excess of Costs and Estimated Earnings” (credit balance). Putthese deferred titles in “Current Assets” or “Current Liabilities”.

3) Revenue Recognition - The Percentage of Completion Method

The mechanics are the same as the Completed Contract Method. The big difference is the timingof when the earnings and costs are transferred down to the Income Statement from the Balance

Sheet.

So how to determine how much of a project has been completed? What kind of objective measures are

used?

Input measures are things that go into a project.



Examples

Percent of costs incurred to total estimated costs.

Percent of labor hours used to total estimated labor hours.

Output measures are things that are the outcome of a project.

Examples

Number of miles of a highway already completed versus the total miles to build.

Number of stories in a building completed versus the total stories of the building.

Output costs are not as reliable as input costs. Early work on a project may involve a learning curve.

The earlier part of a project may take longer and be more costly than the later parts because the builder

simply learns how to be more efficient.

Yes, construction accounting is one of the more difficult areas to learn. In our books page, we will

recommend some good reading.

NON-PROFIT ACCOUNTING

Welcome to a new world! Yes, this is. Just plant your flag atop that hillock over there and let’ssurvey the countryside.

Okay, so there’s no harbor. Quit complaining! The entire concept of profit and loss is gone. Thisis Non-Profit Accountingdom! The entire base of accounting is different here.

The result of revenues and expenses is of secondary importance here. The results used to becalled “Surplus” and “Deficit” instead of “Net Income” and “Net Loss”. The lords of FASB(that’s Financial Accounting Standards Board to you, immigrant) have signaled their distain bymandating the terms “Net Increase in Net Assets” and “Net Decrease in Net Assets”. Surely,

they could not be so demented as to think that these new terms are improvements!

Look around. The landscape sure is different! That’s because when people read non-profitfinancial statements, they are looking at different issues then when they read regular financials.

How much of it’s funding does this charity spend on it’s programs and how much does it spendon overhead? Is officer salaries a small grove or a whole forest? Look for things like that.

http://www.lemoineandjames.com/gaap/books.html






Over there are still other unique concerns.

Some of the money is restricted. Charities have Building Funds, Homeless Funds, and otherfunds that have been raised for specific purposes. Some of the money is temporarily restricted.So where did these restricted funds go? People want to know!

Now unrestricted funds on the other hand are a different matter. They can get spent on anything.

The accounting needs to keep track of all of these because the financial statements need to showthem.

Okay, so now let’s hit the road and look into the shops and see how these things are done.

First, you got to know the right titles. The Balance Sheet is now The Statement of FinancialPosition. The Income Statement is now the Statement of Activity. The Cash Flow Statement isthe same.

Now there’s a new statement, though. The Statement of Functional Expenditures. This breaks outthe expenditures (oh, yes – another name change) to programs, fundraising costs, and overhead.

We keep track of fund accounting by using department accounting. Each fund is a department.When the charity borrows money from one fund to pay another fund’s bills, we show that asreceivables and payables on each fund’s books.

Just like Columbus when he discovered the Western Hemisphere, you are now standing upon awhole lot of territory to explore. We hope that this page helps you get your bearings.

accounting advice

Documents