Accounting Basics

Like all small business owners, you went into business with a dream: to sell your unique product or services and make a good living for you, your family, your employees and your partners. You also wanted to change the world so you made the decision to run your small business using AccountEdge. Now reality has kicked in and you are faced with the challenge of managing your operations and your finances, all on a Macintosh. In this special edition of “Accounting 101” we’ll explain the basics of accounting in easy to understand terms with real life examples, showing you the impact on your financial statements. We’ll also discuss working with your accountant, no matter what platform they are using.

Let’s review what you’ve probably already done today. When you got to work you probably checked the fax machine for any incoming orders. Next, you reviewed your email for any email or web orders. You also check voice mail to see if any previous quotes have been accepted. You also checked the mail, where you found a stack of vendor bills and a few customer cheques. Next, you reviewed your online bank balance and saw that the big deposit you were waiting for finally arrived. Next, you wrote some cheques and ordered more inventory. Feeling kind of flush, you called the local Apple Store and placed an order for that new MacBook Pro you wanted, using your credit card. Since it’s Friday, you also had to run payroll, process paycheques and make your direct deposits. You also went to the bank and made a HMRC liability deposit. When you got back to the office you had a stack of phone messages, including one from your best supplier offering a one-day sale and from your newest customer who wanted to exchange some parts and place another order, he was also asking for credit terms, and he had a lead for some new business you had discussed. Then your cell phone rings, another new client with a huge order asking if you accept credit cards. Finally, you realize you better pay yourself, if there is money left. Then you ask yourself: How’s cash flow? Who owes me money? Whom do I owe money to? Is my business going to succeed? How do I keep it all straight?

Does this sound like a typical day for you? As a Mac small business entrepreneur, it probably does. Most likely, you deal with all this stuff and more before your first cup of coffee. Admit it, you probably struggle a little bit to keep it all together. No matter how you handle all these transactions, the fact is, they are all accounting transactions: taking orders, buying stock, selling parts, buying computers, making deposits, writing paycheques, remitting payroll taxes, paying yourself, and more. In the average day, you probably do more accounting than you ever thought possible. How you track that data, what reports you have access to and how accurate and up to date they are play a large part in determining your financial success. How you work with your bookkeeper (if that’s not you) and your accountant (you should have one you love) probably determine how successful your business is.

How you keep it all running smoothly probably falls on your shoulders. Knowing your local, state and federal tax regulations, deadlines and responsibilities probably keeps you up at night. Understanding what it all means and using that information to your advantage is what this document is all about.

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When you started your small business you probably did as most small business entrepreneurs do and tried to use what came with your Mac or PC to run your business. Maybe you tried some Appleworks or Excel. If you are a creative professional, you may have used a system that looks like this: Invoices were done in Quark (because you could put your logo on them in 1200dpi...), chequebook register in Excel, and everything else done by hand. Your first experience with ‘bookkeeping’ was probably to use a computerized chequebook system since it worked so well for your home finances. Not a bad place to start. But, as your business grew ‘beyond the chequebook,’ your record keeping, reporting, and compliance requirements also grew.

Now you have customers to track, vendors to pay, sales to record, sales taxes and payroll taxes to track and a full set of accounts to maintain. You probably also have an accountant who is preparing your state, federal and maybe even your payroll taxes for you. Maybe you have inventory, or bill your employees time, or hire lots of subcontractors – all of these things require integrated record keeping, they require... a-c-c-o-u-n-t-i-n-g!

By now you find yourself spending more time keeping your books than keeping your customers happy. You understand the importance of having accurate books, but you have a lot of demands on your time, so accounting and record keeping never seem to get the attention they require. You fondly skipped all those high school and college accounting courses, figuring you weren’t “going to be an accountant anyway.” Well, surprise! Not only are you an accountant, you are a lawyer, a shipping clerk, a customer service rep, a lawyer and more – all in the pursuit of your dream.

So what can you do to make this work? The first step is to understand the basics and how they all fit together. At the end of this booklet is a glossary of all the relevant accounting terms that will help you understand the science of accounting. Understanding the terminology will help you understand the concepts and their relevance to you, and more importantly, they will help you analyze and run your small business. All the information you need to run a successful small business is contained in your accounting system – recording your transactions, verifying their accuracy, and interpreting your financial statements – that’s your goal!

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Before we go any further, keep this in mind: you don’t have to be an accountant to run AccountEdge. All too often small business owners use this line to shun doing any type of record keeping (and therefore, business management), to their own detriment. The reality is, I’m not a mechanic, but I can drive my car. I’m also not a plumber, but I can fix a running toilet and I’m certainly not a doctor, but I can put a band-aid on my kids’ knee, even take out a splinter. All it takes is the will to succeed and the desire to run a successful operation. Will it be easy? I wish I could say yes. Will it be frustrating? I wish I could say no. Will it be invaluable to your business and your long-term success? You bet! Will you ever need outside help? You might, so don’t be afraid to call in a professional – either your accountant or one of our Mamut Partners (local, tech-savvy, business management experts) in your community.

Our goal is to help you understand the basic concepts of accounting and how they relate to your business. One of the great things about AccountEdge is that it does all the debits and credits for you empowering you to manage your business. Smarter.

■ Your Daily Life First, lets start with an overview of how accounting fits into your daily life. Quite simply, every transaction you make results in an entry into your “books.” Whether it is a receipt of cash, a sale, a cheque you’ve written or a deposit from a customer – every transaction gets recorded in your books at some point. The timeliness and accuracy of when and how you record your transaction directly affects your ability to manage your business and your cash flow because accurate and timely data entry equal accurate and timely financial statements. Want to know how you’re doing year to date? As long as all your transactions are entered correctly, a simple click of the mouse will produce the information you need.

If you think your business is “chequebook-centric,” remember that there are plenty of transactions that do not involve cash that should be recorded in your books. Anything that affects the things you own (assets) like repairs or purchases, all require a transaction. Anything that affects what you owe (liabilities) like VAT or PAYE taxes requires a transaction to be recorded. Anything that affects sales (revenue), like an invoice or a product return needs to be recorded. And, as you no doubt already know, all your supplier bills (expenses) are recorded when received and again when they are paid. Just because cash is not exchanged does not mean there are no entries to record. For example, you might sell items or services on credit. In this simple example, you record the sales when your invoice is issued, and then subsequently record the cash receipt when your customer pays you..

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■ Cash vs. Accrual Accounting Cash-based accounting recognizes revenue and expenses ONLY when cash is received or paid. In our simple example above, your revenue would be recognized when you receive payment from your customer – not when you invoice them. Conversely, expenses would be recognized when cash is disbursed – not when the bill is received.

Businesses that start out using a chequebook-centric method of recording cash are basically using a cash-based system. For companies that use accrual accounting, their system looks like this: An invoice is generated for goods and services sold, increasing sales and creating an amount due (an accounts receivable). When the customer pays you another transaction is recorded increasing your cash balance and reducing their receivable to zero. The same idea works when recording expenses: an bill is received and recorded by tracking what expense was incurred and creating an accounts payable record. When you pay your supplier another transaction is recorded, a cheque, which reduces cash and reduces your payable to the supplier.

In the end, your accountant will make the necessary adjustments in order to prepare and file your tax returns. They will take your hybrid system and adjust it to reflect cash- based or accrual-based numbers. What that means is that they adjust your ‘accrued’ balances back to zero as if the transactions never happened. If you have an Trade Debtors balance reflecting £2,500 in sales you’ve not been paid for, your accountant will make an adjustment to reduce Trade Debtors by £2,500 and reduce Sales by the same amount, as if it never happened. In the world of cash-based accounting, technically, those sales aren’t recorded until cash changes hands. The same idea applies to Trade Creditors (by adjusting the amounts posted to each asset or expense, for example).

For companies that use accrual accounting, their system looks like this: An invoice is generated for goods and services sold, increasing sales and creating an amount due (a Trade Debtors). When the customer pays you another transaction is recorded increasing your cash balance and reducing their receivable to zero. The same idea works when recording expenses: an bill is received and recorded by tracking what expense was incurred and creating an Trade Creditors record. When you pay your vendor another transaction is recorded, a cheque, which reduces cash and reduces your payable to the vendor.

In AccountEdge terms, the scenario above would look like this: An invoice is generated for goods and services sold, crediting Sales and debiting Trade Debtors. When the customer pays you another transaction is recorded increasing your cash balance and reducing their receivable to zero. The same idea works when recording expenses: A bill is received and recorded by tracking what expense was incurred and creating a Trade Creditors record. When you pay your vendor, another transaction is recorded – a cheque – which reduces cash and reduces your payable.

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■ The Golden Rules of Accounting Lets discuss the Golden Rules of Accounting. They are:

1.) Debits ALWAYS EQUAL Credits 2.) Increases DO NOT NECESSARILY EQUAL Decreases 3.) Assets - Liabilities = Owner’s Equity (The accounting equation!)

Don’t let the words ‘debits’ and ‘credits’ scare you. They simply refer to the ‘left side’ and ‘right side’ of a ‘T Account’, a graphical representation of the amounts recorded into an account (see the examples below). Every transaction recorded into AccountEdge is posted to your accounts as a combination of debits and credits; we do all the work for you, so relax, get more coffee...

■ Chart of Accounts The chart of accounts, or simply ‘accounts’, is a list of categories into which all your accounting transactions will be recorded. In AccountEdge they are defined by a five- digit number and account name: A one-digit prefix designates what type of account it is (asset, liability, expense) and where it will be displayed on your financial statements, followed by a four-digit main account number. With AccountEdge you have complete control over your account numbers and their names. You can add your own, delete ones you don’t use or combine similar accounts. When creating a new company data file you can select an account template from a list provided by us or create your own. Either way, this list becomes the basis for your financial statements and can be molded as your business and your requirements change. You can add, edit, delete, and combine accounts.

Here is a table that will help you understand what this means and how it applies to your business.

ACCOUNT NUMBER

ACCOUNT TYPE

INCREASE DECREASE

Balance Sheet (As of a ‘point of time’)

1-xxxx Assets DEBIT CREDIT 2-xxxx Liabilities CREDIT DEBIT

3-xxxx Owner’s Equity CREDIT DEBIT

Profit and Loss (For a ‘period of time’)

4-xxxx Revenue CREDIT DEBIT

5-xxxx

Cost of Goods Sold

DEBIT CREDIT

6-xxxx Expenses DEBIT CREDIT 8-xxxx Other Income CREDIT DEBIT 9-xxxx Other Expenses DEBIT CREDIT

The exceptions are contra accounts, which are accounts that are offset against another account. Examples include: Accumulated Depreciation, Sales Discounts, and Sales Returns and Allowances.

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Let’s drill down on how each account type actually relates to your small business.

■ Assets An asset is anything you own in your business. They are the things in your office, your laptops and desktops, scanners, hard drives, your vehicles, your receivables owed by customers and your cash on hand. Everything you own is considered an asset of the business. Assets are used to generate revenue and purchase other assets. For example, when you buy a new computer, you use one asset (cash) in exchange for another asset (computer equipment).

■ Liabilities Your liabilities are the things you owe, like sales taxes received from sales but not yet paid to the state, or loans payable to your bank. Another example is your credit cards – unless you pay your balance off every month, the money you owe to your credit card company is considered a liability on your books. Liabilities represent claims against your assets.

■ Owner’s Equity The difference between the value of your assets and the total of your liabilities is the value of your company. As the Accounting Equation states: Assets - Liabilities = Owner’s Equity. Depending on the type of taxable entity you created when you first formed your company, the Owner’s Equity section of your Chart of Accounts and Balance Sheet may have another name.

■ Revenue The revenue of your company is the total amount of proceeds generated for providing goods and services to your customers. This is typically the total amount of the invoices that you generated for your customers.

■ Cost of Sales Cost of Sales (or COGS) refers to the total value of the goods and services that were sold to your customers. Typically, this refers to items-based businesses that buy inventory for resale, or a manufacturer who builds items for resale. Total revenue less cost of goods sold equals your gross profit.

■ Expenses Expenses are the costs you incur to run your business, whether they are fixed costs (independent of how much business activity you have, like rent) or variable costs (directly related to how much business activity you have, like shipping).

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■ T Accounts and Double-Entry Accounting T accounts are a graphical representation of debits (left side) and credits (right side) in a specific General Ledger account. Double-entry accounting means that every transaction has at least one debit and one corresponding credit.

The total debits always equal the total credits.

Account Name (x-xxxx) debits credits debits credits debits credits debits credits

Below is a series of typical accounting transactions and their affect on the appropriate General Ledger accounts. The next page shows the financial statements resulting from these entries. This example assumes cash-based accounting is being used.

■ Examples

(Part 1)

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When your bank says that they are crediting your account, they are referring to an entry on THEIR books.

Your money in the bank is a liability to the bank; therefore, when they credit your account, they are increasing their liability to you on their books.

: There is an initial £5,000 cash investment by the owner. 1.) You buy an iMac at the Apple store and pay £1299 cash 2.) You buy two Mini Mac’s for £1,000 with your company credit card* 3.) You buy 10 Widgets for inventory at £150 each and pay on COD 4.) You sell 4 Widgets from inventory for £250 each on Net 30 terms 5.) You pay your monthly rent of £800 6.) You pay your credit card company for your new Mini’s 7.) Your customer pays for the Widgets they purchased 8.) You sell 3 Widgets for £300 each, cash 9.) You buy 10 Widgets for inventory at £150 each and pay on COD 10.) You sell 3 Widgets for £350 each and take a £500 deposit

* Using FirstEdge or BusinessBasics, no transaction is recorded until the bill is paid. (With AccountEdge a purchase can be recorded showing a £1,000 liability in Trade Creditors.)

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Cash (1-xxxx) £5,000 1.) £250 7.) £1,000 3.) £1,500 8.) £900 5.) £800 10.) £500 6.) £1,000 9.) £1,500

Trade Debtors (1-xxx) 4.) £1,000 7.) £1,000 10.) £550

Inventory (1-xxxx) 3.) £1,500 4.) £600 9.) £1,500 8.) £450 10.) £450

Owner’s Equity (3-xxxx)

£5,000

Sales (4-xxxx)

4.) £1,000 8.) £900 10.) £1,050

COGS (5-xxxx) 4.) £600 8.) £450 10.) £450

Office Expense (6-xxxx) 1.) £250 6.) £1,000

Rent (6-xxxx) 5.) £800

■ Financial Statements The primary financial statements of any business include the Balance Sheet and the Profit and Loss. Together, they represent the total financial picture of your business. They must be reviewed as a set because collectively they tell you about your business, both in the short term and the long term.

■ The Balance Sheet The Balance Sheet, one of the primary financial statements, is a reflection of your total assets, less total liabilities and the difference, or owner’s equity. The balance sheet reflects a ‘point in time’ in the life of the business; for example, you could produce a Balance Sheet as of December 31, 2010 that would reflect all the account balances “as of” that date - a point in time. For example, you would see the balance of your assets, liabilities and owner’s equity accounts on December 31st.

■ The Profit and Loss Statement (or Income Statement) The Profit and Loss, also one of the primary financial statements, is a reflection of your total revenue generated, less the cost of items sold (which equals your Gross Profit), less your operating expenses (which equals your Net Income or Loss). The profit and loss reflects results for a ‘period of time’: the net income or loss for a specific period of time, for example, January 1, 2010 through December 31, 2010.

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