Category: Accounting Knowledge

 

 

My net profit on my monthly income statement looked great, but my checking account balance is a LOT lower.  How did that happen?

 

In an earlier post, I explained why “checkbook bookkeeping” is a less-than-optimal method of tracking your business’s financial health.  You might think you have more money to spend because you haven’t considered future withdrawals.

 

However, the same checkbook balance that creates a false sense of having lots of cash available can also create a false sense of having cash problems.

 

That’s because these transactions actually aren’t part of the income statement.  They might be money flowing in and out of your business, but instead of creating revenue and expenses, they actually reside on the balance sheet as assets, liabilities or equity:

 

1. Inventory Purchases – Inventory that you purchase to resell to customers at a profit is considered an asset, not an expense.
2. Paying Last Month’s Bills – If your service vendors allow you time to pay bills (usually 15 or 30 days), then the bill you are paying this month might technically have been part of last month’s income statement, but are part of this month’s balance sheet.
3. Paying Out Tips to Employees or Taxes Collected for Payroll or Sales – Money you collect for employee tips,payroll and sales tax isn’t considered income, which means the money you pay isn’t considered an expense.
4. Paying Yourself via Owner’s Draw – If your business structure requires an owner’s draw to pay yourself, that withdrawal is taken from the equity you have in the company instead of as a salary expense.

 

It’s essential that you, as the business owner, know how different transactions affect your business.  In addition to your “cash in the bank”, the profit margin and the equity are both important to understanding your business’s financial health.

 

Questions or comments?  Let us know below!

 

“So, I’ve been checking my bank account balance online to see how much money my business has to spend.  I even subtract out the checks I recently wrote and debit card transactions from the day, so that should be fine, right?”

Many business owners run what some bookkeepers call “checkbook bookkeeping”.  That is, they check their business financial health mainly by reviewing their bank account balance online to determine how much they can spend.

The ability to know your bank balance up to the day, sometimes even up to the hour, with a button click or a phone call is certainly a great tool.  But it is not a great way to manage your business finances.  Because even if you take into account the transactions that haven’t cleared yet, you’re still not getting a full picture of your business’s finances.

Here’s how checkbook bookkeeping can create problems:

• Outstanding and upcoming bills – Sure, you’ve subtracted out the checks and debit card transactions that haven’t cleared. But what about the upcoming utility bills?  How many vendor bills are outstanding?  And wait, is the annual insurance bill due soon?   You need to look at what you’ll need to pay over the next few weeks in comparison to your expected income, not just you how much have in the bank today.
• Sales tax – Most likely, you’re collecting sales tax in some, if not all, of your transactions. And while that money does go into your bank account, that money is NOT your income.  It’s money that you’re temporarily holding on behalf of the tax agency (possibly more than one, depending on location) to be paid at a later date.  Depending on the revenue your business brings in, the sales tax due to the tax agency could add up to thousands of dollars.  Not filing and paying the sales tax by the deadline will result in fines and interest charges.
• Payroll tax – If you have employees, you have payroll tax. Payroll involves a relatively complicated set of transactions, so I won’t delve too deeply into it here.  But in a nutshell, as the employer, you’re required to withhold a certain amount from each employee’s paycheck to send over to the federal and state tax agencies on behalf of the employee.  So, similarly to sales tax, you are temporarily holding on to these taxes for a while.  At filing time, you are required to send that withheld money, as well as the taxes your business is responsible for, to the appropriate tax agencies.  And if you think the consequences for delayed sales tax filings are stiff, they’re less than the consequences for delayed payroll tax filings (especially since you’re dealing with federal AND state at the minimum).
• Tips – Unless your customer pays a tip in cash directly to your employee, the tip is included in a check or credit card payment. When you deposit the check or receive the payment from your credit card processor, the tips are included in the total balance of your checkbook.  Once again, however, these tips are money intended for a third party – in this case, the employee who earned it.

Knowing how much your business has in the bank is certainly a vital piece of financial information.  However, it’s only one piece.

As a business owner, you should always know what your business owes so you can make informed decision about how much you can spend or invest.  Reviewing your balance sheet on a regular basis will give you a more accurate picture of your business’s spending ability.

Comments or questions?  Let us know!

“I need to buy a gift for my kid’s birthday.  Is it okay to write a check from my company’s bank account to pay the toy shop?”

Short answer:  No.

Long answer:  Technically, maybe, but you should only consider it after you’ve consulted with your tax accountant to make sure, if it is a possibility, that it’s handled correctly.

Yes, you started the business with money that you contributed, either from your own pocket or via a business loan.   And yes, you are the boss, so you are the ultimate decision maker on the business that helps you earn a living.

However, from an accounting perspective, you and your business are two separate entities.  This separation is known as the Economic Entity Assumption or Economic Entity Principle, as outlined in Generally Accepted Accounting Principles (commonly referred to as GAAP … here is a link with a quick summary).

This separation means it’s a bad practice to make a personal purchase from the business bank account.  This practice is referred to as commingling, and it can create major problems for you if the IRS comes at you for an audit.

You’ll have to defend all deductions on your return, including the personal expenses.  If you can’t defend them to the IRS standards, then you’ll probably be faced with a recalculated tax return along with the interest and penalties that go along with the new tax liability.

And depending on your business structure, your personal return might have to be recalculated, which means another set of interest and penalties.

If you find yourself in a situation where you need to take money from the business for personal reasons outside of your normal business wages or draws, talk to your accountant first to work out the best way to do so from a tax perspective based on your business’s legal setup.  Then make sure you alert your bookkeeper so these transactions can be recorded properly for reporting and tax preparation.

As a general rule, though:  Don’t use your business accounts as your personal piggy bank.  Keeping your personal and business finances separated makes your bookkeeping easier and reduces your stress levels at tax time.

 

 

“Okay, I’ve got that box of receipts, vendor bills, loan docs, paid invoices … so what goes where?”

When you review your financial reports, you might be wondering about the different categories listed in them.  Each of these categories is called an Account, and together they form a very important list called the Chart of Accounts, which are used to group all the financial transactions in your business (represented by all of those papers you have gathered).

 

There are seven general groups of accounts:

• Assets
• Liabilities
• Equity
• Revenues
• Expenses
• Gains
• Losses

You’ve seen most of these labels in previous posts:  the first three groups make up the Balance Sheet, and the other four groups make up the Income Statement (the Statement of Cash Flows is generated using parts of each of these reports).

You’re probably familiar with and often use several accounts:  Cash, Accounts Receivable, Accounts Payable, Sales, Rent, Utilities, Inventory, Salaries & Wages, Office Supplies and so on.  However, some may not be relevant to you at all – for example, if you operate on a cash-and-carry basis, you might not use the Accounts Receivable entry routinely.

One useful thing to do is to divide those accounts you do use down into very specific subgroups as needed (utilities are sometimes separated into electricity, natural gas, internet and telephone).  There could also be specific groups based on your business’s industry:  veterinarians could separate revenue into clinic visits and surgical services, or dog groomers could divide blades and brushes into separate expense subgroups. Having a good level of detail will help you understand your business better by seeing what segments are performing well and which need attention.

Being able to connect revenues and expenses to each other in by relevant category allow you analyze a given business segment’s profitability at a given point in time and as a trend. Decisions about pricing, staffing and inventory levels become better grounded when you can see how specific revenue and cost streams are behaving.

One warning: Avoid the temptation to break things down into too many sub-accounts.  The bookkeeping work will become too time-consuming to maintain and can actually make it hard to separate real information from noise. You and your bookkeeper need to think carefully about the relevance of the categories chosen. Industry associations often can help with this as well.

As you can see, the chart of accounts is very important in understanding how your financial activities are grouped together. You manage what you can measure!

“So, I know what I have and how much I earned, but where did that money actually GO?”

The Statement of Cash Flows is probably the least known and appreciated financial report among business owners.  However, this is report that tells you the vital information how you generated or used cash in a given period.  Basically, it show how the changes in your Balance Sheet  along with your net income affected your cash flow.

Here’s an example of a very basic Statement of Cash Flows:

The Statement is divided into these sections:

Cash provided from or used by Operating Activities: This is where the cash flow of day-to-day business such as sales and expenses, plus changes in working capital (A/R, A/P, inventory, etc.) and are detailed.

Cash provided from or used by Investing Activities: This is where your acquisitions/disposals of building, equipment or long-term financial assets are detailed.

Cash provided from or used by Financing Activities: This is where inflows/outflows of cash when you borrow or re-pay debt or pay dividends are detailed.

The Statement of Cash Flows can tell you a lot about how the business is being managed and will be the focus of savvy lenders and potential investors who want to know if your Income Statement profits convert into cash that can pay them; it is also where red-flags of impending problems first surface.

For example, a classic problem of a young successful business is a cash squeeze where sales are rising rapidly (good) but payments on customer invoices lag (bad) and cash is short to replenish inventory to support that sales growth.  Paying close attention to the Statement of Cash Flows will let you get a jump on this paradox of success.

When combined with the Balance Sheet and Income Statement, you have a clear picture of your business’s health.

 

“So how do I know how much money I *really* made last month?”

As you read earlier, the Balance Sheet shows you what your business’s finances look like for a single day.  But what about how much your business earned in a particular period of time?

Enter the Income Statement.

The Income Statement (or Profit & Loss Statement, or P&L) provides an outline of what your business earned (Income), along with what your business spent (Costs and Expenses). 

INCOME is comprised of Operating Income (i.e., sales income) and sometimes Gains.  The second section is the DIRECT COSTS, which are costs that are a direct result of providing the sales and services.  INCOME minus DIRECT COSTS gives you the business GROSS PROFIT. 

Next you have the EXPENSES section.  This section is sometimes called Indirect Costs since these expenses are a result of normal business operations whether or not a sale is made.  

After subtracting the EXPENSES, you get the final result of the Income Statement:  NET PROFIT.  Technically, that figure can be positive or negative (at which point the proper term would be NET LOSS).

Unlike the Balance Sheet, the Income Statement shows activity over a period of time.  The two most common date ranges for Income Statements are one month and one year, but your accounting software can create an income statement for any period of time.

So now you can look at a snapshot of your business’s finances with the Balance Sheet, as well as how your business performed with the Income Statement. 

But what about which way the money is moving?  Stay tuned for the next segment which talks about the Statement of Cash Flows.

Any questions?  Need help with reading your own Income Statement?  Send me an email and we’ll work through it!

“I have no idea on how financially healthy my business is. Where do I start?”

You love running your business, but maybe your understanding of the finances is focused on checking the bank account to make sure there’s enough in there to pay the bills and that your customers have paid you. But cash in the bank is only one way to see how your business is doing. You need to know what your business has, what your business owes, how your business is performing and how the cash is flowing.

In this short blog series, I’ll explain three basic yet vital financial statements: the Balance Sheet, the Income Statement, and the Statement of Cash Flows.

The Balance Sheet

The balance sheet shows you what your business owns, how much your business owes to others, and how much of the business you can claim as an owner.

• The things your business owns are called ASSETS. Assets include the cash in the bank accounts, inventory for sale, major equipment and buildings bought for the business, plus intangibles like trademarks and internet domain names.
• The money your business owes to other entities is called LIABILITIES. Liabilities include business loans, credit card balances and expenses owed at a future date (like sales tax or income tax).
• EQUITY is the difference between ASSETS and LIABILITIES. This amount represents how much of the business can claim as owner.

Here is an example of a balance sheet:

My Company
Balance Sheet
As of 30 June 20XX
ASSETS				LIABILITIES
Cash in First American Bank	$10,000			Business credit card from Northern Bank		$15,000
Company car	$15,000			Loan from ABC Bank		$75,000
Office building	$100,000
Web domain	$5,000			TOTAL LIABILITIES		$90,000
				EQUITY
				Owner’s Contribution		$40,000
				TOTAL EQUITY		$40,000
TOTAL ASSETS	$130,000			TOTAL LIABILITIES & EQUITY		$130,000

Did you notice that Total Assets equals Total Liabilities & Equity? That’s where the “balance” comes in. Assets are brought into the business by either the owner (Equity) or loans (Liabilities).

Did you also notice that the balance sheet date has the phrase “As of” before it? That’s because the balance sheet only shows figures for a single date. You can see how the finances have changed over a period of time by comparing one or more balance sheets, but each one will only reflect the Assets, Liabilities and Equity for one day.

In a nutshell, the Balance Sheet shows you a quick snapshot of what you own and how you paid for it. It’s a crucial piece of assessing the business’s financial status, but only how the finances are for a fixed point in time. The next post in the series will highlight the Income Statement, which shows your business’s profit margin.

Any questions? Comment below or send me an email!