SETTING UP YOUR BUSINESS ACCOUNTING SYSTEM

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1 100 Arbor Drive, Suite 108 Christiansburg, VA Voice: FAX: Providing Professional Business Advisory & Consulting Services Douglas L. Johnston, II SETTING UP YOUR BUSINESS ACCOUNTING SYSTEM BASIC ACCOUNTING FOR THE NON-ACCOUNTANT

2 CONTENTS The Balance Sheet 1 The Income Statement 4 The Cash Flow Statement 5 Accounting Concepts 6 Accounts Requiring Special Attention 8 Sample Financial Statements 9

3 THE BALANCE SHEET PURPOSE: The balance sheet is a summary of total assets and total liabilities of a given business to portray its net worth at a given moment of time. MAJOR COMPONENTS: ASSETS - Economic resources owned by or available to the business LIABILITIES - Obligations due to others OWNERS EQUITY - Residual interest in assets after deducting liabilities THE ACCOUTING EQUATION : ASSETS = LIABILITIES + OWNERS EQUITY 1

4 THE BALANCE SHEET CURRENT ASSETS: Cash and other assets that are expected to be converted to cash or consumed within one year. Examples: Trade Accounts Receivable Amounts owed by customers Inventory Raw materials and finished goods for sale to customers Prepaid Expenses Amounts paid for expenses attributable to subsequent accounting periods NON-CURRENT ASSETS: Assets expected to be held for longer than one year. Examples: Property and Equipment Physical assets of a durable nature that will be expended gradually in the operation of the business Intangible Assets Assets that are not physical in nature such as goodwill, non-compete agreements, patents, and franchise licenses OTHER ASSETS: Example: Investments Real estate, securities, and other assets held for appreciation or future development and not used in the operations of the business 2

5 THE BALANCE SHEET CURRENT LIABILITIES: Obligations due to be paid within one year. Examples: Trade Accounts Payable Amounts owed to vendors Accrued Expenses Expenses incurred as of the balance sheet date that will be paid in the subsequent accounting period Current Maturities The portion of long-term debt that will be paid within one year LONG-TERM LIABILITIES: Obligations due in more than one year. Example: Long-Term Debt Amounts owed to lenders excluding the current maturities OWNERS EQUITY: The residual value of assets over liabilities. Components: Paid-In Capital Amounts contributed by the business owners, whether in cash or other property. Retained Earnings Cumulative net income of the business that has not been distributed to owners 3

6 THE INCOME STATEMENT PURPOSE: The income statement is a summary of the revenue and expense transactions of the business over a given period of time. MAJOR COMPONENTS: REVENUES - Amounts earned/received from sales to customers COST OF SALES - The cost of goods bought or produced and sold to customers GROSS PROFIT - Profit on sales after deducting the cost of goods sold and before the deduction of other expenses OPERATING EXPENSES - Expenses of marketing and operating the business, including taxes NET INCOME - Profit after deducting all expenses THE BOTTOM LINE : REVENUES EXPENSES = NET INCOME 4

7 THE CASH FLOW STATEMENT PURPOSE: The cash flow statement is a summary of the increase or decrease in cash generated from the business activities after adjusting for changes in other assets and liabilities. MAJOR COMPONENTS: OPERATING ACTIVITIES - Cash generated or consumed by day to day business activities INVESTING ACTIVITIES - Cash provided by or consumed by non-operating assets FINANCING ACTIVITIES - Cash provided by or used in equity or debt transactions 5

8 ACCOUNTING CONCEPTS DOUBLE ENTRY: Debit Accounts Asset Expenses Credit Accounts Liabilities Owners Equity Revenue Each entry on one side of the T-chart must be accompanied by either: an opposing entry on the same side of the chart or a parallel entry on the other side of the chart. HISTORICAL COST: Transactions are generally based on the actual historical cost of assets used in the business. While historical cost doesn t reflect the true economic equity in the business, it does eliminate the subjectivity inherent in the determination of market value. There are exceptions to the historical cost method of accounting for certain assets, such as worthless inventory and for readily marketable securities. MATCHING: Expenses should be recognized in the same accounting period as the revenue which is generated from the use of those resources 6

9 ACCOUNTING CONCEPTS CAPITAL EXPENDITURE VS. EXPENSE: CAPITAL EXPENDITURE - Expected to benefit future periods and must be expensed over time EXPENSE - Consumed and expensed in the current period and is therefore expensed currently CASH VS ACCRUAL ACCOUNTING: CASH METHOD - Revenues are recorded when received Expenses are recorded when paid Exceptions for inventory and long-term assets ACCRUAL METHOD - Revenues are recorded when earned Expenses are recorded when incurred 7

10 ACCOUNTS REQUIRING SPECIAL ATTENTION ACCOUNTS RECEIVABLE: Accounts Receivable generally consists of numerous customer accounts. A sub ledger is typically used to track each of these individual customer accounts and reconcile back to the main ( general ) ledger. The individual customer accounts receivable should be aged to indicate the time elapsed since the sale. INVENTORY: Inventory generally consists of an assortment of raw materials and/or finished goods held for sale to customers. Inventory quantities can be determined upon each sale using a perpetual inventory system, or inventory can be periodically counted to determine the quantity on hand and compute the amount consumed. There are several different techniques to determine a value for inventory quantities, including specific pricing, first-in-first-out (FIFO), and last-in-first-out (LIFO). NON-CURRENT ASSETS: It is desirable and necessary to match the consumption of assets with the revenue that their consumption helps generate. Consequently, the cost of these assets is expensed over time through depreciation (for tangible assets) or amortization (for intangible assets.) Depreciation and amortization are required by generally accepted accounting principles and income tax law. There are numerous depreciation and amortization methods ranging from simple straight-line to various accelerated methods. ACCOUNTS PAYABLE: Accounts Payable generally consists of numerous vendor accounts. A sub ledger is typically used to track each of these individual vendor accounts and reconcile back to the main ( general ) ledger. As a general rule, accounts payable should be paid on the latest date possible to obtain discounts and/or avoid penalties. 8

11 SAMPLE FINANCIAL STATEMENTS 9

12 ABC COMPANY BALANCE SHEET ASSETS Year 2 Year 1 CURRENT ASSETS Cash $ 70,000 $ 40,000 Accounts receivable 330, ,000 Inventory 400, ,000 Prepaid expenses 20,000 15,000 Total current assets 820, ,000 PROPERTY, PLANT, AND EQUIPMENT Machinery and equipment 175, ,000 Furniture and fixtures 75,000 75, , ,000 Less accumulated depreciation 80,000 45, , ,000 OTHER ASSETS Goodwill 10,000 12,000 Total assets $ 1,000,000 $ 1,082,000 LIABILITIES AND STOCKHOLDERS EQUITY CURRENT LIABILITIES Accounts payable 280, ,000 Accrued expenses 20,000 26,000 Notes payable 100, ,000 Current maturities of long-term debt 40,000 50,000 Accrued income taxes 10,000 2,000 Total current liabilities 450, ,000 LONG-TERM DEBT 160, ,000 DEFERRED INCOME TAXES 10,000 6,000 Total liabilities 620, ,000 STOCKHOLDERS EQUITY Common stock 10,000 10,000 Additional paid-in capital 40,000 40,000 Retained earnings 330, ,000 Total stockholders equity 380, ,000 Total liabilities and stockholders equity $ 1,000,000 $ 1,082,000 10

13 ABC COMPANY INCOME STATEMENT Year 2 Year 1 SALES $4,325,000 $4,000,000 COST OF GOODS SALES 2,950,000 2,728,000 Gross profit 1,375,000 1,272,000 SELLING, GENERAL AND ADMINISTRATIVE EXPENSES 1,209,000 1,196,000 OTHER EXPENSES Interest 28,000 32,000 Income before income taxes 138,000 44,000 INCOME TAX EXPENSE 41,000 8,000 Net income 97,000 36,000 RETAINED EARNINGS Beginning of year 233, ,000 End of year $ 330,000 $ 233,000 11

14 ABC COMPANY CASH FLOW STATEMENT Year 2 CASH FLOWS FROM OPERATING ACTIVITIES Net income $ 97,000 Depreciation 35,000 Amortization 2,000 (Increase) Decrease in: Accounts receivable 80,000 Inventory - Prepaid (5,000) Increase (Decrease) in: Accounts payable (65,000) Accrued expenses (6,000) Accrued income taxes 8,000 Deferred income taxes 4,000 Cash Provided by Operations 150,000 CASH FLOWS FROM INVESTING ACTIVITIES Capital expenditures - CASH FLOWS FROM FINANCING ACTIVITIES Payments notes payable (70,000) Payments on long-term debt (50,000) Cash used in Financing Activities (120,000) NET INCREASE IN CASH 30,000 BEGINNING CASH 40,000 ENDING CASH $ 70,000 12

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