The ABC s of 123 s (The Simple Secrets to Accounting Wisdom.) Thank You for attending our QuickBooks seminar today. Your time is valuable and our goal is to make sure it is well spent. QuickBooks is a wonderfully simple accounting program for the typical small business; but, to get the most out of your QuickBooks, it is important that you understand the basic accounting concepts that QuickBooks automates for you behind the pretty screens used for data entry. Let QuickBooks do the bookkeeping so that you are free to do what you do best run your business! The basic accounting concepts presented here are affectionately referred to as The ABC s of 123 s. It generally will surprise the non-accountant to learn that there are only three places to post a bookkeeping entry. If you can count to three, you can do your own bookkeeping and business related accounting! The purpose of an accounting system in business, whether it s QuickBooks or another program, is to track the flow of money in your business. Money is always flowing, from point A to point B, like the currents of a river. In fact, that s why money is referred to as currency. So QuickBook s main purpose is to track the flow of your money in your business. Naturally, the hope of all entrepreneurs is that more money flows into your business than out of your business! There are two sides to each and every business transaction. For example, you pay the rent the money flows out of your hands into the hands of the landlord. Your hands and the hands of the landlord are the two sides to that particular transaction. Let s say you sell flowers. Someone buys the flowers from you the money flows into your hands out of the customer s hands the two sides to the transaction. When you pay your suppliers for the flowers you sold, the process continues. QuickBooks simplifies the bookkeeping of the two sides of each business transaction. When you make a sale, typically the money goes into your checking account (one side of the transaction) and is also recorded as a sale on your books (the other side of the transaction). When you purchase something for your business, the money usually comes out of your checking account (one side of the transaction) and is recorded as an expense on your books (the other side of the transaction). That s a simplified look at the two sides of any given transaction. Now let s explore the idea mentioned earlier that there are only three places to bookkeep any business transaction. The three places to bookkeep any transaction in business are,, and. If this were Harvard Business School, and this were the first day of class, the following formula would be on the board: = +. Please don t be intimidated by the math or the fancy words the concept is really quite simple and will be explained below. However,,, and are the ONLY three places a bookkeeping entry can be posted in an accounting system, and the formula presented above is the universal business formula, I
whether you are talking Wall Street or Main Street. Once the terms are properly defined, you will quickly see the simplicity and meaning behind a set of books. An Asset, simply put, is any thing of value in a business that typically lasts for one year or more. For arguments sake, let s define of value as any single item that costs at least $500 or more. Likewise, if you spend $500 on office supplies that will be used up in 90 days to 6 months, the expected life span of the supplies is less than 1 year and would therefore NOT qualify as an asset. Office supplies, in fact, are typically expensed when purchased. A Liability, simply put, is where a business (or individual) owes another entity, typically a creditor such as a bank, a credit card company, or a supplier, a stated amount of principal, to be paid back over a given time period, at an agreed upon interest rate. Monthly bills such as utilities and general operating expenses are not considered liabilities or debt. are defined by the intention of borrowing money or incurring debt for a specific purpose, typically to finance equipment, buildings, and possibly inventory. And, simply put, reflects the net amount of ownership interest a business owner has in the of the business. The simplest example, to which most people can readily relate, is the a person has in his or her home. It is calculated easily by taking the appraised value of the home, say $300,000 in this example, and subtracting the outstanding balance of any mortgages on the home, say $175,000 in this example. Using the values provided, the in the home would be $300,000 - $175,000 = $125,000. If the owner were to sell the home, and pay off the mortgages, then the owner would have $125,000 in cash left over at the end of the day that cash left over reflects the owner s equity in the home. So whenever you see the classic business formula = +, you now know the big picture verity of business accounting. The Home ($300,000) = the Mortgage ($175,000) + the ($125,000); and these three places,,, and, are the ONLY three places that a business transaction can be bookkeep or posted to an accounting system, such as QuickBooks. Also, the big picture formula depicted above, ( = + ), is a common business report, generated by all accounting systems, known as the Balance Sheet. The reason it s called the Balance Sheet is because the left side of the formula (in this example, $300,000) must ALWAYS equal (or be in balance with) the right side of the formula (in this example, $175,000 + $125,000). From now on, when you see a Balance Sheet, ask yourself these two questions: First, what are the of the business (there will be a list of things the business owns); then Second, ask yourself, where did the come from? The Asset list will tell you what the are, the will show what part or portion of the were provided by creditors through financing, and the will reflect that net portion of the owned free and clear by the owner(s) of the business. II
Another way to look at a Balance Sheet is as follows: First, as above, what are the of the business (there will be a list of things the business owns); then Second, ask yourself, who can stake a legal claim to the of the business. Financial accounting records (the Balance Sheet), if properly compiled, should reflect the legal financial position of the business in the marketplace, according to the tenants of business law, at any given point in time. So, when looking at a Balance Sheet, ask the question, what are the of the business, and who can legally stake a claim to those in the unlikely event of a dissolution of the business? The creditors, the, are typically in the first, or majority position; while the owner(s), the, are in a second, or subordinate position. If the business should fail, the would be sold, the would be satisfied to the extent possible, and perhaps there might be something left in the form of for distribution to the owner(s). Now, let s run through some basic transactions common to most businesses on a routine basis. We will post or bookkeep the transactions to our paper accounting system and see the impact or effect of those transactions on the books of the business. The transactions outlined herein will be duplicated in the QuickBooks seminar, so you will not only get a theoretical accounting presentation in this summary, but you will also see how these transactions are actually entered into QuickBooks and the resulting financial statements generated there from. On any given day, most businesses will perform the following four transactions: Make Deposits, Write Checks, Invoice Customers, and Post Vendor Bills. The first two activities (Making Deposits & Writing Checks) are commonly related to businesses which operate from their check books only, then need a way to post the activity data to QuickBooks after-the-fact. This form of accounting is often referred to as Cash Basis or shoe box accounting. By Shoe Box accounting, imagine putting all incoming receipts in a shoe box, then pay all bills out of the shoe box at the end of the year, what s left in the shoe box is how much money the business made. The second two activities (Invoicing Customers & Posting Vendor Bills) are generally defined as Accrual Basis accounting. There can be a debate as to which form of accounting is more accurate Cash Basis vs. Accrual but, one thing that is clear, Accrual Basis reflects where your business stands legally, according to the tenants of business law, in the market place at any given point in time, which is the goal of financial accounting. Using Accrual Basis accounting, a business owner would invoice its customers once a product has been sold or a service rendered. On the date that a business has fulfilled its duty in a contract, a sale is recorded on the books (one side of the business transaction) and an Accounts Receivable (often referred to as an A/R) is also established on the books (the other side of the business transaction). The sale is recorded once the money is III
earned, even if the money is not paid (in hand) at the date the sale is complete. Similarly, on the date that a business has become obligated in a purchase activity or transaction, once the vendor or supplier has fulfilled its duties in the contractual relationship, the business should recognize on the books the fact that it has incurred an expense (one side of the transaction) and simultaneously incurred a liability (the other side of the transaction) in the form of an Accounts Payable (often referred to as an A/P). So let s see what happens when we make the initial deposit into a business to open our doors. Basically, all that happens is that the owner opens up a checking account and places some money, referred to as Initial Capital, into the account. Let s assume our owner places $10,000 into the checking account. Here s what the books would look like immediately after the account is open. (Cash) $10,000 = (None) + (Initial Capital) $10,000 Shown another way, stating the SAME concept, we could say: Cash $10,000 Total $10,000 Total $00.00 Total $10,000 The up and down presentation is typically how financial statements are presented in the world of business, so let s gravitate that way for our purposes as well. Whether up or down, or side to side, the concept is the same: The of a business will always equal the of a business plus the of the business that is the big picture accounting verity (immutable truth) of any bookkeeping system. The formula will always be true, no matter what! Another important concept to share here and now is the fact that once a business owner places the initial capital into a business, it is assumed the initial capital always stays in the business. So in this example, since our owner placed $10,000 into the business as startup capital, that $10,000 is assumed to always stay in the business as startup capital. That way, the owner can always look at the books and see where the business started as compared to where the business stands today or some other date in the future. IV
Now let s assume the owner decides to rent some space for the business. The owner would probably write a check to the landlord to pay the rent. Let s assume the rent is $1,000. After writing the check, the books would look as follows: Cash $9.000 Total $9,000 Total $00.00 Total $9,000 You will notice here, that as the owner spent the $1,000 to pay the rent, the owner s equity, or initial capital, in the business was reduced or decreased by the expenditure. Simply put, as the owner makes decisions to spend money to operate the business, those decisions will have an impact on the business, and the impact will be a reduction in the owner s capital in the business. V
Now let s assume the owner decides to have the lights turned on and pays $500 to the local electric company. After the expenditure, the books would look as follows: Cash $8,500 Total $8,500 Total $00.00 Total $8,500 Once again, notice how the owner equity goes down, or is reduced, to the extent of, or by, the expenditure. When an owner spends money, the net capital goes down, there is no other choice on the books. VI
Now let s assume the business owner is ready to open the doors of the business and starts making sales. Further assume that on the first day of the business, things went great and $4,000 in sales were made! Once the doors were closed at the end of the day, our owner immediately took the daily sales receipts of $4,000 to the bank and deposited the funds into the checking account. Here s what the books would look like after the close of business on the first day: Cash $12,500 Total $12,500 Total $00.00 Plus: Sales Revenue +$4,000 Total $12,500 Notice how, in the above example, the money deposited into the bank (one side of the transaction) is offset by the increase in the owner s equity due to the sales revenue recorded (the other side of the transaction). In short summation, notice how the owner s equity in the business goes UP (increases) each time a sale is made, and also notice how the owner s equity in the business goes DOWN (decreases) each time an expense is incurred. That s pretty much it, in a nutshell, as far as cash basis accounting goes. Money into the checking account from sales increases the owner s equity in the business. Money out of the checking account from expenses decreases the owner s equity in the business. VII
Now let s examine Accrual Based accounting examples to see what happens to the books when we post an Account Receivable A/R) and also an Account Payable (A/P). Remember, in business, it is important to record the fact that a customer owes us money once we have completed our part of the bargain in a sales transaction. It is common that a customer may pay later for goods or services already delivered, but we want to keep track of the fact that the customer owes us the money. Also remember, in business, it is important to record the fact that we owe a vendor or supplier money once the vendor or supplier has completed its part of the bargain in a purchase transaction. It is common that a business owner may pay later for goods or services already received or delivered, but we want to keep track of the fact that we owe the vendor or supplier the money. So let s assume we make a $100 sale on account we delivered the goods or services today, but expect to get paid later. We have completed our part of the bargain, fulfilled our duties in the contract, but will be paid at a future date. We want to record the sale today, because that s when it was made, but we did not get the cash today. So on the books, we record the sale today (one side of the transaction) and also record simultaneously an account receivable (the other side of the transaction) because the customer still owes us the money. Here s what the books would look like after the above: Cash $12,500 Accounts Receivable $100 Total $12,600 Total $00.00 Plus: Sales Revenue +$4,100 Total $12,600 VIII
Once again, notice how the increase in assets in the form of an account receivable is offset by an increase in the equity of the business due to a sale. Even though the money was not collected at the time the sale was made, we still record the sale (because the money was earned) and show the offset as an account receivable. Later when the customer pays, here s what the books would look like: Cash $12,600 Accounts Receivable $00.00 Total $12,600 Total $00.00 Plus: Sales Revenue +$4,100 Total $12,600 Especially notice here, when the $100 is paid, we did NOT record the sale a second time. When the money was paid by the customer, a deposit was made into the checking account and the cash balance went up; and at the same time, the accounts receivable balance went down or was reduced to the extent of the payment. IX
To wrap up our examples of accrual based accounting, let s assume we have an account at Office Depot. When we buy office supplies there, we place the charge on our account and they bill us later. Further, let s assume we spend $200 on office supplies one day, and we intend to pay for those supplies sometime in the near future, when the bill becomes due. Here s what the books would look like immediately after we bought the supplies and owed Office Depot $200: Cash $12,600 Accounts Receivable $00.00 Total $12,600 Accounts Payable $200 Total $200.00 Plus: Sales Revenue +$4,100 Office Supplies ($200) Total $12,400 Notice in this example how the liabilities went up (increased) to the extent of the account payable (one side of the transaction) while simultaneously the owner equity went down to the extent of the office supplies purchased (the other side of the transaction). In this case, the owner bought the office supplies even though payment was not made at the time of purchase. But, the owner owed the money at that point in time, so we want the books to show both facts: the business owed the money; and simultaneously, the business incurred an expense! X
To complete our example of owing the money for office supplies purchased at a prior date, let s assume we make payment to Office Depot once the bill comes due. Here s what the books would look like immediately after making payment: Cash $12,400 Accounts Receivable $00.00 Total $12,400 Accounts Payable $00.00 Total $00.00 Plus: Sales Revenue +$4,100 Office Supplies ($200) Total $12,400 Here, please notice that the cash balance decreased by the $200 paid (one side of the transaction) and simultaneously the accounts payable balance also went down by $200 (the other side of the transaction). Especially note that when the $200 was paid, we did NOT record the payment as an expense at that time. The expense was recorded earlier when the account payable was initially put on the books! Congratulations! The above synopsis covers everything you need to know before coming to class. In fact, it hopefully summarizes everything you need to know about accounting and bookkeeping for a small business! I look forward to meeting you at the QuickBooks seminar and please try to bring a USB memory stick to class if you want to back up the practice data file we will create together. XI