It starts with a vision. A big idea. You know how to do something or make something or provide something better than anyone else. So you start a business. You’ve never taken an accounting class. Maybe you’ve heard of Debits and Credits, but your focus is on your dream, not the numbers. Here are the very basic things you need to know:
Profit and Loss
Also known as an Income Statement, a P&L tells you how much money you made (or didn’t make) in a given time period. It’s a vertical listing of your accounts and how much you took in or spent for each one.
Income or Revenue will be at the top, probably in a category called Sales or something along those lines. Below it will be your expenses in corresponding categories like Insurance, Office Supplies, or Payroll. This is so you can see not only how much money went out, but who got it.
At the very bottom will be a line called Net Income (or Loss). That’s the amount of money that’s left over from the Income after you deduct all of the expenses. Let’s hope it’s a positive number. If it is positive, it’s profit. If it’s negative, it’s a loss.
At the end of your accounting period – usually a year – all of your P&L accounts go to zero and start over. The Net Income (or Loss) turns into Retained Earnings and goes onto your Balance Sheet.
This is a list of Assets and Liabilities. Assets are things you have – cash in the bank, inventory, Fixed Assets like vehicles. Liabilities are things you owe – loans, credit card balances, Accounts Payable to your vendors. The difference between your Assets and your Liabilities is your Equity. A Balance Sheet always balances. Assets = Liabilities + Equity.
These are forever accounts. They do not zero out at the end of a period. Your bank balance continues month to month, regardless of your accounting period. So do your loans and your other Balance Sheet accounts. They keep a running balance for the life of your business.
Cash or Accrual
These are the two methods of accounting – either by Cash Basis or Accrual Basis. What’s the difference?
Cash Basis means that you count your income or your expenses ONLY when the cash has changed hands. If your customer owes you $100, you don’t consider that income until you GET the $100. If you owe your supplier $50, you don’t count that as an expense until you physically PAY the $50. Your accounting is measured by your CASH in and out of your bank.
Accrual Basis is an attempt to match income and expenses to the appropriate periods when they took place. On Accrual Basis, you have income the moment you sell something and create an invoice for it. If your customer owes you $100, you show $100 of income even if they haven’t paid you. If you buy something from a Vendor today and take it home with you, you recognize that expense even if you have not paid for it yet. Your accounting is measured by what’s happening in time, whether the money has changed hands or not.
“I paid my mortgage every month! Why don’t I see that in my P&L?” Good question. Loan payments are not expenses. A loan payment is reducing a liability. Let’s say you bought a car for $5000. You put no money down and you financed the entire thing. Your books will show a FIXED ASSET of a Vehicle for $5000 and a corresponding LOAN PAYABLE for that Vehicle for $5000. (remember – your Balance Sheet has to balance, so the entry for the Asset has to equal the entry for the Liability).
Now it’s time to make that first payment. To make it easy, let’s say that the payment is $200 of which $180 goes to pay down the loan (the principal), and $20 is for interest. Then your books will show the loan amount is now $4820, (5000 minus 180), and you’ll see INTEREST EXPENSE on your P&L of $20. The interest that you pay for the loan is an expense. The principal reduces the loan.
“But what about the expense of the vehicle!” Another good question. That shows up as DEPRECIATION. Every asset you own depreciates (lessens in value) over time. There are IRS rules regarding how much depreciation is allowed over what time period. Your CPA will give you entry at the end of the year called Depreciation Expense. This allows you to deduct part of the vehicle’s value as an expense, and it reduces the value of the vehicle on your Balance Sheet.
One common mistake of new business owners is tagging that entire payment to the IRS as an Expense. It’s not. Only the matching taxes are an expense. Let’s look at why. We’re going to use some simple numbers to make it easy to understand. Let’s say your employee earns $1000 per week. The paystub will look something like this:
Wages – $1000
Federal Withholding – $100 (just an example; it depends on a variety of things)
Social Security – $62 (always 6.2 percent)
Medicare – $14.50 (always 1.45 percent)
Net Pay – $823.50
There may or may not be state taxes too. For our example, we’ll assume federal taxes only.
The federal government requires employers to match social security and Medicare payments. So when you file the payroll taxes for this period, the total will be $253.00. How much of that is an expense to you?
Here’s how that $253 breaks down:
$100 – the amount your employee has withheld for his income tax
$62 – the amount your employee must pay for social security
$14.50 – the amount your employee must pay to Medicare
$62 – the amount YOU must pay for social security (matching)
$14.50 – the amount YOU must pay for Medicare (matching)
Now you can easily see how much of that $253 is an expense to you. The top three numbers (100, 62, 14.50) are your employee’s money that you held out of his check and are turning in to the federal government on his behalf. The bottom two (62 and 14.50) are your money that the federal government requires you to pay for your employee. So your expense is $$76.50.
These are just a few examples of accounting things you need to know in recording your income and expenses. There are much more, but master these, and you’re on the way to a better understanding of your company’s numbers.