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Accounting Basics If you understand the definition, you are ready to learn the following accounting concepts and definitions. Assets: Things of value held by the business. Assets are sheet accounts. Examples of assets are cash, accounts receivable, and furniture and fixtures. Liabilities: What your business owes creditors. Liabilities are balance sheet accounts. Examples are accounts payable, payroll taxes payable, and loans payable. Equity: The net worth of your company. Also called owner's equity or capital. Equity comes from investment in the business by the owners, plus accumulated net profits of the business that have not been paid out to the owners. It essentially represents amounts owed to the owners. Equity accounts are balance sheet accounts. The accounting equation: Assets = liabilities + owner's equity. The financial statement called the balance sheet is based on the "accounting equation." Note that assets are on the left-hand side of the equation, and liabilities and equities are on the right-hand side of the equation. Similarly, some balance sheets are presented so that assets are on the left, liabilities and owner's equity are on the right. Balance sheet: Also called a statement of financial position, a balance sheet is a financial "snapshot" of your business at a given date in time. It lists your assets, your liabilities, and the difference between the two, which is your equity, or net worth. The balance sheet is a real-life example of the accounting equation because it shows that assets = liabilities + owner's equity. Once you master the above accounting terms and concepts, you are ready to learn about the following day-to-day accounting terms. Debits: At least one component of every accounting transaction (journal entry) is a debit amount. Debits increase assets and decrease liabilities and equity. For this reason, you will sometimes see debits entered on the left-hand side (the asset side of the accounting equation) of a two-column journal or ledger. Credits: At least one component of every accounting transaction (journal entry) is a credit amount. Credits increase liabilities and equity and decrease assets. For this reason, you will sometimes see credits entered on the right-hand side (the liability and equity side of the accounting equation) of a two-column journal or ledger. Note: In bookkeeping texts, examples, and ledgers, you may see the words "Debit" and "Credit" abbreviated. Dr. stands for Debit; Cr. Stands for Credit. Double-entry accounting: In double-entry accounting, every transaction has two journal entries: a debit and a credit. Debits must always equal credits. Because debits equal credits, double-entry accounting prevents some common bookkeeping errors. Errors that do occur are easier to find. Double-entry accounting is the basis of a true accounting system. In double-entry accounting, every transaction in your business affects at least two accounts, since there is at least one debit and one credit for each transaction. Usually, at least one of the accounts is a balance sheet account. Entries that are not made to a balance sheet account are made to an income or expense account. Income and expenses affect the net profit of the business, which ultimately affects owner's equity. Each transaction (journal entry) is a real-life example of the accounting equation (assets = liabilities + owner's equity). Some simple accounting systems do not use the double-entry system. You will have to choose between double-entry and single-entry accounting. Because of the benefits described above, we recommend double-entry accounting. Many accounting programs for the computer are based on a double-entry system, but are designed so that you enter each transaction once, and the computer makes the corresponding second entry for you. The double-entry part goes on "behind the scenes," so to speak. You also need to decide whether you will be using the cash or accrual accounting method. We recommend the accrual method because it provides a more accurate picture of your financial situation. Definitions of Accounting Terms The following terms are often used by accountants, in accounting software, and in fact throughout our discussion. We've placed their definitions here so that you can print them out, if you wish. Definitions are also scattered throughout the text when you see blue or gray underlined text, click on the word to get more information.

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Accounting equation:Assets = liabilities + owner's equity. The accounting equation is the basis for the financial statement called the balance sheet. Accounts payable: Also called A/P, accounts payable are the bills your business owes to suppliers. Accounts receivable: Also called A/R, accounts receivable are the amounts owed to you by your customers. Accrual method of accounting: With the accrual method, you record income when the sale occurs, not necessarily when you receive payment. You record an expense when you receive goods or services, even though you may not pay for them until later. Adjusting entries: Special accounting entries that must be made when you close the books at the end of an accounting period. Adjusting entries are necessary to update your accounts for items that are not recorded in your daily transactions. Aging report: An aging report is a list of customers' accounts receivableamounts and their due dates. It alerts you to any slow-paying customers. You can also prepare an aging report for your accounts payable, which will help you manage your outstanding bills. Allowance for bad debts: Also called reserve for bad debts, it is an estimate of uncollectable customer accounts. It is known as a "contra" account because it is listed with the assets, but it will have a credit balance instead of a debit balance. For balance sheet purposes, it is a reduction of accounts receivable. Assets: Things of value held by the business. Assets are balance sheetaccounts. Examples of assets are cash, accounts receivable, and furniture and fixtures. Balance sheet: Also called a statement of financial position, it is a financial "snapshot" of your business at a given date in time. It lists your assets, your liabilities, and the difference between the two, which is your equity, or net worth. Capital: Money invested in the business by the owners. Also called equity. Cash method of accounting: If you use the cash method, you record income only when you receive cash from your customers. You record an expense only when you write the check to the vendor. Chart of accounts: The list of account titles you use to keep your accounting records. Closing: Closing the books refers to procedures that take place at the end of an accounting period. Adjusting entries are made, and then the income and expense accounts are "closed." The net profit that results from the closing of the income and expense accounts is transferred to an equity account such as retained earnings. Corporation: A legal entity, formed by the issuance of a charter from the state. A corporation is owned by one or more stockholders. Cost of goods sold: Cost of inventory items sold to your customers. It may consist of several cost components, such as merchandise purchase costs, freight, and manufacturing costs. Credit memo: Writing off all or part of a customer's account balance. A credit memo would be required, for example, when a customer who bought merchandise on account returned some merchandise, or overpaid on their account. Credits: At least one component of every accounting transaction (journal entry) is a credit. Credits increase liabilities and equity and decrease assets. Current assets: Assets that are in the form of cash or will generally be converted to cash or used up within one year. Examples are accounts receivable and inventory. Current liabilities: Liabilities payable within one year. Examples are accounts payable and payroll taxes payable. Debit memo: Billing a customer again. A debit memo would be required, for example, when a customer has made a payment on their account by check, but the check bounced. Debits: At least one component of every accounting transaction (journal entry) is a debit. Debits increase assets and decrease liabilities and equity. Depreciation: An annual write-off of a portion of the cost of fixed assets, such as vehicles and equipment. Depreciation is listed among the expenses on theincome statement. Double-entry accounting: In double-entry accounting, every transaction has two journal entries: a debit and a credit. Debits must always equal credits. Double-entry accounting is the basis of a true accounting system. Drawing account: A general ledger account used by some sole proprietorships and partnerships to keep track of amounts drawn out of the business by an owner. Equity: The net worth of your company. Also called owner's equity or capital. Equity comes from investment in the business by the owners, plus accumulated net profits of the business that have not been paid out to the owners. Equity accounts are balance sheet accounts.

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Expense accounts: These are the accounts you use to keep track of the costs of doing business: where your money goes. Examples are advertising, payroll taxes, and wages. Expenses are income statement accounts. Fixed assets:Assets that are generally not converted to cash within one year. Examples are equipment and vehicles. Foot: To total the amounts in a column, such as a column in a journal or a ledger. General ledger: A general ledger is the collection of all balance sheet, income, and expense accounts used to keep the accounting records of a business. Income accounts: These are the accounts you use to keep track of your sources of income. Examples are merchandise sales, consulting revenue, and interest income. Income statement: Also called a profit and loss statement or a "P&L." It lists your income, expenses, and net profit (or loss). The net profit (or loss) is equal to your income minus your expenses. Inventory: Goods you hold for sale to customers. Inventory can be merchandise you buy for resale, or it can be merchandise you manufacture or process, selling the end product to the customer. Journal: The chronological, day-to-day transactions of a business are recorded in sales, cash receipts, and cash disbursements journals. A general journal is used to enter period end adjusting and closing entries and other special transactions not entered in the other journals. In a traditional, manual accounting system, each of these journals is a collection of multi-column spreadsheets usually contained in a hardcover binder. Liabilities: What your business owes creditors. Liabilities are balance sheetaccounts. Examples are accounts payable, payroll taxes payable, and loans payable. Long-term liabilities: Liabilities that are not due within one year. An example would be a mortgage payable. Merchandise inventory: Goods held for sale to customers. Net income: Also called profit or net profit, it is equal to income minus expenses. Net income is the bottom line of the income statement (also called the profit and loss statement). Partnership: An unincorporated business with two or more owners. Post: To summarize all journal entries and transfer them to the general ledgeraccounts. This is done at the end of an accounting period. Prepaid expenses: Amounts you have paid in advance to a vendor or creditor for goods or services. A prepaid expense is actually an asset of your business because your vendor or supplier owes you the goods or services. An example would be the unexpired portion of an annual insurance premium. Prepaid income: Also called unearned revenue, it represents money you have received in advance of providing a service to your customer. Prepaid income is actually a liability of your business because you still owe the service to the customer. An example would be an advance payment to you for some consulting services you will be performing in the future. Profit and loss statement: Also called an income statement or "P&L." It lists your income, expenses, and net profit (or loss). The net profit (or loss) is equal to your income minus your expenses. Proprietorship: An unincorporated business with only one owner. Reserve for bad debts: Also called allowance for bad debts, it is an estimate of uncollectable customer accounts. It is known as a "contra" account because it is listed with the assets, but it will have a credit balance instead of a debit balance. For balance sheet purposes, it is a reduction of accounts receivable. Retained earnings: Profits of the business that have not been paid to the owners; profits that have been "retained" in the business. Retained earnings is an "equity" account that is presented on the balance sheet and on thestatement of changes in owners' equity. Sole proprietorship: An unincorporated business with only one owner. Trial balance: A trial balance is prepared at the end of an accounting period by adding up all the account balances in your general ledger. The debit balances should equal the credit balances. Unearned revenue: Also called prepaid income, it represents money you have received in advance of providing a service to your customer. It is actually a liability of your business because you still owe the service to the customer. An example would be an advance payment to you for some consulting services you will be performing in the future. Cash vs. Accrual Accounting There are two basic accounting methods available to most small businesses: cash or accrual.

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Cash method. If you use the cash method of accounting, you record income only when you receive cash from your customers. You record an expense only when you write the check to the vendor. Most individuals use the cash method for their personal finances because it's simpler and less time-consuming. However, this method can distort your income and expenses, especially if you extend credit to your customers, if you buy on credit from your suppliers, or you keep an inventory of the products you sell. Accrual method. With the accrual method, you record income when the sale occurs, whether it be the delivery of a product or the rendering of a service on your part, regardless of when you get paid. You record an expense when you receive goods or services, even though you may not pay for them until later. The accrual method gives you a more accurate picture of your financial situation than the cash method. This is because you record income on the books when it is truly earned, and you record expenses when they are incurred. Income earned in one period is accurately matched against the expenses that correspond to that period, so you get a better picture of your net profits for each period. Pros and cons. The cash method is easier to maintain because you don't record income until you receive the cash, and you don't record an expense until the cash is paid out. With the accrual method, you will typically record more transactions. For example, if you make a sale on account (or, on credit), you would record the transaction at the time of the sale, with an entry to thereceivables account. Then, when the customer pays the bill, you will record the receipt on account as another transaction. With the cash method, the only transaction that is recorded is when the customer pays the bill. If you are using computer software to do your accounting, this is probably not a big concern, since the computer program automates much of the extra effort required by the accrual method. Another issue to be considered is the accounting method you use for tax purposes. For convenience, you probably want to use the same method for your internal reporting that you use for tax purposes. However, the IRS permits you to use a different method for tax purposes. Some businesses can use the cash method for tax purposes. If you maintain an inventory, you will have to use the accrual method, at least for sales and purchases of inventory for resale. We recommend the accrual method for all businesses, even if the IRS permits the cash method, because accrual gives you a clearer picture of the financial status of your business. You probably need to keep a record of accounts receivable and accounts payable anyway, so you are already keeping track of all the information needed to do your books on the accrual basis. If you are using a software system, there really isn't much extra effort involved in using the accrual method. Who Can Use the Cash Method? Although the IRS allows all businesses to use the accrual method of accounting, most small businesses can instead use the cash method for tax purposes. The cash method can offer more flexibility in tax planning because you can sometimes time your receipt of revenue or payments of expenses to shift these items from one tax year to another. However, some businesses must use the accrual method: corporations that are not S corporations and partnerships that have at least one corporation (other than an S corporation) as a shareholder. There are some exceptions to these restrictions the cash method is available for farming businesses and entities (including corporations) with average annual gross receipts of less than five million dollars for all prior years. Tax shelters may never use the cash method. If your business has inventories, you must use the accrual method, at least for sales and merchandise purchases. If you are thinking about using the cash method of accounting for tax purposes, you should discuss these rules with your accountant. Single- or Double-Entry Accounting The double-entry systemprovides checks and balances to ensure that your books are always in balance. In double-entry accounting, every transaction has twojournal entries: a debitand a credit. Debits must always equal credits. Because debits equal credits, double-entry accounting prevents some common bookkeeping errors. Errors that aren't prevented are easier to find. Double-entry accounting is the basis of a true accounting system. With double-entry accounting, every transaction in your business affects at least two accounts, since there is at least one debit and one credit for each transaction. Usually, one of the accounts is a balance sheet account. Entries that are not made to a balance sheet account are made to an income accountor expense account. Income and expenses affect the net income of the business, which ultimately affects owner's equity. Each transaction (journal entry) is a real life example of the accounting equation (assets = liabilities + owner's equity).

Ex: You provide consulting services, on account, to one of your regular customers, Betty Fry, for $1,500. When you write up the invoice, you would make the following bookkeeping entry in your sales journal: Debit Credit Accounts receivable (Fry) Consulting revenue 1,500 1,500

These entries show that your accounts receivable (a balance sheet account) has increased by $1,500, and your consulting revenue (an income statement account) has also increased by $1,500. Ex: Upon receipt of the invoice, your customer sends you a check for $1,500 in payment of her account. When you receive the check, make the following entry in yourcash receipts journal: Debit Cash Accounts receivable (Fry) 1,500 1,500 Credit

These entries show that your cash (a balance sheet account) has increased by $1,500, and your accounts receivable have decreased by $1,500. Single-entry accounting. Rather than dealing with debits and credits, some businesses just record one side of the transaction. This is a single-entry accounting system. In the above example, you would simply record the revenue amount of $1,500 in your sales journal. However, you would also want to make a separate entry in your accounts receivable ledger, so that you keep track of all customers that owe you money. We recommend a double-entry accounting system because it will result in more accurate financial records. Because debits must always equal credits, a double-entry system will help you find common bookkeeping errors. Such errors include an amount entered incorrectly, forgetting to record a transaction, improperly copying an amount from one page to another, and transposition errors. If your accounts don't balance (total debits don't equal total credits), you know you've made an error that must be investigated. If you use a computer, the good news is that many accounting software programs will allow you to make a single entry for a transaction, and the software will make the second entry for you. The double-entry system is still there, but it exists mostly "behind the scenes." Daily Recording of Transactions In order to take control of your financial recordkeeping, you must accurately record your day-to-day sales, purchases, and other transactions. Specifically, you need to record: sales and revenue transactions cash transactions accounts receivable, if you extend credit to your customers accounts payable, if you purchase from your suppliers on credit summaries of transactions in your general ledger Do you have more than one product line or department? If possible, you may want to keep a separate set of books for each. Separate accounting will provide you with more meaningful information. It may show you that one product line or department is profitable, and another is not. Unfortunately, it may be difficult to keep a separate set of books for each product line or department. For example, some or all expenses may not apply to only one department, but must be allocated among departments. You should seek the advice of an accountantbefore setting up an accounting system of this nature. There are many software solutions on the market to help you automate your accounting procedures. Shop around. Accounting software is sold in office supply stores, software outlets, electronics stores, mail order houses, and directly from software publishers. Ask for your

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accountant's opinion. Your accountant may want you to use software that is compatible with the system he or she uses. If you have employees, look for accounting software that permits the use of passwords to control access to all or some of your accounting transactions. In order to prevent irregularities by your employees or others, it's wise to restrict access to your accounting records. Whether your business is a sole proprietorship, partnership, or corporation, always keep your personal transactions separate from your business transactions. For example, using business funds to pay for personal expenditures complicates your recordkeeping and can lead to serious tax problems. It can also result in some hefty accounting fees as you pay your accountant to sort it all out. Sales and Revenue Transactions You record daily sales in a sales journal. To simplify your bookkeeping, we recommend a combined sales and cash receipts journal. With a journal that combines sales and cash receipts, you record all sales (cash and credit) and all cash receipts, including collection ofaccounts receivable, in one journal. Entries in your sales and cash receipts journal come from the source documents you use in your business every day. These documents are sales invoices, daily cash register totals, daily cash sheets, and daily sales registers. Sales invoices. If you use sales invoices, you will post the information from each invoice to an entry in the sales journal. If you maintain customer charge accounts, you will also be posting entries to the accounts receivable ledgers so that each customer account is up-to-date. Sales invoices should be numbered. At a minimum, prepare two copies; give one copy to the customer, and retain the other. Preferably, you should prepare the invoices in triplicate, with two copies retained by you. File one by customer name; the other by invoice number. Include canceled or voided invoices when filing by number, so that you can account for all of them. The invoice should show the date of the sale, quantity, if applicable, price or rate, an extension column, if applicable (quantity multiplied by price), and a payment due date. If you use a computer software program to perform your accounting, it probably has a pre-designed sales invoice that you can use. Most office suites (such as Microsoft Office or OpenOffice.org) also contain a template that may be used as a starting point to design your own sales invoice. In addition, free templates may be found on a number of websites. Cash register totals. If you use a cash register, daily sales can be totaled on the register. Most new cash registers should be able to separately record cash sales and charge sales, and keep track of sales tax. Some should also be able to record cash received on account. At the end of the business day, record your cash register totals in the sales journal.

Ex: You total the cash registers of your automotive supply store at the end of the day. The totals show cash receipts of $1,640, cash and charge sales of $1,325 and $450, respectively, which include sales tax of $75, and $315 received for payment on customer charge accounts. You will make the following entry in your combined sales and cash receipts journal: Debit Credit Cash Accounts receivable Sales Accounts receivable Sales tax payable 1,640 450 1,700 315 75

When you become more comfortable with bookkeeping entries, you could simplify the above entry slightly by "netting" the change in accounts receivable for the day:

Debit Credit Cash Accounts receivable Sales Sales tax payable 1,640 135 1,700 75

Cash sheets and sales registers. If you don't use a cash register, you can record cash receipts on a daily cash sheet and record sales on a columnar sales register. The sales register is simply a record of each sale for the day. Total the cash sheet and sales register at the end of the day. Enter the totals in the sales and cash receipts journal. Sales and Cash Receipts Journal There are many different types of sales journals and cash receipts journals available. To simplify your bookkeeping, we recommend a combined sales and cash receipts journal. If you are going to be recording sales and cash receipts manually in a journal, visit an office supply store. They will have many different kinds for you to choose from. Look at the different column headings, and choose the one that best meets the needs of your business. If you will be using computer software, you probably won't have to decide which type of journal to use. Your program will probably have some type of sales and cash receipts journal, but may allow you to customize it based on your type of business. Assume that your business is a retail sales outlet that extends credit to some customers. Here is an example of a few entries in a combined sales and cash receipts journal. The following transactions occurred: On February 2, you sold, on credit, $476 worth of goods to Sandra Shaw. Sales tax on that amount is $24. Since Shaw owes you a total of $500 (476.00 + 24), your accounts receivable have increased by that amount. Also on February 2, Tamara Dwight paid you her account balance of $1,359. On February 5, several customers bought merchandise for cash. Total cash sales were $682. On those sales, $34 of sales tax was collected, adding up to a total of $716 of cash receipts from your customers. On February 6, Sandra Shaw paid her balance of $500. Upon completion of this journal page, you should foot all five amount columns. Since you are using a double-entry accounting system, you can check to see if all entries were recorded correctly. Make sure the sum of the debits equals the sum of the credits. Total debits: 2,575 + 500 = 3,075. Total credits: 1,859 + 1,158 + 58 = 3,075.

SALES AND CASH RECEIPTS JOURNAL FOR: FEBRUARY 2010 Accounts Receivable Dat e 2 2 5 6 Description Invoice Numbe r Cash Debit Debit 500 1,359 716 500 500 1,359 682 34 Credit Sales Credit 476 Sales Tax Payable Credit 24

S. Shaw - sale on account 10034 T. Dwight - received on account Daily Cash Sales S. Shaw - received on

account Totals 2,575 500 1,859 1,158 58 If the sum of the debit columns doesn't equal the sum of the credit columns, you have a problem that you should investigate right away. You may have recorded one of the amounts in the wrong column. Maybe you charged the customer the wrong amount. Or you might have simply added incorrectly when computing the totals. It is usually easy to pinpoint the error because the debits should equal the credits for each transaction. Your sales and cash receipts journal will probably have more columns than our sample. For example, you could have more than one column for "Sales" by splitting your sales into categories. You might have one column labeled "Parts and Supplies Sales" and another labeled "Service and Repair Revenue." This could provide you with more meaningful information. The way you do business might require additional columns. For example, if you give a discount to your charge customers who pay within 10 days, you could add a column labeled "Sales Discounts Dr." Cash Transactions A typical small business has a variety of different types of cash transactions, which should be recorded in a number of different places: Sales and cash receipts journal: to simplify your recordkeeping, we recommend that you combine your salesand cash receipts in a combined journal. Daily cash sheet: if a lot of cash moves in and out of your business each day, you should also prepare a daily cash sheet to reconcile your cash received and paid out for the day. If you use a daily cash sheet, you can reconcile your cash receipts with your daily deposit into your bank account. A bank reconciliation: a bank reconciliation, at the end of every month, verifies the amount you have in your checking account. It will also help you find bookkeeping errors and could help prevent irregularities such as employee theft. A cash disbursements journal: your daily cash disbursements should be recorded here. A petty cash fund: if your customers normally pay by check, you may need to set up so that you will have some currency on hand to pay miscellaneous small expenses. A petty cash fund isn't necessary if you use a cash register and always have currency on hand, as long you keep track of these small purchases. Daily Cash Sheets A cash sheet is a daily reconciliation of cash received and cash paid out. If a lot of your business is transacted in cash, such as in a retail store, you should prepare a cash sheet at the end of each day. Deposit all cash receipts in your bank account daily. Your daily cash receipts should generally be the same amount as your daily bank deposit. If they are not the same, you should investigate and reconcile the two amounts. Any reasons for a difference should be apparent on your cash sheet, such as a small amount of cash paid out for a miscellaneous expense. An important reason to do a cash sheet is to alert you to any shortage or surplus of cash for the day. Some businesses that do not prepare a cash sheet simply count the cash in the register at the end of the day. Without doing a reconciliation, they don't discover any shortages or overages. A shortage could be the result of theft, or it could simply result from your failure to record a special transaction, such as an expense you paid in cash. Tools to use: Among the Business Tools is a cash sheet for your use. Simply plug in your daily amounts, and you will instantly see whether you have a cash shortage or surplus at the end of the day. It is an Excel 4.0 spreadsheet template, so you can use the template over and over again for your daily needs; you need to download it only once.

Bank Reconciliation Prepare a bank reconciliation when you receive your bank statement every month. This is a very important part of your cash control procedures. It verifies the amount of cash you have in your checking account. The cash balance in your books will never agree with the balance shown on the bank statement because of the delay in checks and deposits clearing the bank, automatic bank charges and credits

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you haven't recorded, and errors you may have made in your books. After preparing the bank reconciliation, you can be comfortable that the account balance shown on your books is up-to-date. Another important reason to do a bank reconciliation is that it may uncover irregularities such as employee theft of funds. Here are step-by-step instructions for preparing a bank reconciliation. 1. Prepare a list of deposits in transit. Compare the deposits listed on your bank statement with the bank deposits shown in your cash receipts journal. On your bank reconciliation, list any deposits that have not yet cleared the bank statement. Also, take a look at the bank reconciliation you prepared last month. Did all of last month's deposits in transit clear on this month's bank statement? If not, you should find out what happened to them. 2. Prepare a list of outstanding checks. In your cash disbursements journal, mark each check that cleared the bank statement this month. On your bank reconciliation, list all the checks from the cash disbursements journal that did not clear. Also, take a look at the bank reconciliation you prepared last month. Are there any checks that were outstanding last month that still have not cleared the bank? If so, be sure they are on your list of outstanding checks this month. If a check is several months old and still has not cleared the bank, you may want to investigate further. 3. Record any bank charges or credits. Take a close look at your bank statement. Are there any special charges made by the bank that you have not recorded in your books? If so, record them now just as you would have if you had written a check for that amount. By the same token, if there are any credits made to your account by the bank, those should be recorded as well. Post the entries to your general ledger. 4. Compute the cash balance per your books. Foot the general ledger cash account to arrive at your ending cash balance. 5. Enter bank balance on the reconciliation. At the top of the bank reconciliation, enter the ending balance from the bank statement. 6. Total the deposits in transit. Add up the deposits in transit, and enter the total on the reconciliation. Add the total deposits in transit to the bank balance to arrive at a subtotal. 7. Total the outstanding checks. Add up the outstanding checks, and enter the total on the reconciliation. 8. Compute book balance per the reconciliation. Subtract the total outstanding checks from the subtotal in step 6 above. The result should equal the balance shown in your general ledger. Alpha Company Bank Reconciliation March 31, 2010 Balance per bank statement Deposits in Transit Date 3/30 3/31 Subtotal Outstanding Checks Check Number 1656 1693 1696 1697 1698 Balance per books Amount $ 22.50 $ 150.00 $ 32.00 $ 1,902.00 $ 1,105.80 $ 3,212.30 $ 3,851.26 Amount $ 500.25 $ 1,890.33 $ 2,390.58 $ 7,063.56 $ 4,672.98

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In the above example, if the general ledger cash account does not show a balance of $3,851.26, you will need to track down the cause of the difference. Tools In the Business Tools area is a reconciliation spreadsheet to to Use: make bank reconciliations easy for you. It is an Excel 4.0 spreadsheet template, so you can use it as a starting point for your own bank reconciliations. If your bank reconciliation doesn't balance, you need to find the error or errors. Here are the possible causes of a bank balance error: Total outstanding checks added incorrectly. Double check your addition of the total outstanding checks. Total deposits in transit added incorrectly. Double check your addition of deposits in transit. Bank balance written down incorrectly. Did you start with the correct amount at the top of your reconciliation? Double check by comparing it to the month end balance on your bank statement. Failed to record all items clearing the bank statement. Look at your bank statement carefully. Are there any items, such as miscellaneous bank charges or automatic deposits or withdrawals, that were not recorded in your books? Journals added incorrectly. Double check your addition of cash receipts and cash disbursements. Failed to record a check or deposit. Did you record all checks and deposits in your journals? This should have been apparent when you were preparing your lists of deposits in transit and outstanding checks. Incorrectly recorded an amount. Compare each item on the bank statement with your journal entry for that item. Did you enter the correct amount? Cash Disbursements and Purchase Journals A cash disbursements journal is where you record your cash (or check) paid-out transactions. It can also be called a purchases journal or an expense journal. There are many different types and styles of cash disbursements journals. If you will be recording expenses manually in ajournal, visit an office supply store. They should have different types to choose from. Look at the column headings, and choose the journal that best meets the needs of your business. You might consider a disbursements journal that is integrated with your checkbook this may save you some time because your journal entry is made at the same time as you write the check. If you are using computer software, you probably won't have to decide which type of journal to use. Your program will probably have some type of disbursement and purchase journals, but may allow you to customize it based on your business needs. If you use the accrual basis of accounting, as we recommend, you'll record expenses in the cash disbursement journal at the time you pay for goods or services, or in the purchase journal if you purchase on credit. Ex: You own a variety store. You purchase from your main supplier, on account, items totaling $7,800. Most of the purchase is inventory for resale, but also included are $100 of office supplies. Make the following entry in your purchases journal: Debit Credit Purchases Office supplies expense Accounts payable 7,700 100 7,800

Next month, after receiving a statement from your supplier, you write a check to settle your account. Make the following entry in your purchases journal: Debit Credit

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Accounts payable Cash

7,800 7,800

Assume that your business is a retail store that sells merchandise for resale. Here is an example of a few entries in a purchases journal. The following transactions occurred: (Note: All dollar amounts have been rounded off to the nearest dollar.) On February 2, you paid your electric bill of $177. Also on February 2, you bought merchandise inventory on account from Ash Wholesale at a cost of $9,500. On February 5, you spent $82 at Atkins Service Station to fill up your delivery vehicles with gas. You charge it all to the account you maintain with Atkins. On February 8, you write a check for $9,500 in payment of the bill you receive from Ash. On February 10, you write a check for $82 to Atkins Service Station to settle your account there. Upon completion of this journal page, you should foot all seven amount columns. Since you are using a double-entry accounting system, you can see if all entries were recorded correctly. Check to see if the sum of the debitsequals the sum of the credits. Total debits: 0 + 9,582 + 9500 + 82 + 177 = 19,341. Total credits: 9,759 + 9,582 = 19,341. PURCHASES JOURNAL FOR: FEBRUARY 2010 Cash Dat e 2 2 5 8 8 Descrip. Edison Util. - electricity Ash Whlsle - inventory Atkins Serv. Station gas Ash Whlsle - on account Atkins Serv. - on account 9,500 82 0 9,759 9,500 82 9,582 9,582 9,500 82 177 Dr . Cr. 177 9,500 82 9,500 82 Accounts Payable Dr. Cr. Purch. Dr. Delivery Expense Dr. Utilities Exp. Dr. 177

Totals

If the sum of the debit columns doesn't equal the sum of the credit columns, you have a problem that you should track down right away. You may have entered one of the amounts in the wrong column. You might have simply added incorrectly when computing the totals. It is usually easy to pinpoint the error because the debits should equal the credits for each transaction. Your purchases journal may have many more columns than this sample because you probably will have more expense classifications. Petty Cash Fund Set up a petty cash fund if you need cash on hand to pay miscellaneous small expenses of your business. If yours is a retail business with cash on hand, you probably don't need a petty cash fund. Just be sure to carefully record all cash paid out of the cash register. Preparing a cash sheet at the end of the day will help control cash paid out of the register. A petty cash fund is set up and used as follows: 1. Start a petty cash fund by writing a check to "Petty Cash." Cash the check. 2. Physically place the cash in a petty cash drawer or petty cash box. 3. As you pay for expenses out of petty cash, keep an itemized list of each expenditure. 4. When the cash is almost depleted, add up the expenses on your itemized list. 5. Write another check to "Petty Cash" for the total of the expenses. That check should replenish the fund back to the initial balance.

12

Ex: You decide to set up a petty cash fund to pay small expenses that you don't pay by check. You feel a petty cash fund of $100 is necessary, so you write a $100 check payable to "Petty Cash." You physically place the $100 in a petty cash box. Make the following entry in your cash disbursements journal: Debi Credit t Petty cash Cash 100 100

Two weeks later, you review the petty cash box and find that there is $25.00 left. You add up the items listed on the expenditures list, and you are happy to find that they add up to $75.00 (25 + 75 = 100). You write a check, payable to "Petty Cash," for $75.00. The cash is placed in the petty cash box. This replenishes the fund back to $100. Using the list of petty cash expenditures as your source document, make the following entry in your cash disbursements journal: Debit Credit Office supplies 13.20 Auto expenses 39.00 Misc. labor Misc. expenses Cash 15.00 7.80 75.00

The petty cash drawer or box should be locked when not in use. Only one person should have access to the petty cash, so that one person is held accountable for it. Accounts Receivable Accounts receivable are unpaid customer invoices, and any other money owed to you by your customers. The sum of all your customer accounts receivable is listed as acurrent asset on yourbalance sheet. Tip: You will often see Accounts Receivable abbreviated as A/R. You should keep an accounts receivable ledger account for each customer. The accounts receivable ledger, which can also double as a customer statement, is a record of each customer's charges and payments. When a customer purchases something, you'll first record the sale in the sales and cash receipts journal. This journal will have accounts receivable debit andcredit columns. Charge sales and payments on account are entered in these two columns, respectively. Then, each day, the credit sales recorded in the sales and cash receipts journal is posted to the appropriate customer's accounts in the accounts receivable ledger. This allows you to know not only the total amount owed to you by all credit customers, but also the total amount owed by each customer. Entries made in the sales and cash receipts journal are also totaled at the end of the month, and the results are posted to the accounts receivable account in your general ledger. This account is your accounts receivable "control account." What "control" means is that after all your posting is completed, the total amount of customer balances in the accounts receivable ledger will be the same as the balance in the control account in the general ledger. If they aren't the same, you can tell that you made an error somewhere along the line. If you extend credit to your customers and maintain a sales and cash receipts journal by hand, look for a journal that integrates posting to the accounts receivable ledgers with the recording of sales

13
and cash receipts transactions. This is called a "one-write" system. It will usually save you time and cut down on posting errors. If you use a computer program, posting to the accounts receivable ledgers will occur automatically. Accounts receivable ledger. You must maintain an accounts receivable ledger account for each customer you extend credit to. Post your sales invoice charges from the sales and cash receipts journal to the customer ledgers at the end of each day. Also, whether you use a cash register or a separate cash receipts book, be sure to post cash receipts on account to the appropriate ledgers at the end of the day. Keep all your accounts receivable ledgers in one binder. To save paperwork, we recommend that copies of the accounts receivable ledgers also serve as the statements you mail to your customers in request for payment. If you are going to mail them out as statements, begin a new ledger sheet every month. The monthly ledger sheet should start with a balance forward, which is the ending balance from the previous month. If your ledger sheets will not be doubling as your customer statements, you don't need to start a new sheet every month. Just keep a permanent ledger for each customer that maintains a running total of the customer balance. For most businesses, statements should be sent once a month to all customers with an account balance. The statement should show the following: a beginning balance (the previous month's ending balance) all invoices charged during the month payments on account during the month any debit memos or credit memos an ending balance a due date Tools to Use: We recommend that your accounts receivable ledger double as your monthly customer statement. In the Business Tools area is a ledger statement that we have designed. Simply plug in your monthly entries, and you will have a ledger statement suitable for you, and a copy of which you can send to your customers. It is an Excel 4.0 spreadsheet template, so you can use the template over and over again; you need to download it only once.

Control account: When you mail statements to your customers every month, you should reconcile your accounts receivable ledgers with the accounts receivable control account. The control account is the total accounts receivable balance from your general ledger. The beginning accounts receivable total, plus charge sales for the month, minus payments on account for the month, should equal the ending accounts receivable total. Compare this amount to the sum of the individual customer accounts receivable ledgers. This will help you discover any errors in your customer statements before you mail them out. Aging reports critical: You should periodically prepare an accounts receivable aging report. This is a valuable cash management tool which you will use to contact past due customers. Accounts Payable Accounts payable are the unpaid bills of the business; the money you owe to your suppliers and other creditors. The sum of the amounts you owe to your suppliers is listed as a current liability on your balance sheet. Tip: You will often see Accounts Payable abbreviated as A/P. If you use the accrual basis of accounting, as we recommend, expenses are recorded in the cash disbursements journal at the time the goods or services are paid for or in the purchase journal if you buy on credit. If you deal with a given supplier many times during the month, you don't have to record every purchase. You could accumulate all bills for the month from that supplier, then record one transaction in the purchases journal at the end of the month.

14
You should keep an accounts payable ledger account for each supplier. Expenses from the cash disbursements journal are, at the end of each day, posted to the appropriate accounts payable ledger. The accounts payable ledger is a record of what you owe each vendor. The general ledger contains an accounts payable account, which is your accounts payable control account. The cash disbursements journal has accounts payable credit and debit columns. Credit purchases and payments on account are entered in these two columns, respectively. At the end of the month they are totaled and posted to the control account in the general ledger. Accounts payable ledgers. Accounts payable ledgers will help you control your expenditures and payables. If you maintain accurate payable ledgers, it will be easy for you to double check the bills you get from your suppliers. At the end of the month, reconcile your accounts payable ledgers with theaccounts payable control account. The control account is the total accounts payable balance from your general ledger. The beginning accounts payable total, plus purchases on account during the month, minus payments on account during the month, should equal the ending accounts payable total. Compare this amount to the sum of the individual accounts payable ledgers. This will help you discover any errors you made in recording your payables. A reconciliation might also help you catch any errors on vendor bills. An accounts payable aging report is a good cash management tool that should be prepared periodically. It will help you plan the timing and amount of your cash disbursements. General Ledger The general ledger is a permanent summary of all your supporting journals, such as the sales and cash receipts journal and the cash disbursements journal. Your financial statementsare built from the general ledger. For each account title shown on your sales and cash receipts journal columns and your cash disbursements journal columns, there is a general ledger account. There are also separate general ledger accounts for miscellaneous items that don't have their own column in the journals, but are entered in a "miscellaneous" column. For example, Cash, Accounts receivable, Accounts payable, Sales, Purchases, Telephone expense, and Owners equity are all examples of general ledger accounts. There is a page reserved in the general ledger for each general ledger account. The individual entries in the general ledger are always from the total columns of your supporting journals. When all journal entries are posted, you can arrive at the ending balance for each account. The sum of all general ledger debitbalances should always equal the sum of all general ledger credit balances. Suggested General Ledger Accounts A list of common general ledger accounts is shown below. Depending on your type of business, you will use many, but probably not all, of these account names. On financial statements, they should generally be placed in the order shown. Balance Sheet Accounts Assets: petty cash (if you maintain a petty cash fund) cash in checking (a separate ledger account for each bank account) cash in savings accounts receivable reserve for bad debts inventory prepaid expenses office supplies (if you maintain a significant amount of office supply inventory) utility deposits notes receivable investments organization expenses vehicles accumulated depreciation vehicles furniture and fixtures accumulated depreciation furniture and fixtures equipment accumulated depreciation equipment buildings

15
accumulated depreciation buildings land goodwill Liabilities: accounts payable sales tax payable federal withholding taxes payable FICA taxes payable state withholding taxes payable unemployment taxes payable accrued wages unearned revenue accrued income taxes note payable Capital Accounts: owner's equity owner's drawing account common stock additional paid-in capital preferred stock retained earnings Income Statement Accounts Income: sales revenues sales returns and allowances sales discounts investment income gain (loss) on sale of assets Expenses: purchases (if you purchase inventory for resale) freight (if you purchase inventory for resale) purchases returns and allowances (if you purchase inventory for resale) cost of goods sold: materials cost of goods sold: labor cost of goods sold: direct expenses cost of goods sold: indirect expenses advertising amortization bad debt expense bank charges charitable contributions commissions expense contract labor credit card fees expense delivery expense depreciation expense dues and subscriptions entertainment income taxes insurance interest expense maintenance miscellaneous office expense

16
operating supplies payroll taxes permits and licenses postage professional fees property taxes rent repairs telephone travel utilities vehicle expenses wages Tip: Have you been running your business for a while, and are just now trying to take over some of the basic bookkeeping? If you've had financial statements prepared by an accountant in the past, look at last year'sbalance sheet and income statement. You can get started by setting up general ledger accounts for each account title shown on those financial statements. Closing the Books When you reach the end of an accounting period, you need to "close the books." At a minimum, you will close your books annually because you have to file an income tax return every year. If you are having financial statements prepared, you will want them done at least annually. However, annual financial statements may not be enough to help you keep tabs on your business. You may want financial statements monthly, bi-monthly, or quarterly. Even if you are not having financial statements prepared, you may want to close your books monthly. Sending out customer statements, paying your suppliers, reconciling your bank statement, and submitting sales tax reports to the state are probably some of the tasks you need to do every month. You may find it easier to do these if you close your books. How to close your books. After you finish entering the day-to-day transactions in your journals, you are ready to "close the books" for the period. A step-by-step description of how to close the books follows. How many of the steps you do yourself depends on how much of the accounting you want to do, and how much you want to pay your accountant to do. 1. Post entries to the general ledger. Transfer the account totals from your journals (sales and cash receipts journal and cash disbursements journal) to your general ledger accounts. 2. Total the general ledger accounts. By footing the general ledger accounts, you will arrive at a preliminary ending balance for each account. 3. Prepare a preliminary trial balance. Add all of the general ledger account ending balances together. Total debits should equal total credits. This will help assure you that your accounts balance prior to making adjusting entries. 4. Prepare adjusting journal entries. Certain end-of-period adjustments must be made before you can close your books. Adjusting entries are required to account for items that don't get recorded in your daily transactions. In a traditional accounting system, adjusting entries are made in a general journal. 5. Foot the general ledger accounts again. This will give you the adjusted balance of each general ledger account. 6. Prepare an adjusted trial balance. Prepare another trial balance, using the adjusted balances of each general ledger account. Again, total debits must equal total credits. 7. Prepare financial statements. After tracking down and correcting any trial balance errors, you (or your accountant) are ready to prepare a balance sheet and income statement. 8. Prepare closing entries. Get your general ledger ready for the next accounting period by clearing out the revenue and expense accounts and transferring the net income or loss to owner's equity. This is done by preparing journal entries that are called closing entries in a general journal. 9. Prepare a post-closing trial balance. After you make closing entries, all revenue and expense accounts will have a zero balance. Prepare one more trial balance. Since all

17
revenue and expense accounts have been closed out to zero, this trial balance will only contain balance sheet accounts. Remember that the total debit balance must equal the total credit balance. This will help ensure that all general ledger account balances are correct as of the beginning of the new accounting period. Trial Balance The trial balance is a worksheet on which you list all your general ledger accounts and their debit or credit balance. It is a tool that is used to alert you to errors in your books. The total debitsmust equal the totalcredits. If they don't equal, you know you have an error that must be tracked down. When closing out your books at the end of an accounting period, you will prepare three trial balances: 1. A preliminary trial balance is prepared using your general ledger account balances before you make adjusting entries. 2. An adjusted trial balance is done after preparing adjusting entries andposting them to your general ledger. This will help ensure that the books used to prepare your financial statements are in balance. 3. A post-closing trial balance is done after preparing and posting yourclosing entries. This trial balance, which should contain only balance sheet accounts, will help guarantee that your books are in balance for the beginning of the new accounting period. Ex: You are getting ready to close the books for the year ended December 31, 2009. You post totals from the journals to the general ledger, and foot the general ledger accounts. Then you prepare the following preliminary trial balance, using the balances from your general ledger accounts. Beta Service Company Preliminary Trial Balance December 31, 2009 Debit Cash in bank Accounts receivable Equipment Accumulated depr. equip. Buildings Accumulated depreciation building Land Accounts payable Payroll taxes payable Mortgage payable Capital Drawing account Sales Advertising Depreciation Insurance 18,900 16,760 4,500 24,000 332,462 80,000 2,213 2,567 135,812 59,823 119,000 17,950 3,423 11,400 42,900 29,500 Credit

18

Interest expense Payroll taxes Property taxes Repairs and maintenance Utilities Wages

12,421 16,233 4,989 23,430 3,856 198,515 580,32 7 580,32 7

Tool to A trial balance spreadsheet can be found in the Business Use: Tools area. It is an Excel 4.0 spreadsheet template, so you can use the template as a starting point for your own trial balance. What if your trial balance does not balance? In other words, what if total debits don't equal total credits? This shouldn't surprise or discourage you. In fact, it might be more surprising if it does balance. Accounting errors happen. Even experienced bookkeepers normally have to find trial balance errors. Finding Trial Balance Errors When preparing a trial balance, the total debitsmust equal the totalcredits. Don't be discouraged if they don't. Bookkeeping errors happen. Just think of the trial balance as a tool to find the errors. Use the following steps as a guide to track down the error or errors. Be sure the numbers on your trial balance are the same numbers shown in your general ledger. Check to see if you properly classified amounts as debits or credits on your trial balance. Go back to your journals (sales and cash receipts journal, cash disbursements journal, and general journal). Check that the journal totals were properly posted to the general ledger. Were the correct amounts posted? Were they properly classified as debits or credits? Go back to each journal again. Look at the totals that were posted to the general ledger. Do total debits equal total credits in each journal? Go back to each journal again. Did you foot each column on each page of the journal? Did you carry forward all column totals to the next page? Did all the items entered in the "miscellaneous" column get posted to the general ledger? Is the difference divisible by nine? If so, it could be a simple transposition error. For example, writing down 540 instead of 450 results in a difference of 90. Writing down 26 instead of 62 results in a difference of 36. Notice that both of these differences are divisible by nine. If the difference between debits and credits is divisible by nine, go back to the journals, looking for the error. Knowing that it may be the result of transposed numbers should help you find it. Is the difference between debits and credits 1, 100, 1,000, 10,000, etc.? If so, it is probably an addition or subtraction error. Divide the difference by two. Is the resulting number shown on your trial balance? If so, check to see if you have incorrectly classified the amount as a debit or credit. General Journal The general journal is usually a two-column journal used for unusual and annual accounting entries that aren't recorded in the sales and cash receipts and cash disbursements journals.Adjusting entries andclosing entries, made at the end of an accounting period, are the most common entries made in the general journal. The general journal is also used to record special transactions that don't get recorded in one of the regular journals. Ex: As an example of a "special transaction," on April 12, 2009, $7,500 was spent on new production equipment in your machine shop. At that time, the amount was incorrectly expensed to repairs and maintenance in the cash disbursements journal. It should have been recorded as a purchase of fixed assets. Upon discovery of the error,

19

you make the following correcting entry in your general journal. Debit Equipment Repairs and maintenance 7,500 7,500 Credit

To correct 4/12/2009 purchases journal entry General journal entries are posted to the respective general ledger accounts. Adjusting Entries Certain end-of-period adjustments must be made when you closeyour books. Adjusting entries are made at the end of an accounting period to account for items that don't get recorded in your daily transactions. In a traditional accounting system, adjusting entries are made in a general journal. Some adjusting entries are straightforward. Others require judgment and some accounting knowledge. You will have to decide if you are going to tackle some or all adjusting entries, or if you want to pay your accountant to do them. If your accountant prepares adjusting entries, he or she should give you a copy of these entries so that you can enter them in your general ledger. The following are situations requiring adjusting journal entries. Some, but not all, should apply to your business: Accrue wages earned by employees but not yet paid to them. Accrue employer share of FICA taxes due. Accrue property taxes. Record interest expense paid on a mortgage or loan and update the loan balance . Record prepaid insurance. Adjust your books for inventory on hand at period end. Accrue interest income earned but not yet received. Record depreciation expense. Adjust for bad debts. Accrue dividends payable if a corporation. Accrue income taxes payable if a corporation. Account for the sale of fixed assets. Set up accounts receivable balance if your day-to-day books are maintained on a cash basis. Set up accounts payable balance if your day-to-day books are maintained on a cash basis. After all adjusting entries are made, do the following to complete your books for the accounting period: 1. Foot the general journal. 2. Post the general journal totals to the general ledger. 3. Foot the general ledger accounts to arrive at the final, adjusted balance for each account. 4. Prepare an adjusted trial balance using the general ledger balances. 5. Prepare financial statements using the adjusted trial balance. Accruing Wages Payable If you have employees, chances are you owe them a certain amount of wages at the end of an accounting period. If so, an adjusting entry is required in your general journal. Ex: As an example, on December 31, 2010 you owe your employees one week of salary that will be paid on January 8, 2011. The gross wages for that week are $1,512.00. Make the following general journal entry: Debit Wages expense Accrued wages 1,512 1,512 Credit

To accrue wages owed but unpaid on 12/31/2010 Accruing Employer FICA Taxes

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One component of the payroll taxes you deposit with the government is FICA tax (made up of Social Security and Medicare taxes) One-half of the FICA you pay is withheld from employees; the other half is your share (an expense of the business). If you have payroll taxes due at the end of an accounting period that will be paid next period, you should accrue the employer share of FICA that is due at period end. This is done with an adjusting entry in your general journal. Ex: As an example of accrued FICA taxes, let's say that on January 4, 2011, you deposit payroll taxes due as of December 31, 2010. The deposit includes FICA taxes of $420.50. One-half of that ($210.25) is the employer share that has not yet been recorded on the books. Make the following general journal entry: Debit Payroll taxes expense Payroll taxes payable 210.25 210.25 Credit

To accrue employer share of FICA owed but unpaid on 12/31/2010 Accruing Property Taxes Due Do you pay property taxes on buildings or land? Your tax payment may not be due for several months, but in reality you incur one-twelfth of your annual property tax bill every month. At the end of the accounting period, you should make anadjusting entry in yourgeneral journal to set up property taxes payable for the amount of taxes incurred but not yet paid. Ex: Estimated property taxes of $5,200 were assessed on July 1, 2010, for the 12-month period to end on June 30, 2011. The first payment of the first half year tax is due on March 1, 2011. As of December 31, 2010, no payments have been made on this assessment although the half-year estimate is owed, even though not due until March 1st. You need to accrue six months of property taxes ($2,600) as of December 31, 2010. Make the following general journal entry: Debit Property tax expense Property tax payable To accrue six months' property tax owed but unpaid on 12/31/2010 Adjusting Interest and Loan Balances If you've been making monthly payments on a loan, you will probably need to make anadjusting entry in yourgeneral journal at year end so the correct amount of interest expense is on your books, and the loan balance as of year end is correctly shown on your books. Ex: Assume that you make a monthly mortgage payment of $1,200. Of course, each monthly payment is part interest, part principal. If you record the correct amount of interest and principal in your cash disbursements journal every month, no adjusting entry would be necessary. An example of such a cash disbursements journal entry: Debit Interest expense 633.60 Mortgage payable Cash 566.40 1,200 Credit 2,600 2,600 Credit

21
Chances are, you do not correctly record both interest and principal every month. Do you simply put the entire debit amount to the mortgage payable account every month? Or do you put the entire debit amount to the interest expense account? Either way, you will need an adjusting entry so that your period end books show the proper amount of interest expense and mortgage payable. You should have an amortization schedule, or a statement from your lender, showing you the amount of interest paid for the year and the year-end loan balance. (If you don't have one, your accountant can prepare one for you.) Ex: Assume that your monthly mortgage payment is $1,200, and you make the following entry in your cash disbursements journal every month: Debit Credit Mortgage payable Cash 1,200 1,200

Since you haven't recorded interest expense every month, you refer to the statement from your lender. It shows that you paid a total of $7,560.49 in interest for the year. You make the following adjusting entry in your general journal: Debit Interest expense Mortgage payable 7,560.49 7,560.49 Credit

To adjust for mortgage interest paid in 2010.

Or, assume that you've been making the following cash disbursements journal entry every month:
Debit Credit Interest expense 1,200 Mortgage payable 1,200

Since you have been charging the entire payment to interest every month, you need to refer to the statement from your lender. You find that a total of $6,839.51 was paid in principal for the year. Make the following adjusting entry:
Debit Mortgage payment Interest expense 6,839.51 6,839.51 Credit

To adjust for mortgage balance at Dec. 31, 2010 Prepaid Insurance Typically, insurance premiums are paid when coverage begins. So if you paid for an insurance policy during the accounting period, you probably bought coverage for several months or a year in advance. At the end of the accounting period, a prepaid expenseaccount called prepaid insurance

22
should be set up as an asset, reflecting insurance coverage for the future that you have already paid for. This can be done by making an adjusting entry in your general journal. Ex: You paid an annual insurance premium of $1,200 on September 1, 2010, and charged the $1,200 to insurance expense in your cash disbursements journal. As of December 31, 2010, you have used up just four months ($400) of this coverage, and have eight months of coverage coming to you. This eight months of prepaid coverage ($800) represents an asset to you. Make the following general journal entry: Debit Prepaid insurance Insurance expense 800 800 Credit

To set up eight months of prepaid insurance on 12/31/2010 Adjusting Entry for Inventory Do you maintain aninventory of merchandise for sale to your customers? If so, you need to physically count the items that are in your inventory at the end of the accounting period. Yourgeneral ledger inventory account should show the total cost of your inventory items on hand at period end. Adjusting entries are required in your general journal so that your ending inventory is reflected on your books. Ex: On December 31, 2010, you physically count the inventory items you have on hand. Using your costs and the quantities of items on hand, you determine that the total cost of your inventory at December 31 is $18,500. Looking back at your general ledger, you see that you started the year with a December 31, 2009, inventory cost of $15,200. Make the following general journal entries to update inventory: Debit Purchases Inventory To clear out beginning (1/1/2010) inventory Debit Inventory Purchases 18,500 18,500 Credit 15,200 15,200 Credit

To book ending inventory at 12/31/2010 Accruing Interest Income Receivable If you are earning interest income that will be payable sometime after the end of the accounting period, you need to make an adjusting entry in yourgeneral journal. The entry is needed to reflect the amount of unpaid interest income you have earned as of the end of the accounting period. Ex: As an example, say that your company has a one-year, $10,000 certificate of deposit that you purchased on May 1, 2010. It pays simple interest, at 6 percent, at the end of its term on April 30, 2010. As of December 31, 2010, you have earned $400, which is eight months of interest (10,000 x 6 percent x 8/12). You should make the following adjusting entry:

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Debit Interest receivable Interest income To record eight months' accrued interest on 12/31/2010 400

Credit

400

Recording Depreciation Expense At the end of an accounting period, you must make an adjusting entry in your general journal to recorddepreciation expenses for the period. The Internal Revenue Service has very specific rules regarding the amount of an asset that you can depreciate each year. You don't have to compute depreciation for your books the same way you compute it fortax purposes, but to make your life simpler, you should. You should consult your accountant about how to compute depreciation. More than likely, your accountant will make this adjusting entry for you, or your accountant may be able to provide you with a schedule showing the amount of depreciation for each asset for each year. Ex: Your business has equipment and a building. Using a depreciation schedule provided by your accountant, you determine that current period depreciation is $3,400 on the equipment, and $2,550 on the building. You need to make the following adjusting entry to record depreciation expense and update your accumulated depreciation accounts: Debit Credit Depreciation expense Accumulated depreciation equipment Accum. depreciation building To record depreciation for the period ended 12/31/10 Adjusting for Bad Debts Do you extend credit to your customers? If so, do you have any accounts receivable at year end that you know are uncollectable? If you do, the end of the year is a good time to make anadjusting entry in yourgeneral journal to write off any worthless accounts. Ex: You extend credit to your regular customers, and normally do not experience any trouble collecting from them. Since you rarely have trouble collecting from your customers, you have not set up a reserve for bad debts. However, as you review your accounts receivable at year end, you notice that a particular customer, now insolvent, still owes you $750. You are certain that you will never be paid. Write off this account by making the following adjusting entry: Debit Bad debt expense Accounts receivable To record bad debts for the year ended 12/31/2010 Be sure to write off this account in your accounts receivable ledger, so that it agrees with your general ledger. If you extend credit to numerous customers, and your experience is that a certain amount of your sales on account will be uncollectable, you should probably set up a reserve for bad debts. That 750 750 Credit 5,950 3,400 2,550

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way, your books and financial statements will more accurately reflect your true financial picture. At the end of every year, you should evaluate your accounts receivable and adjust yourallowance for bad debts accordingly. Your accountant may be able to help you do this. Ex. You extend credit to your customers, and experience tells you that a small amount of your sales on account will never be collected. On December 31, 2010, you evaluate your accounts receivable. You estimate that $1,000 of your receivables will not be collectible. On December 31, 2009, you estimated that $800 of your receivables at that time were uncollectable and your reserve for bad debts account in the general ledger currently reflects that $800 balance. You need to make the following adjusting entry to record this $200 increase in estimated bad debts: Debit Bad debt expense Allowance for bad debts To adjust allowance for uncollectable accounts at 12/31/2010 For what to do if you've written off a bad debt, but the customer later pays some or all of what he owes, see bad debt recoveries. Accruing Dividends Payable If your business is a corporation, and your corporation has declared a dividend payable to shareholders, the declared dividend needs to be recorded on the books. Assuming the dividend will not be paid until after year end, anadjusting entry needs to be made in the general journal. Ex: Your corporation declares a dividend of $1.00 a share on December 31, 2010. There are 10,000 shares of common stock outstanding. The dividend will be paid on January 15, 2011. Make the following adjusting entry: Debit Retained earnings Dividends payable To record dividends payable as of 12/31/2010 10,000 10,000 Credit 200 200 Credit

Accruing Income Taxes Payable If your business is a corporation, it is a separate entity that is required to pay income taxes. After your accountant computes the income tax liability of the corporation, an adjusting entry should be made in the general journal to reflect the income tax expense for the year. Ex: Your corporation has made four estimated income tax payments of $3,000 each for its calendar-year 2010 tax liability. These payments were each recorded during the year in your cash disbursements journal as follows: Debit Credit Reserve for income. tax Cash 3,000 3,000

25
Since the four payments were made during the year, there is a debit balance of $12,000 ($3,000 x 4) in the reserve for income tax account on December 31, 2010.

Your corporate income tax return for the year ended December 31, 2010, has been completed, and it shows a tax liability for the year of $13,450. Since you've already paid in $12,000, you owe another $1,450 to the IRS. Make the following adjusting entry to reflect the income tax expense for the year and the amount of tax owed to the IRS at year end:
Debit Income tax expense Reserve for income tax Income taxes payable To record income taxes for the year ended 12/31/2010 Adjusting for Sales of Fixed Assets Did you sell any fixed assets during the year? If so, you probably need to make an adjusting entryin your general journal to properly account for the sale. You may need to have your accountant help you with this type of transaction. Ex: On March 4, 2011, you sold a truck outright for $5,000. At the time of the sale, you made the following entry in your sales and cash receipts journal: Debit Credit Cash Gain on sale of asset 5,000 5,000 13,450 12,000 1,450 Credit

The truck had a cost of $24,000. As of December 31, 2010, you had taken $20,500 of depreciation on the truck. The adjusted basis of the truck is $3,500 ($24,000 cost minus $20,500 depreciated). Therefore, you have a gain of $1,500 on the sale ($5,000 received minus $3,500 basis). Make the following adjusting entry to take the truck off your books and reflect the correct amount of gain (or loss) on the sale: Debit Gain on sale of asset Accumulated depreciation truck Truck To adjust for sale of truck on 3/4/2011 Adjusting Year-End Receivables If you prepare your financial statements using the accrual method, but maintain your books on a daily basis using the cash method, you normally do not make entries to your accounts receivablegeneral ledger account during the accounting period. At the end of your accounting period, you need to make anadjusting entry in yourgeneral journal to bring your accounts receivablebalance up-to-date. Ex: As an example, assume that you keep your books on the cash basis, but your financial reporting and tax return are done on the accrual basis. You add up youraccounts receivable ledgers and find that 3,500 20,500 24,000 Credit

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your total receivables are $16,500 on December 31, 20100. Your accounts receivable balance on December 31, 2009, which is currently shown in your general ledger, was $13,950. You need to make the following adjusting entries to update your year-end accounts receivable balance: Debit Sales Accounts receivable 13,950 13,950 Credit

To clear out 1/1/2010 accounts receivable balance Debit Accounts receivable Reserve for income tax To set up 12/31/2010 accounts receivable balance Preparing Financial Statements After you have prepared your adjusting entries in the general journal,posted the general journal totals to the general ledger, and footed the general ledger accounts, you are ready to prepare financial statements. If all adjusting entries have been made, and a trial balance done, preparing financial statements is really just a matter of putting the trial balance amounts onto properly formatted statements. The financial statements prepared for most small businesses are: a balance sheet an income statement Usually these are prepared by an accountant. But with the help of computer software, you may be able to prepare your own financial statements. If you need to prepare financial statements for third parties, such as a banker, sometimes the third party may request that the financial statements be prepared by a professional accountant or certified public accountant. Balance Sheet Also called a statement of financial position, a balance sheet is a financial "snapshot" of your business at a given date in time. It lists yourassets, your liabilities, and the difference between the two, which is your owner's equity, or net worth. The accounting equation (assets = liabilities + owner's equity) is the basis for the balance sheet. The balance sheet is prepared after all adjusting entries are made in the general journal, all journal entries have been posted to the general ledger, the general ledger accounts have been footed to arrive at the period end totals, and an adjusted trial balanceis prepared from the general ledger amounts. Financial statements normally do not show cents. All amounts should be rounded to the nearest dollar. The following is an example of a balance sheet for a sole proprietorship: Beta Sales Company Balance Sheet December 31, 20XX Assets Current Assets Liabilities and Capital Current Liabilities 16,500 16,500 Credit

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Cash Accounts receivable Inventory Prepaid Insurance Total Current Assets Fixed Assets Equipment Less: Accumulated Depreciation Total Fixed Assets Total Assets

$12,300 22,900 32,090 2,500

Accounts payable Wages payable

$ 8,900 11,525 $20,425

Total Current Liabilities Long-Term Liabilities $69,790 Bank Loan Payable 17,500 Total Long-Term Liability

17,500 37,925

100,200 (78,321 )

Total Liabilities Capital 21,879 Tom Beta, Capital $91,66 Total Liabilities/Capital 9

53,744 $91,66 9

Tools to Among the Business Tools is a sample balance sheet. It is an Use: Excel spreadsheet template, so you can use the template over again; you need to download it only once. Income Statement Also called a profit and loss statement, or a "P&L," an income statement lists yourincome, expenses, andnet income (or loss). The net income (or loss) is equal to your income minus your expenses. Your business's tax return will use a variation of the income statement to determine your potentially taxable income. The income statement is prepared after all adjusting entries are made in the general journal, all journal entries have been posted to the general ledger, the general ledger accounts have been footed to arrive at the period end totals, and an adjusted trial balance has been prepared from the general ledger totals. Financial statements normally do not show cents. All amounts should be rounded to the nearest dollar. The following is an example of an income statement: Beta Sales Company Income Statement For the Year Ended December 31, 20XX Sales Cost of Goods Sold Beginning Inventory Add: Purchases Total: Less: Ending inventory Cost of Goods Sold Gross Profit Expenses Advertising Depreciation Insurance 1,850 13,250 5,400 $ 27,335 235,689 263,024 32,090 230,934 231,518 $462,452

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Payroll taxes Rent Repairs and maintenance Utilities Wages Total Expenses Net Income

8,200 9,600 13,984 17,801 98,852 168,937 $ 62,581

Tools In the Business Tools area is a sample income statement for to Use: your use. It is an Excel 4.0 spreadsheet template, so you can use the template over again; you need to download it only once. Closing Entries After financial statementsare prepared, you are ready to get your books ready for the next accounting period by clearing out the incomeand expense accounts in the general ledger and transferring the net income (or loss) to yourowner's equity account. This is done by preparing closing entries in thegeneral journal. Note the distinction between adjusting entriesand closing entries. Adjusting entries are required to update certain accounts in your general ledger at the end of an accounting period. They must be done before you can prepare your financial statements and income tax return. Closing entries are needed to clear out your revenue and expense accounts as you start the beginning of a new accounting period. Preparing your closing entries is a very simple, mechanical process. Follow these steps: 1. Close the revenue accounts. Prepare one journal entry that debits all the revenue accounts. (These accounts will have a credit balance in the general ledger prior to the closing entry.) Credit an account called "income summary" for the total. 2. Close the expense accounts. Prepare one journal entry that credits all the expense accounts. (These accounts will have a debit balance in the general ledger prior to the closing entry.) Debit the income summary account for the total. 3. Transfer the income summary balance to a capital account. Prepare a journal entry that clears out the income summary account. This entry effectively transfers the net income (or loss) of the business to the owner's equity account. 4. Close the drawing account. If your business is a sole proprietorship or partnership, close the drawing accounts (if any) by preparing a journal entry that credits the drawing account and debits the owner's equity account. Ex: As an example, assume that you have finalized your general ledger and prepared a balance sheet and income statement for the year ended December 31, 2010. You want to get your books ready for next year. You prepare the four closing entries as follows: Debit Sales Income summary To close the revenue account on 12/31/2010 462,452 462,452 Credit

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Debit Income summary Purchases Advertising Depreciation Insurance Payroll taxes Rent Repairs and maintenance Utilities Wages To close the expense accounts on 12/31/2010 Debit Income summary Tom Beta, capital 62,581 399,871

Credit

230,934 1,850 13,250 5,400 8,200 9,600 13,984 17,801 98,852

Credit

62,581

To transfer 12/31/2010 net income to the capital account Debit Tom Beta, capital Tom Beta, drawing To close drawing account for year ended 12/31/2010 After all closing entries are made, post the entry totals to the ledger. Foot the general ledger accounts to arrive at the beginning amounts for the new accounting period. All revenue and expense accounts should have a zero Accounting for Tax Purposes One of the most important uses of your financial records is to help you comply with federal and state tax laws and prepare tax returns. A good bookkeeping system will help make dealing with Uncle Sam relatively painless. If you keep good records and operate your business in a professional manner, you should find tax compliance pretty easy. Moreover, if you ever get audited and have to prove some or all of the items on your tax return, you'll find it easy to do so with up-to-date, orderly records. You already keep accounting records so that you know how your business is doing financially. These same books and procedures are used to keep your tax records. You don't always have to use the same accounting rules for tax purposes as you do for financial reporting. However, we highly recommend that you do use the same rules for both tax and financial purposes. Your life will be complicated considerably if you try keep two sets of records for your business. For example, the federal government has very specific rules on how muchdepreciation you can deduct each year on equipment, vehicles, and buildings. You can use depreciation methods for your own financial reporting purposes that differ from Uncle Sam's tax rules. But using two separate depreciation methods will either cost you a lot more time keeping track, or will cost you more money as you pay your accountant to keep track of them for you. 12,000 12,000 Credit

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Another example is the use of the cash or accrual accounting methods. Most small businesses can use the cash method for tax purposes. However, some businesses must use the accrual method. We recommend the accrual method for all businesses, for both tax purposes and financial reporting. The accrual method gives you a clearer picture of the financial status of your business, and it's just too expensive, in terms of time and money, to keep two separate sets of books. If you are thinking about using the cash method of accounting for tax purposes, you should discuss these rules with your accountant. If you do use the accrual method, one adjustment you'll have to make to your books for tax reporting purposes involves your treatment of bad debts. For tax purposes, bad debts may be written off only when they become uncollectible. Therefore, if you've set up a reserve or allowance for estimated bad debts during the year, you'll have to adjust this figure to reflect only the debts that you actually wrote off in this period, for purposes of computing your taxable business income. Regarding some of your day-to-day expenditures, there are a few things to keep in mind that will help you at tax time: Auto expenses. If you use your car for both personal and business use, you need to keep a written mileage log. You can pick up a mileage log in any good office supply store, and use it to keep track of all your personal and business miles. For your business miles, make a notation in your log as to what the business purpose of each trip was. You should keep this log in your car, and complete it on a daily basis. Don't try to reconstruct a mileage log at the end of the year. Entertainment expenses. If you have business-related meal or other entertainment expenses, keep a detailed written log of each occurrence, as well as the actual receipt from the event. Your record of entertainment expenses should list who, what, when, and where. Who was there, what was the business purpose, when did it take place, and where did it occur? Such a log will be invaluable if your business is ever audited.