Everything Small Business Owners Need to Know About COGS

Women working on an assembly line, symbolic of the concept of COGS.

Many small business owners have come across the concept of COGS, also known as Cost of Goods Sold, and wondered what on earth it means. At My OC Bookkeeper, we’ve encountered this many times, and that’s why we’ve put together our handy guide: Everything Small Business Owners Need to Know About COGS (Cost of Goods Sold). So, if you are a small business owner, or medium business owner, or are just interested in business, grab a cup of coffee and let’s start learning.

What Is Included in COGS?

First things first, let’s start with the basic definition of COGS: the costs of inputs used directly in the production of goods. Examples include raw materials, labor tied directly to production, and overhead tied directly to production. So, the fabric bought and turned into sweaters is included in COGS, as is the labor of the worker who sews the sweaters, and the cost of shipping the fabric.

Why do we care? Well, that depends a bit on the situation, but the general idea is that COGS helps to isolate the true cost of products by including expenses that extend beyond the basic costs of materials.

What Isn’t Included in COGS

Learning what isn’t included in cost of goods sold can be as helpful as learning what is included. In short, general expenses that aren’t directly tied to the production of whatever products that you sell aren’t applicable. Management and sales salaries, amounts paid to accountants, marketing costs, and interest on loans are common examples. These are considered operating expenses, that is, expenses associated with operating a company rather than producing a good. Operating expenses occur further down the income statement (also known as P&L) than COGS, but like COGS are deducted in order to calculate a company’s net profits, or bottom line.

Do All Companies Use Cost of Goods Sold? Why?

Not all companies use COGS when generating their financial information. Those that do are using what is known as gross profit accounting. That is, accounting which calculates gross profits by deducting COGS from revenues at the top of the income statement. (As opposed to not having any COGS category and therefore skipping the gross profit line altogether. (Click here if a refresher on income statements would be helpful.))

The obvious follow up question is, why don’t all companies calculate COGS? Well, for some companies it doesn’t really make sense. Service companies, for example, don’t sell any physical merchandise. If you don’t sell a widget, you can’t calculate the costs used in its production very well can you. Common examples of companies that don’t use cost of goods sold are accounting firms, real estate firms, consulting firms, and companies that do repair work. (A ton of small businesses fall into this category.) Basically, if you don’t hold inventory, than COGS doesn’t make a whole lot of sense.

There are also some companies who prefer to spread their expenses throughout their income statement rather than grouping production expenses together into COGS. When making decisions on matter like this, be sure to consult with a tax professional to make sure you are compliant with all of the relevant rules and regulations. You certainly don’t want to make an accounting mistake that causes you problems down the road.

How Do You Calculate COGS?

Calculating COGS is done using the value of a company’s inventory. It can get rather complicated because there are several different ways of calculating inventory, some of which are accepted in some countries but not others. (For the curious among you, common inventory calculation methods include Last in First Out, First in First Out, the Special Identification Method, and the Average Cost Method.) As this is an introductory lesson, we won’t get too deep into the weeds and will stick with the basic idea. That is, COGS = Beginning Inventory + Purchases – Ending Inventory.

If you break down this equation, you’ll see that it implies that COGS equals the value of the inventory that was sold during the given period. (If we circle back to the fact that COGS includes all of the costs directly associated with producing an item, we’ll see that the value of inventory on a company’s balance sheet represents the cost of creating it, but that goes beyond this lesson.)

Hands holdings hundred dollar bills, symbolic of using COGS to calculate gross profit.
One key thing that small business owners need to know about COGS is that it is used to calculate the gross profit margin. (That’s pretty important, hence the big bills above.)

What Can COGS Teach Us About a Company?

A metric which is often used to analyze COGS is the gross profit margin. The calculation for this is (Net Sales – COGS) / Net Sales. The higher this ratio, the more the company is making for each unit sold.

As is the case with most accounting measures, properly analyzing the gross profit margin is all about context. At first glance, a high gross profit margin seems great, but if you are pricing your product too high you might not sell anything. That having been said, if your gross profit margin is too low, you’ll have to sell a ton of products to make any money. In order to account for these issues the gross profit margin is often viewed in conjunction with other metrics, such as net profit, or the number of units sold. Likewise, it can be helpful to compare a company’s gross profit margin to similar companies so you have an idea what is common in the industry.

Another issue to consider is how gross profit margin fluctuates through time. If a company’s margin changes wildly from period to period, it might be indicative of supplier problems, issues in the manufacturing process, or the failure to find a good price point for the products being sold. If the margin is changing regularly, it’s often wise to do a bit more research. Is that normal for the industry or is it just this company? If it’s just this company, what is causing it?

Further Learning

Looking for some advanced training on COGS? Wall Street Prep has some pretty good stuff here. Or, if you want to really dig into COGS along with all kinds of things related to finance, business, and economics, while pushing yourself and picking up a master’s level designation, check out the CFA Institute. I can tell you from experience that taking the CFA exams is a challenging but rewarding experience. Finally, for more info on income statements, check out our introduction to income statements blog post.

Prefer learning from videos? Check out the great clip below on COGS.

Well, there you have it, our handy introduction to Cost of Goods Sold, also known as everything small business owners need to know about COGS. We hope you’ve found this incredibly illuminating and composed with poetic prose. (Or, maybe at least one of the two.)

Who are we? We are My OC Bookkeeper, Orange County’s premier bookkeeping and business consulting firm. If you need help with your books, whether it’s payroll, a bookkeeping cleanup, monthly bookkeeping, or anything else (including financial modeling), we are here to help. Reach out to us today and let’s do great things together.

What are Contra Accounts?

An accountants calculator, symbolic of accounts working with contra accounts.

Understanding business accounting can be an overwhelming task. There are common accounting terms like assets, liabilities, and equity that individuals and small business owners quickly become familiar with, and some like debits, receivables, and contra assets that require more research. Contra assets are an important bookkeeping concept that helps balance a business’s books. In this article, we look closely at contra assets and the different types of contra accounts you may see on financial statements.

What is a contra asset?

Contra assets are negative asset accounts that show an opposite balance to a normal account in the same asset category. The purpose of a contra asset account is to offset the asset account and show a reserved amount that reduces the balance of the corresponding asset account. The balance in a contra asset account allows the accountant, tax preparer, or other end-user to know how much to subtract from the paired asset’s value.

One reason contra asset accounts are used is that they facilitate a faster calculation of net book value, which is the amount a business records as an asset on financial reports. The contra accounts make financial statements more user-friendly, help preparers complete annual filings, and are globally accepted accounting policies.

How are contra asset accounts presented?

Assets, or what is owned by the business, are recorded in a company’s general ledger and appear on the balance sheet. Assets appear with a positive balance because they are recorded as a debit to the account. A negative balance, or credit entry, in an asset account, usually indicates a mistake or is accompanied by an explanation. Contra assets are a rare exception as they are recorded as a credit balance and appear as a negative number. A debit entry in a contra asset account is unnatural and most likely indicates an incorrect journal entry.

Contra asset accounts appear as separate line items on the balance sheet. They are also accessible via the general ledger, trial balance, and some cash flow statements. Contra accounts with small balances may not appear separately, but may be combined with the asset account, subtracting the contra balance from the asset balance. Contra accounts that are combined into the asset value and not shown as separate line items are noted in the footnotes of the balance sheet.

Types of contra accounts (they’re not only for assets…)

So far, we’ve discussed contra asset accounts, which offset the value of asset account balances. Contra accounts can be used for all of the financial components on the balance sheet including assets, liabilities, and equity. (That is, you can have contra assets, contra liabilities, and contra equity.) In fact, contra accounts can even be reflected on the income statement in the form of contra revenue accounts.

Contra asset accounts

As discussed in the first sections of this article, contra asset accounts carry a credit balance. The balance sheet of a business shows:

Assets – Liabilities = Owner’s Equity

The equation shows that liabilities offset assets. Contra assets are classified as assets on the balance sheet, but their negative balance and purpose of offsetting the asset value mean they act more like a liability. Examples of contra asset accounts include accumulated depreciation, obsolete inventory reserves, and allowance for doubtful accounts.

Accumulated depreciation

The accumulated depreciation account is the contra account for fixed asset values. Fixed assets are long-term tangible assets purchased by the business and may include:

  • Land
  • Buildings
  • Equipment and Machinery
  • Computer Hardware and Software
  • Vehicles
  • Furniture and Fixtures

While the balance sheet often lists fixed assets separately, there is only one contra account: the accumulated depreciation account, to which all fixed asset accounts are linked. Contra asset accounts can be used to quickly evaluate depreciation and the remaining useful life of assets.

Obsolete inventory reserves

The obsolete inventory reserve account is the contra account to inventory, another asset listed on the balance sheet.  Products that become unusable are recorded in this contra account to show that they are still owned by the company, but they should be excluded from the market value of inventory.

A forklift in a warehouse filled with inventory, symbolic of the accounting concept obsolete inventory reserves.
Have obsolete inventory? Than use an obsolete inventory account!

Allowance for doubtful accounts

The contra account to the accounts receivable account is the allowance for doubtful accounts and is used to represent the amount of invoiced goods or services that the business does not expect to collect. Combining the value of the allowance for doubtful account and the accounts receivable balance gives a company the net amount of cash it can expect to receive from goods it has sold or services it has already provided.

Contra liability accounts

Just like contra asset accounts offset the positive values of assets on the balance sheet, contra liabilities offset the negative value of liabilities on the balance sheet. Since liabilities are recorded with credit entries, contra liabilities show a debit balance. A contra liability acts more like an asset account because it is recorded as a debit and benefits the business’s bottom line by decreasing the liabilities. Examples of contra liability accounts include financing fees and original issue discounts (OID).

Financing Fees

Financing fees are a contra account used in debt accounting and are seen when a business is engaged in mergers and acquisitions. Businesses amortize the fees associated with debt over the life of the loan. The fees reduce the tax burden for the business so it can be beneficial to record them in a separate contra account called financing fees.

Original Issue Discounts

Original issue discounts (OID) are a type of contra liability like financing fees because they are also amortized over a loan’s term and reduce pre-tax income. The purpose of recording OID as a contra account is to quickly show the difference between the redemption price and the discounted offering price of debt.

Contra equity accounts

The owner’s equity is calculated by subtracting liabilities from the business’s assets. Contra equity accounts reduce the total amount of the owner’s, or shareholders’, equity. While equity accounts typically appear on the balance sheet as a credit balance, the contra equity accounts have a debit balance. An example of contra equity accounts is treasury stock.

Treasury stock

Treasury stock is a contra equity account that is entered as a negative value on the balance sheet of public companies. It shows the amount of funds used to repurchase previous issuances of stock, reducing the total number of shares outstanding.

Contra revenues

Revenues do not appear on the balance sheet but are listed as part of the income statement. Some accounting professionals use contra revenue accounts to adjust gross receipts and calculate net revenue. Contra revenue carries a debit balance and may be listed as sales discounts, sales returns, or sales allowances.

The Bottom Line

At first glance, contra accounts may seem complicated, but contra accounts exist to simplify financial statements. Contra asset accounts appear as a credit balance and reduce the value of assets. Contra liabilities appear as a debit balance and reduce the amount a company owes. Contra equity accounts reduce shareholders’ equity and contra revenues account for a reduction of collected income. Using contra accounts can allow financial statement users to prepare annual reports and calculate net values more efficiently and are an important part of the accounting toolkit.

Still need a bit more help? Better understanding balance sheets and income statements can help you to better understand contra accounts. Our introduction to income statements and introduction to balance sheets is just the thing. Take a look to continue on with your accounting learning.

Interested in learning more cool accounting concepts in general? Check out the best bookkeeping and accounting blog known to man. (Ok, that might be a bit of an exaggeration.)

Who are we? We’re My OC Bookkeeper, the best bookkeeping firm in Orange County. (Or so we’ve been told.) Reach out to us today for all of your bookkeeping and business consulting needs. Click on the surfers below to learn more.

What are Liquidity Ratios?

A series of equations and geometric designs on a blackboard, symbolic of liquidity ratios.

What are liquidity ratios? Well, let’s start with liquidity. Put simply, liquidity is the ability to convert an asset into cash. In terms of a business, it refers to the general amount of liquidity the business has. In other words, the amount of cash and/or assets that can be easily converted to cash that a business has available to it.

Accounts receivables and inventory are great examples of liquid assets. When a balance sheet has more liquid assets (or current assets) than current liabilities (i.e., payments that the company will need to make in the short-term), it shows the company has enough liquidity to meet its short-term obligations. 

However, there’s a better way to gauge a company’s liquidity—with liquidity ratios.

What are liquidity ratios exactly?

Liquidity ratios represent a company’s relative access to liquid assets, and in turn, its ability to pay short-term obligations without external financing.

Financial analysts and investors commonly use liquidity ratios to gauge a company’s ability to pay its creditors and lenders. 

Before you use liquidity ratios, there’s something you should know—more liquidity isn’t always better. When a company has too much money tied up in liquid assets, it will lose out on earning higher returns on relatively less liquid assets. Ideally, a company should hit the sweet spot between having too much and not having enough. 

For instance, you’d never want to see more current liabilities than current assets on your balance sheet because that means you don’t have enough liquidity. On the other hand, if your current assets are 10x the current liabilities, you’re not investing money optimally.

Now that you know what liquidity ratios tell you and have a basic idea of how you should interpret them, let’s look at the three types of liquidity ratios.

Types of liquidity ratios

Each liquidity ratio tries to analyze the company’s liquidity, but with varying levels of conservatism. The current ratio is the least conservative, while the cash ratio is the most conservative. Let’s talk about how.

1. Current ratio

The current ratio simply compares current assets to current liabilities. It tells if you have enough liquidity to meet your short-term obligations. The formula, quite intuitively, is:

Current Ratio = Current Assets ÷ Current Liabilities

A current ratio of less than 1 can spell trouble, but there’s no optimum ratio, because the optimum current ratio differs based on the industry.

Current Asset Definition: current assets are assets that are expected to be converted to cash or used up within one year, or one business cycle.

Current Assets Definition: current assets are assets that are expected to be converted to cash or used up within one year, or one business cycle.

Current Liabilities Definition: current liabilities are liabilities that are expected to be due within one year, or one business cycle.great way to learn more Want to learn some more great accounting / finance terms? Check out our list of key accounting vocabulary here.

Several runners racing on a track, symbolic of the quick ratio.
A good quick ratio doesn’t mean that you’re fast, it means that your company is relatively liquid.

2. Quick ratio

The quick ratio is also called the acid-test ratio because it tests a company’s liquidity more stringently than the current ratio. Unlike the current ratio, the quick ratio doesn’t include all current assets. It only includes current assets that can be quickly converted into cash.

For instance, inventory is excluded because even though it’s a current asset, you may or may not be able to liquidate it quickly.

The formula for quick ratio is:

Quick Ratio = [Cash & Cash equivalents + Accounts Receivable + Marketable Securities] ÷ Current Liabilities

Cash Equivalents Definition: cash equivalents are assets that are not at risk of significantly changing in value that can be converted to cash immediately. Examples include commercial paper, Treasury bills, and some short term government bonds.

3. Cash ratio

The cash ratio is the most stringent of all the three liquidity ratios. It only includes cash and cash equivalents in the numerator and tells you whether you’re holding enough cash and marketable securities to meet short-term obligations.

The cash ratio can be calculated using the formula:

Cash Ratio = [Cash + Cash Equivalents] ÷ Current Liabilities

How do you calculate liquidity ratios?

Liquidity ratios are what are known as balance sheet ratios. That is, ratios whose data is pulled from the balance sheet. So how do you calculate them? It’s simple, just pull the info described above straight off of the balance sheet. (Want to learn more about balance sheets? Check out our great introduction to balance sheets here.)

Importance of liquidity ratios

Liquidity ratios allow companies and stakeholders to monitor liquidity.If a company becomes illiquid, it can be at significant risk of not being able to satisfy its upcoming obligations. (Not to mention any surprise obligations.) It may also experience higher borrowing costs as lenders may charge a higher interest rate because they perceive the company as a higher risk borrower.

The ratios can also be useful in rooting out the causes of poor liquidity. For instance, if a company’s current ratio is poor, but it has a good quick ratio, the problem probably has something to do with inventory. If you’ve started holding too much inventory, it will adversely impact your current ratio, but not the quick and cash ratios. 

However, context is important too. A company may need more inventory because they expect greater demand for their product or because they’re introducing a new product line.

Limitations of liquidity ratios

Liquidity ratios help analysts, investors, and lenders understand a company’s liquidity position. They do come with a few inherent limitations, though:

  • Liquidity ratios are calculated based on historical figures,i.e., the book value of current assets. The value of marketable securities can often change quickly and can impact a company’s liquidity position. 
  • It’s possible that a fundamentally strong company is going through a brief rough patch. Such circumstances aren’t reflected in a liquidity ratio and may create unnecessary concern.
  • Liquidity ratios are calculated the same way for all industries. This is a problem because different industries require different levels of liquidity. Some industries are cyclical, while others have significantly higher working capital requirements. 

Even with their limitations, liquidity ratios provide valuable insight into a company’s liquidity position. They’re reliable tools as long as you’re mindful of their limitations and understand how to use them.

Who are we? We are My OC Bookkeeper – Southern California’s best bookkeeping and business consulting firm. We do everything from financial modeling to day to day bookkeeping and are ready to help you. (Even with liquidity ratios…) Reach out today and let’s do great things together. Check out the video below to learn more.

What is the Difference Between Cash Flows and Profits?

A zoomed in photo of Ben Franklin on a dollar bill, symbolic of the importance of understanding how cash flows and profit are not the same.

Business Owners Need to Understand the Difference Between Cash Flows and Profits

Cash flows and profits are financial metrics that are crucial to business success. And people, especially those new to finance and accounting, can confuse the two terms. But cash flow and profit are not synonymous.

You must understand the difference between these terms to run your business successfully. You can jeopardize the financial health of your business if you constantly mix up cash flow with profit.

If you are an investor, understanding cash flows and profits can make it easy to spot a good investment. As a business owner, you can skillfully make crucial decisions and identify growth opportunities.

Let’s find out everything you need to know about cash flows and profits, how they are different, and how they can affect your business.

What is Profit?

Profit is what remains after subtracting all the expenses from revenue. If you are making a profit you are making more money than you need to run your business.

Like cash flow, profit can also be positive or negative. To help you calculate your profit, you need to figure out your total revenues, costs, and total expenses. These three numbers determine whether there is net profit or net loss. (By costs we mean costs of goods sold, or costs of sales. If you don’t know what those are, don’t worry, you can just consider them another expense.)

Subtract your costs and expenses from your revenues. If your profit turns out to be a negative number, your business has sustained a loss. This situation means you are spending more than you are gaining. If the number is positive, you are netting a profit. 

There are three different forms of profit.

  • Gross profit is your revenue minus the cost of products sold, also known as COGS.
  • Operating profit is the net profit generated from your core business operations. It does not include deductions from interest and taxes.
  • Net profit is the amount left after subtracting all operating costs, interests, and tax expenses over a given period. It is the result of deducting your total expenses from your total revenue.

Given this equation, you can deduce that your product price and the costs it takes to produce it are two important components involved in determining your gross profit. 

How you manage your expenses has a considerable impact on the outcome of your business. Evaluate your expenses if your net profit isn’t big enough, or worse, you’re not netting a profit. From there, you can improve your company’s profitability.

Proper pricing could also help increase your profit. You can switch vendors or reduce your employee salary to control your costs, but it is the price that you have total control over. The bigger the difference between your product price and the cost of production, the bigger your gross profit. Find the highest possible price that will not scare off your customers.

What is Cash Flow?

Running a successful business requires you to follow numerous rules. But if there is one rule you must stick to, it would be to never run out of cash. It is extremely important to maintain an adequate cash balance, but unfortunately, many business owners and managers ignore this issue until it is too late.

Cash flow is the net balance of cash going in and out of your business at a given point in time. It can either be positive or negative. Negative cash flows means that your business has more money going out than going in. Positive cash flows suggest that you have more money coming in than going out. Positive cash flow gives you the ability to pay loans, pay expenses, and have a buffer in case of financial challenges in the future.

It is necessary to manage cash flow for daily operating costs, purchases, salaries, and tax payments. You must control cash that moves in and out of your business and know how well your cash balance stands against cash demands. (The statement of cash flows is the financial statement that provides info on the cash that is coming in and out and what it is being used for.)

It’s never safe to assume that cash will always be available as long as you are making a profit. If you don’t monitor and control your cash flow, you may find yourself in a serious bind.

An extremely anxious man squeezing his head, indicative of how not understanding the difference between cash flows and profit can hurt business.
If you don’t understand the difference between profits and cash flows your business might be in serious trouble. Don’t be like this guy!

This is one of the reasons why many product-based startups face money issues. A business that sells products has to spend cash first, whether for buying the product or for getting raw materials. Even if the product has the potential to bring in enormous profits, if the startup does not have enough cash, it will not survive.

​​It can be confusing when you are running out of cash, yet your startup is making money. Experienced business owners will tell you that it’s possible to be making strong profits yet not have enough cash.

This scenario happens because each sale adds to your revenues, and therefore profits (see above); however, sales don’t translate into cash flows until you get paid. So, if you are making sales like crazy and creating products like crazy to satisfy the demand but not getting paid quickly enough you may run out of cash and not be able to pay things like rent and salaries. That is a big problem, to say the least.

With this in mind, “Don’t focus on sales,” is sound advice. Sales are important, but cash is king.

But it’s important to remember that cash flows don’t just come from sales. Cash flows can come from various sources. If you get a loan, that is a source of cash flows. If you sell a piece of equipment, that is a source of cash flows. If you finally get paid on a sale you made a year ago, that is a source of cash flows. If you sell equity to some new investors, wait for it, that is a source of cash flows.

So, in summary, cash flows and profits are not the same thing. Profits are what is left over after you deduct all of your expenses / costs from your revenue, but that doesn’t necessarily translate to cash. Cash flows are a separate phenomenon independent from profits, and represent the actual net amount of cash in and out of the business. To run a successful business you must mind both. (Want to learn more? Check out our handy definitions page here.)

Who are we? We’re My OC Bookkeeper. Orange County’s premier bookkeeping and business advisory firm. (We also really understand cash flows…) No matter what kind of business you run we can serve as your back office so you can focus on the front. Reach out to us today and let’s do great things together! Watch the video below to learn more.

What is the Best Method for Deducting Vehicle Expenses in CA?

An old car with CA plates, symbolic of choosing the best method to deduct vehicle expenses in CA.

As a business owner, you’re probably well aware of the fact that you only pay taxes on your net income which means you can write off some of the expenses that occur in your everyday life.  If you need a vehicle for business purposes (and, as car-based as life is in California, nearly every business owner needs a car), then you can write off a portion of the expenses related to owning the car. 

But how do you determine how much of your vehicle expenses are eligible to be deducted against your business income and how do you calculate the deduction?

You have two options when it comes to calculating your car expenses – you can either use the actual expense method or the mileage rate. 

So, what is the best method for deducting vehicle expenses in CA? Well, it kind of depends. Read on to find out more.

What counts as a business mile?

Regardless of which type of expense calculation you decide to use, you need to start by calculating your business mileage for the year. Business mileage includes any time you drive from one workplace to another.  If your primary work location is your home, then driving from your home to a client site would count as business mileage.  If your business includes a physical location but your primary work location is your home, the mileage you rack up driving to the office would also count.

If you meet clients for business meals or run out to the store to get office supplies, those miles also count as business miles.

In order to justify your business mileage expense, you should keep a log of your mileage including the date of the trip, purpose, and destination.  If you met with a client, you should note that as well.

How do you calculate the vehicle expense using the mileage method?

The mileage method (once you’ve calculated your business mileage) is the easier method for calculating your business vehicle expense.  You take your total business mileage for the year and multiply it by the standard mileage rate to get your total deduction.

California adheres to the federal mileage rate which is 58.5 cents per mile for 2022.  As you can see, the expense adds up very quickly with every 10-mile trip giving you a $5.85 deduction against your taxable income.

But once you’ve calculated your mileage deduction, you can’t take any additional expenses against your vehicle.  The 58.5 cents per mileage is supposed to cover all of your expenses including gas, repairs, and maintenance.  So, what if your expenses are more than 58.5 cents per mile?  Then you need to consider using the actual expense method.

A line of cars in traffic, representative of the importance of choosing a vehicle expense deduction method for CA businesses.
If you own a business in Southern California you’ve been stuck in traffic. The next time you’re in traffic – think about the best vehicle expense deduction method for your business!

How do you calculate the vehicle expense using the actual expense method?

With gas over $5/gallon in many parts of California, it’s very likely that the federal mileage rate will not cover all of your vehicle expenses.

Under the actual expense method, you take your percentage of business vehicle use for the year and multiply that percent by your total expenses.  The business usage percent is calculated by the business mileage divided by the total mileage. 

Your total vehicle expenses include the following:

  • DMV registration fees
  • Interest paid on the purchase of a vehicle
  • Lease payments
  • Gas
  • Maintenance (carwashes, detailing, replacement parts)
  • Repairs
  • Tires
  • Depreciation on a purchased vehicle*

*Depreciation of a vehicle varies by several factors including the purchase price of the vehicle, federal/state rules which change annually, and the weight of the vehicle.  For example, the entire purchase price of a heavy vehicle (over 6,000 pounds) can be written off in the first year for federal purposes, whereas a small sedan can take a maximum of $18,200 for federal purposes in 2021 and $5,600 for California.  Because the rules change each year, you should check with your tax advisor if you’re considering the purchase of a new business vehicle.

Once you’ve added up your total vehicle expenses, you take the total and multiply it by the business use percentage.  As you can see, this method requires maintaining more records but often results in a higher deduction.

Can you switch between methods?

For each vehicle, you need to choose one method of calculating your expenses for the year.  However, if your business owns multiple vehicles, you can choose which method to use for each vehicle.

Once you have used the actual expense method for a vehicle, you can never use the mileage method for the vehicle.  So, you should consider your long-term plans prior to opting for the actual expense method. 

Interested in learning more about taxes? The websites below are a good place to start.

CA Franchise Tax Board

CA FTB Free Tax Help

IRS Info on Vehicle Deductions

So, as you can see, the best method for deducting vehicle expenses in CA really depends on the situation. Why do we know so much on the topic? We’re My OC Bookkeeper, Southern California’s premier bookkeeping, accounting, and outsourced CFO firm. We help businesses all over SoCal tackle all kinds of challenges so if you have some, reach out to us today. Click on the surfers to learn more!

Everything You Need to Know About PPP Loans

A hand holding several hundred dollar bills, symbolic of the money businesses received through PPP loans.

Our Introduction to Paycheck Protection Program (PPP) Loans

Regardless of what industry your business operates in, the past few years have been a crazy ride. From government-mandated shutdowns to supply chain problems to changing consumer tastes, every business has been affected in some way by the pandemic.

Fortunately, the government stepped in with various loan programs and grants to assist small business owners to weather the storm. Motivated by a desire to keep small businesses in operation and preserve jobs, the government loan programs were available to most small businesses. The Paycheck Protection loan program was by far the most popular pandemic program for small businesses because if the loans were used for approved expenses, the loan were eligible for full, tax-free forgiveness.

What are PPP Loans?

In the early days of the covid pandemic, the U.S. government responded to cries for assistance from small business owners by creating PPP loans. The loans were created to quickly disperse funds to small businesses to prevent excessive business closures. To obtain a loan, a business simply had to prove they were in existence prior to the pandemic and certify that the ongoing uncertainty made the funds necessary to the ongoing operation of the business.

Based on the minimal requirements for the loan, most small businesses qualified for the program. The initial allocation of funds for the program was quickly exhausted but congress allocated additional funds.

What’s the difference between PPP Loans and EIDL Loans?

The government created two concurrent programs to assist small business owners. The first was the PPP loans. The second program was the EIDL loan and grant program.

Under the original rules, a small business was only eligible for either the PPP loan program or the EIDL loan program, however, that rule was later changed to allow businesses to participate in both programs. The only restriction was that the same expenses could not be counted towards both programs. So, if a payroll expense was used to obtain PPP forgiveness, that payroll expense could not be counted as paid for with the EIDL loan funds.

Who was eligible?

All types of businesses were eligible for PPP loans including corporations, partnerships, and sole proprietorships. Sole proprietors were able to use their net income from their Schedule Cs to calculate their own income and quality for a loan even if they had no other employees. Non-profit organizations were also eligible to participate in the loan program.

To be eligible for PPP loans, small businesses had to certify that the loans were necessary to keep the business in operation. Beyond that basic requirement, businesses had to have less than 500 employees or be a part of certain industries that were eligible to count the number of employees by locations (such as restaurant chains).

What do I need to know about accounting for PPP Loans?

When the loan was initially received, it should have been booked as a long-term liability based on the repayment terms and the fact that forgiveness was not guaranteed. A separate loan account should have been created to track the PPP loan.

If you were eligible for loan forgiveness and successfully had your loan written off, you should make a journal entry to debit the PPP loan account you created and credit a new account under other income titled “PPP Loan Forgiveness.” It’s important that the PPP loan forgiveness income be separated from the company’s normal business income.

Various tax forms, a tax letter, a calculator, and a cup of coffee, symbolic of discussion of the tax treatment of PPP loans.
How will PPP loans affect your taxes? Read on to find out!

Are Paycheck Protection Program Loans taxable?

When Congress initially approved the PPP loan program, the PPP loans and the forgiveness was intended to be tax-free for the businesses. However, the IRS initially disagreed with the way the law was written and said that the loan forgiveness income was tax-free but then the expenses paid for with the loan funds could not be deducted. This created a lot of headaches for small businesses that had counted on the tax-free income.

A later vote by Congress adjusted the rules to allow the PPP loan forgiveness income to be tax-free and the expenses paid for with PPP loan proceeds were deductible for federal tax purposes.

However, the vote for the favorable tax treatment of the loan and related expenses was limited to federal income taxes. Each state then had to decide whether to follow the federal rules for the taxation of the loans.

In California, the loans and related expenses were only allowed if the business could show that they had at least one quarter in 2020 where its revenue was 25% lower than the same quarter in 2019. There were additional rules for determining the eligibility of new businesses. Adding to the confusion was the fact that the California rules for the PPP taxation were not decided until March 2021 well after the end of the year.

Will PPP loans be offered again?

Though the future is always uncertain, it seems very unlikely that the government will approve any future PPP loans. The initial PPP loans were created quickly in response to an immediate need to provide financing for small businesses as the economy ground to a halt. Though the pandemic is still going strong, businesses, schools, and government offices are operating near capacity.

If any loans are offered in the future, it’s likely that the loans would have different approval criteria, and forgiveness, if available at all, would be harder to come by. The PPP loans, while well-intentioned, mostly provided benefits to business owners which was not the intent.

Overall, the PPP loans filled a very real need for small business to have quick access to capital at the beginning of the covid pandemic. Despite the complications related to the use of the funds, accounting, and taxation of the funds the PPP loan funds were a huge benefit for many small business owners.

Want to learn even more? Take a look at the resources below:

U.S. Small Business Administration

U.S. Department of Treasury

Looking for someone to help you handle a Paycheck Protection Program loan in your books? At My OC Bookkeeper we help businesses all over Southern California with their bookkeeping, accounting, and outsourced CFO needs. Whether you need basic bookkeeping support or a complex financial model, we are here to help. Reach out to us today and let’s do great things together. Click on the surfers to learn more!

Introduction to Accounts Receivable

A man holding cash in his hand, symbolic of the relationship between accounts receivable and getting paid.

Accounts Receivable Basics

When your business starts out, you’re probably focused on expenses. Every penny going out the door (or your bank account) is money that you’ve invested or borrowed to start up your company. Once you’ve landed your first client, it’s essential to give your revenue just as much time and attention as you gave to those first expenses. (This is why our introduction to accounts receivable is key!)

For some businesses, you receive payment at the time of sale. A restaurant is paid at the end of a meal. A fast-food restaurant receives payments prior to the meal delivery.

But for many other types of businesses, you bill your clients after the services or goods have been delivered. This is especially true of projects that are billed hourly, where you may be able to estimate the amount of time a project will take but you cannot be sure of the final total until the project is complete.

Some businesses take several payments on invoices such as construction companies or manufacturers. They may take an initial deposit and several payments throughout the projects on a single invoice.

Keeping track of the amount you’ve billed your clients or customers is key to maintaining cash flow and ensuring that you get paid for the goods or services you are providing.

What is Accounts Receivable?

Accounts Receivable is calculated as:

Accounts Receivable = Amounts Billed to Customers – Amounts Received

In other words, Accounts Receivable are the payment requests that you have sent out less the payments you received. Like a pirate that buried treasure with the intent of going back and collecting it later, every invoice is like a little bit of treasure that you intend to go back and retrieve.

Accounts Receivable is considered a current asset which means that you expect to receive payment on the invoices in less than a year.

Who needs Accounts Receivable?

Any business that does not receive payment before providing their service or immediately after needs to track their customer’s amount due. Even for businesses that use the cash basis of accounting for tax purposes, it’s essential to have an understanding of how much you expect to collect in the future to be able to project your cash flow. Additionally, businesses that need financing will often have to provide an accounting of account receivable to the financial institution to obtain a loan or line of credit. In some cases, it is possible to sell your Accounts Receivable balance to finance companies to fulfill an immediate need for cash. This is called factoring and usually carries a high imputed interest rate.

What other concepts are related to Accounts Receivable?

There are a few other concepts to understand when it comes to Accounts Receivable.

  • Invoice: A payment request sent by a provider for goods or services.
  • Net 30: When this appears on an invoice it means that payment is due 30 days after the invoice date. There are other common collection periods such as 45, 60, or 90.
  • Discount: Some invoices will include a discount if paid in full within a certain number of days otherwise the full invoiced amount is due.
  • Progress payments: These are payments made against an outstanding invoice that are not intended to cover the full amount of the invoice.
An hourglass symbolic of how you will have to wait to get paid if your business's AR function is poor.
A poor AR function will leave you waiting to get paid!

What is the best way to monitor outstanding invoices?

When your business is small, you might be able to manage a handful of client invoices on your own without much thought. You’ll know who has paid you. A small business may be able to track invoices in Excel or a Google Sheet. But as your business grows, you may find yourself needing a more robust system for tracking invoices.

All significant accounting systems allow you to track customer invoices though some accounting systems, like QuickBooks Online, will require an upgraded subscription to activate this feature. No matter which system you use, you’ll want to track the date that the services or goods were provided, the customer name, the amount due, and any additional fees such as interest, late fees, or sales tax.

Once you’ve entered your invoices including the date that the invoice was sent to the client, you can run an Accounts Receivable aging report. The aging report shows you, by client, how long their invoices have been outstanding, usually grouped into 30-day increments. This helps you determine who needs to be contacted about outstanding bills.

How does thorough tracking of Accounts Receivable help your business?

If you have clients that are consistently behind on your invoices or do not pay them at all, you may want to reconsider them as a client or at least have a discussion with them about paying you in a timely manner.

Minimizing the time that invoices are outstanding creates a healthier cash flow for your business. If your clients are regularly behind on your invoices, you may want to consider accepting other types of payments including credit card payments to reduce the time it takes you to receive funds, even if you end up paying higher fees.

Billing is often the least fun aspect of owning a business and can often be overlooked or put off. By tracking your accounts payable, you can ensure that your clients are being billed regularly. No one likes a surprise bill years later, and those surprise late bills are much less likely to be paid.

Should you manage your AR yourself?

Early in your business’ life, you can probably monitor your Accounts Receivable yourself. As the number of clients grows, the amount of time it takes to input, review, and take action on your Accounts Receivable will also grow.

Many business owners find it uncomfortable to follow up with clients and ask for payments. While no one should feel awkward talking to a client about charges, it’s still fairly common. Outsourcing your accounts payable tracking and collection allows you to continue to focus on running your business while letting someone else deal with the headache of monitoring and collecting your payments. (Want to learn even more? Take a look at Deloitte’s write up on optimizing your AR function.)

Looking for a bookkeeping specialist to help with your accounts receivable or anything else related to your business? At My OC Bookkeeper we help companies all over Los Angeles, Orange County, Riverside, and San Diego with all things business. Whether you need help with bookkeeping, accounting, financial modeling, business plan development, CFO services, or anything in between, we are here to help. Reach out to us here.

Have thoughts on our introduction to accounts receivable? Leave us a comment and let us know!

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Introduction to Accounts Payable

A man pulls money out of his wallet, symbolic of our introduction to accounts payable.

Accounts Payable Basics

When starting a business, you’re probably focused on revenue. Landing those new clients. Building your portfolio of work. Seeing those deposits hit your bank. Revenue is exciting.

But just as important is tracking your expenses, and that means having a solid understanding of Accounts Payable. Nobody loves bills (whether we’re talking about paying bills or tracking them) but let’s talk about why it’s important. So, buckle in and read on for our introduction to accounts payable.

What is Accounts Payable?

The short answer is that Accounts Payable, sometimes referred to as AP, consists of your bills and the payments you’ve made against those bills. Your Accounts Payable balance is:

Accounts Payable = Bills Received – Payments on Bills Received

Your AP balance at any moment of time indicates your obligations to pay your vendors and suppliers. Accounts Payable shows up your balance sheet as a short-term liability meaning that it’s an obligation that will be paid (or should be paid) within a year.

Accounts Payable does not include all of your obligations – it does not include long-term liabilities such as loans, leases, or pension payables. It also does not include tax payment obligations which are tracked separately.

Why is Accounts Payable important?

You’ve probably had the moment of panic when you spot an unpaid bill buried on your desk and wondered if you’re going to get hit by a late fee, or maybe you’ve been embarrassed by a phone call from one of your vendors politely inquiring where their payment is.

Knowing who you owe money to, how much you owe, and when the payment is due is key to streamlining the financial side of your business. By tracking your bills carefully, you’ll be better able to predict your cash flow (or at least the outflows) in the future.

Ensuring that all your bills are paid on time can protect your business credit, or if you’ve personally guaranteed any of the bills, your personal credit. Businesses that habitually pay their invoices late ruin their reputations and have trouble finding good vendors to work with. Just like you want your clients to pay you on time, so do your vendors.

I use cash accounting – why should I care?

It might be tempting to not enter your bills into your accounting system if you use the cash basis of accounting. Most modern accounting systems allow you to switch your reports easily between cash and accrual basis, so don’t use messing up your reporting as an excuse to avoid entering your bills.

As a business owner, you have enough on your mind with the actual operations of your business. Trying to remember how much you owe on a specific bill and when the bill is due just adds one more item to your mental juggling. By entering the bills as they are received, you’ll be able to easily pull up reports and receive automated reminders when bills need to be paid.

Additionally, although the cash basis of accounting may be sufficient for tax purposes, entering your bills will allow you to better match up your revenue and expenses based on when they were incurred. It’s a little extra work to enter the bills, but the extra insight that you gain from entering the bills is usually worth it.

A clock, symbolic of how a good accounts payable system can keep you from paying your bills late.
A good accounts payable process can help you to pay your bills on time!

What is the best way to manage your AP?

There are many ways to manage your Accounts Payable.

You could pay each bill the moment you receive it. This is often not practical since it means pulling out a checkbook, going to a vendor’s website, or entering information into your bill pay when the mail comes every day (or more likely, whenever you receive an email requesting payment). Along with the impracticality of being interrupted by bill paying on a regular basis, you may not have funds available to immediately pay a bill that isn’t due for 30 or 45 days.

You can have a folder set up on your desk with all the bills inside and rifle through it occasionally to figure out which bills are due. This may work while you’re a very small business, but it’s not going to serve you well in the long run. There’s a reason that large corporations have entire departments devoted to Accounts Payable.

Ideally, you’ll enter each bill into your accounting system along with the vendor’s name, bill amount, when it was received, and when it is due. Your accounting system will then produce reports such as an Accounts Payable Aging Report that show which bills are current and if you’ve fallen behind with any vendors. It’s best practice to have one person enter the bills and a second, independent person sign the checks or approve the payments.

If you are a large company, it probably makes sense to have internal people managing bill payment and tracking. But if you’re a small business, it often makes sense to work with an experienced bookkeeper or accounting service. After working with you to gain an understanding of your business and operations, they’ll be able to handle the Accounts Payable system and work with you to make sure that everything stays current and hassle-free for you.

No matter what size business you have nor how complicated your business finances are, Accounts Payable plays an important role in the expense side of your Profit and Loss statement. 

Want to dig deeper than our simple introduction to accounts payable can offer? Check out this Udemy course for advanced AP training.

Looking for an outside bookkeeper to handle your accounts payable for you? Reach out to My OC Bookkeeper! At My OC Bookkeeper we are experts at helping businesses with their accounts payable. Not only that, we can help you with all kinds of issues related to accounting, bookkeeping, outsourced CFO services, and general business consulting. Click on the surfers below to learn more.

Property Management Accounting Basics

A lovely apartment building with several decks intended to represent property management and property management accounting.

An Introduction to Property Management Accounting

Real Estate and Property Management are strong stable markets. Purchasing investment properties or managing those properties for others is a smart move in today’s economy. Making a move towards property management comes with infinite questions about how to handle the transactions, though. All businesses rely on an accounting function to keep them afloat, but property accounting requires specific skills to drive a successful property management venture.

What is Property Accounting?

Property management accounting is essentially landlord accounting. Real Estate structures that contain leased spaces include commercial retail buildings, office buildings, industrial spaces, and residential properties. Property accounting records the transactions that deal with the revenues earned from rents and all the expenses that go into running the property.

Property management accounting is unique from other types of accounting because property management often means multiple properties, so the accounting must be done separately for each entity. Each property requires that accounts be kept for the property itself and for each of its tenants. This means multiple charts of accounts, bank accounts, and financial reports. Investors or small companies that have one or a few buildings may not start out with separate companies for each, but growth will mean setting up multiple legal entities.

Accounting for properties that generate income can be overwhelming, so it is best to break the cycle into steps, or phases. While the demands of properly accounting depend on the specifics of the business, there are four basic phases to the accounting cycle. A property management cycle typically occurs over a period of one month.

1. Collect Rent Revenue

In property management, spaces are leased, or rented, to tenants. The accounting cycle begins with receiving rent and depositing the funds into the bank account.

2. Accounts Payable

Accounts payable is the accounting function that pays and tracks invoices received for products and services needed to run the business. Property management invoices may include those for maintenance, utilities, property taxes, and other operating expenses.

3. Bank Reconciliations

Bank reconciliations are done monthly once the bank statements are received to verify that all rental revenue and operating expenses have been recorded correctly and there is no unexpected or unexplained cash transactions

4. Financial Reports

To complete the accounting cycle for property management, financial reports must be generated. The reports are required for external users including taxing authorities, lenders, and investors. Financial reports are used internally to monitor the financial position of the property and make decisions about future operations.

Rows of windows on the side of an apartment building, symbolic of a business that may require property management accounting.

Property Accounting Terms and Tools

Many of the terms used in property management are similar to general accounting terms, but there are some that carry more weight or are unique to this specific industry. Understanding the meaning of property accounting vocabulary will make a journey into property management much smoother. There are also tools that can be used to make property accounting more efficient. Some common property management terms and tools are described in the list below.

Cash Basis/Accrual Basis

An accounting method must be chosen when starting the books for any business. A cash basis accounting method records transactions as the money comes into or out of the company. In a company that uses cash accounting, rents are recorded onto the ledger as income at the time the funds are received.

Property accounting using an accrual basis means recording transactions when they are due to occur. In a company using the accrual basis, rent would be recorded to the ledger as income on the date it is charged or due, usually the first of the month.

Triple Net/Gross

Triple Net and Gross are both terms that describe lease types. In a gross lease, the tenant pays a monthly base rent, as agreed upon in the lease. The tenant does not share the cost of operating expenses.

 A triple net lease, or NNN lease, means that the tenant pays their pro-rata share of operating expenses and real estate taxes in addition to their base rent. With a NNN lease, operating expenses and property taxes may be paid monthly with base rent based on an estimate provided by the landlord. Some landlords choose to only collect base rent monthly, and bill tenants, following an expense reconciliation, annually.

Trailing 12

A trailing 12 is a term used to describe a format of an income statement. The income statement is also referred to as the profit and loss statement of a business and lists the revenues and expenses to calculate the Net Income. A trailing twelve shows twelve months of income and expenses in one report so that landlords and accountants can see trends from month to month. It is an important tool in analyzing property accounting records because it quickly shows any change in rents or expenses.


A budget lays out the financial plan for a period, usually one year. The budget lists the revenues and expenses that are reasonably expected to happen. A complete and thorough budget is an important analysis tool in monthly reviews of financial statements because it allows the accountant or property owner to track if rents and expenses are occurring as expected.

A forecast is another financial planning tool often used in conjunction with the budget. Proper forecasting gives cash flow expectations for the near future and changes as time goes on. A forecast essentially updates a twelve-month budget with actual data as the months conclude changing the cash flow and income expectations in future months.

Rent Roll

A rent roll is a report that lists each unit in a property. The report lists the tenant, the square footage, the base rent, and important dates. A rent roll is an acceptable way to show current occupancy when working with accounting firms and lenders.

1031 Exchange

The term 1031 Exchange is taken from the IRS Code Section 1031. The 1031 exchange allows real estate investors to defer tax on capital gains by exchanging like-kind property. Basically, when one property is sold, the owner can defer the income tax by purchasing another property within the allowed timeframe. Anyone in the business of buying or selling real estate should speak with their tax advisor regarding the benefits and applications of the 1031 Exchange rules.

Property Management Software

Quite possibly the most important property accounting tool is property management software. Smaller property management companies or individuals owning one or a few buildings may be able to document their financial transactions using a spreadsheet, like Excel. However, because accounting for property management often includes multiple entities and separate accounts for the tenants and the property, good software simplifies the process.

Accounting software that is dedicated to property management, like AppFolio or Onesite, saves time, frustration, and money on generating financial reports, recording rents and expenses, and tenant communications. Purchasing software can be confusing and expensive but using an accounting service to access great property management software is another efficient way to have the best tools in the business.

Final Thoughts

Property management is not for everyone, but many business owners and individuals find that it is a great way to invest in long-term assets while generating income. Accounting for property management requires patience and an overall understanding of the industry-specific terms and expectations beginning with the accounting cycle. For all types and sizes of property management, there are software packages or outsourced accounting services available to aid in the process. One such accounting service is My OC Bookkeeper. We love working with property management companies all over Southern California (and beyond). So if you are looking for a partner to help with your books reach out to us today.

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What are Financial Statements? (An Intro to the Financial Statements)

A business person writing on and reviewing documents that are symbolic of the financial statements.

Introduction to the Financial Statements

If you want to understand accounting, or business in general, then one of the first things that you must learn is how to read financial statements. The financial statements provide summary data (accumulated through day-to-day bookkeeping and accounting) that can tell you a great deal about a company’s financial well-being and the nature of its operations.

For public companies, the financial statements are available to the public in their annual and quarterly reports, also known as 10-Ks and 10-Qs. For private businesses, the financial statements aren’t usually available to the public, but they can be seen in internal documents, internal accounting software, and often-times tax returns. (Strictly speaking that can be said for public companies as well, but the important point is that private companies don’t have formal 10-Ks and 10-Qs that you can find on the web.)

Quick Tip: A great way to learn more about financial statements is to review some real-world examples. If you want to see some 10-Ks from public traded companies check out the SEC’s EDGAR portal where you can search for a public company’s official financial filings. There is a lot of information in an annual or quarterly report (10-K or 10-Q), but if you go through it closely you should be able to find the financial reports – or just check the table of contents if you want to save some time.

So, what are these mysterious financial reports? The three primary statements are the Income Statement (also known as a Statement of Profit and Loss), the Balance Sheet, and the Statement of Cash Flows. (Some public companies may also use a Statement of Changes of Equity, but that is beyond the scope of discussion here.) When reviewed in conjunction, these reports can give a remarkably holistic view of a company, regardless of its size or what it does. In fact, you can learn quite a bit about a company just looking at one or two of these reports, in particular the income statement and the balance sheet.

We will go through each of the documents in turn – so strap on your accounting hat and get ready for some financial statements.

The Income Statement

The income statement, also known as the statement of profit and loss or simply the P&L, is surely the most well-known financial statement. If you want to check out a company’s profitability, or how much revenue it has, or how many expenses it has, then the income statement is what you want. The concept is really quite simple: it starts with the revenue at the top, then begins deducting expenses until you end up with net income, or net loss, which is the amount of money gained or lost after accounting for all of the expenses.

The income statement is made up of flow variables, which is a fancy way of saying that an income statement expresses activity through time, for example a month, or a quarter, or a year. So, when you read an income statement, it is always important to check what the time frame is. (Needless to say, the income statement on an annual report should be for a year and on a quarterly report should be for a quarter.)

A sample income statement showing revenue, followed by several different expenses to get to the net profit.
Sample income statement.

As you can see, an income statement may include some strange vocabulary that you may not be used to. To help with this we’ve put together some definitions which should help to keep things clear – but don’t get too bogged down on any one line item, the most important thing to remember is the basic concept. That is, you start with revenue and then begin pulling out the expenses one by one until you get to your net income, also known as profit.

Cost of Goods Sold (COGS)

You may see COGS listed as an expense just under revenue at the top of an income statement. COGS is an expenses category that some businesses use to describe the internal cost of items they sell. If you buy and then resell shoes, for example, then the cost of buying your shoes is your cost of goods sold, which of course must be deducted from your revenue when trying to determine your profit.

SG&A (Selling, General, & Administrative)

As noted above, SG&A stands for selling, general, and administrative expenses. This can be quite a broad category of expenses, depending on how many unique line items you want on your income statement. It can include anything that would be considered a general or administrative expense like employee salaries, rent, or the cost of office materials and supplies, as well as selling costs like commissions.

Gross Profit

If a company uses COGS, then it will add a subtotal for gross profit which represents the profit after deducting COGS, but before deducting the remaining expenses. This is known as gross profit accounting. (Take look at this article from Investopedia for a bit more info on the difference between gross profit and net income, an important topic.)


EBITDA stands for earnings before interest, taxes, depreciation, and amortization. This represents a subtotal describing profits before deducting the aforementioned amounts and can be useful when undertaking financial analysis or analyzing a company in a bit more detail.


This is the same as EBITDA but with the depreciation (D) and amortization (A) deducted.

Depreciation & Amortization

These are slightly more advanced accounting concepts that represent the amounts deducted as a consideration of the value lost via the depreciation of your equipment or any intangible assets (for example trademarks) that you might own. Unlike most of the expenses on the income statement, these are non-cash expenses, that is, they don’t represent actual cash being lost. We’ll learn a bit more about this concept when we discuss the statement of cash flows later in the article.

Net Income / Net Earnings / Profit

Three ways of saying the same thing, that is, the amount of money left over after deducting all of your expenses.

So those are the income statement basics – for a more detailed description take a look at this blog post which takes a deep dive into all things Income Statement.

The Balance Sheet

The balance sheet is the second most famous financial statement, and when presented alongside the income statement can give a pretty good picture of a company’s financial position. (Although not perfect, for that you need all the statements.)

The balance sheet displays the value of a company’s assets, liabilities, and shareholder’s equity at a given moment in time. This is distinct from the income statement, which describes values that accumulated through a period of time. That is to say, the balance sheet from Dec. 31 describes the value of a company’s assets, liabilities, and equity at the end of that day, and the balance sheet on Dec. 20th describes the values at the end of that day. This may seem a bit confusing, but the key point is that the asset, liability, and equity accounts on the balance sheet represent a store of value that changes through time, not the amount of the actual change.

For example, imagine you bought a multi-million dollar piece of equipment. This is an asset that your business owns and therefore must be displayed on your balance sheet. Just like your car or your house or your computer, this asset will likely lose value over time, so in order to get a good understanding of your company’s financial standing at a given moment it will be key to see the value of the asset at that particular moment in time. Another example would be a loan. On day one of a loan you owe the entire amount, so the entire amount will be shown on the balance sheet. Three years into the loan it will (hopefully) be much smaller, so the amount on the balance sheet will be the remaining balance of the loan after three years.

A bronze bust of lady justice holding scales, symbolic of the balance sheet, one of the financial statements.
Lady justice loves balance sheets.

What is the point of all of this? The point is to show the assets that a company owns, the liabilities that a company owes, and the value that has either been invested in the company or that the company has generated through its operations, (the final concept being the equity). By looking at this one can get a much better understanding of a company’s financial position. Does it have a ton of debt? Does it have a great deal of assets? What kind of assets does it have? What kind of debt does it have? A balance sheet can help to answer these questions.

Quick Tip: Normally, when the balance sheet is displayed alongside the income statement it will represent the last day in the period shown via the income statement. In the case of an annual report, the income statement will display activity from Jan. 1 – Dec. 31, and the balance sheet will display values as of Dec. 31. (Unless of course the company doesn’t use the regular calendar for their fiscal year – but the concept holds regardless of the dates in question.)

The balance sheet can be a bit confusing, but the key points to remember are that it is a snapshot in time, and that it displays a company’s assets, liabilities, and equity, thereby giving you a better understanding of its overall financial health. Take a look at the vocabulary below for a bit more help decoding some of the line items you may encounter, and If you are interested in learning more, check out our great blog post that goes into detail on the ins and outs of balance sheets.

Sample balance sheet, which is one of the financial statements.
Sample balance sheet.

Current Assets

Either cash, or an asset that is expected to be converted to cash within the next year, generally very liquid assets.

Prepaid Expenses / Assets

Items which you have already paid for but haven’t expensed yet on the income statement. For example, good or services that you have already paid for but haven’t received yet. When you receive them you will take this asset off of the balance sheet and add an expense to the income statement.

Long Term Assets

Assets not expected to be converted to cash in the next twelve months.

Current Liablities

Liabilities that will need to be paid in the next twelve months.

Long Term Liabilities

Liabilities that will not be paid in the next twelve months.

PP&E (Property, Plant & Equipment)

As noted above, PP&E stands for Property, Plant & Equipment. This asset category includes the value of the physical assets the you own over a long term such as machinery, buildings, equipment, and vehicles. When these assets lose value through time, it is known as depreciation, which is a non-cash expense on the income statement.

Intangible Assets

Assets that aren’t physical in nature that you will own over a long time frame, such as patents or intellectual property. When these assets lose value through time, it is known as amortization, which is a non-cash expense on the income statement.

Retained Earnings

The profits that have been accumulated through time. Imagine in year 1 you have $1,000 in profits (net income), at the end of year 1 you will have $1,000 in profit on the income statement and $0 in retained earning on the balance sheet. Then in year 2 if you make $3,000 in profits you will have $3,000 on the income statement, and the original $1,000 will be accounted for in retained earnings on the balance sheet. Come year 3 you will have $4,000 in retained earnings on the balance sheet, and the profit you make in that year will be on the income statement. This account represents a key relationship between the income statement and the balance sheet. In short, retained earnings is where you store the net income which you have accumulated in the past.

The Statement of Cash Flows

The third financial statement is the statement of cash flows. The statement of cash flows has never had the same acclaim as the IS and BS, but it is extremely important. The role of the statement of cash flows is to express the actual cash that comes in and out of a business.

You may be thinking, doesn’t the income statement already do that? The answer is no, for several reasons. For one, the income statement includes transactions that may not actually involve the use of cash, for example when you depreciate an asset the depreciation expense is deducted against revenues when determining profit even though there is no cash lost. Or, you may spend cash on transactions that never hit the income statement. For example, when you buy inventory you spend cash, but that inventory is not expensed until it is sold (this is COGS) – in the meantime it represents another asset on your balance sheet.

Another example would be when you purchase long term assets. If you purchase a massive piece of machinery you probably spent a ton of cash, but the purchase won’t hit the income statement at all. The expense associated with that purchase will hit the income statement slowly over time through the depreciation expense, discussed above. Likewise for intangible assets like patents or intellectual property, which eventually are expensed on the income statement via the amortization expense. Given that these kinds of items can be extremely expensive, one can see how checking the income for changes in cash flows can be a major mistake.

Sample statement of cash flows, one of the financial statements.
Sample statement of cash flows.

If you look at the sample statement of cash flows above you will see a perfect example of the difference between net income (from the income statement) and net cash flows, from the statement of cash flows. As you can see, Year 1 has more net income than Year 2, yet in Year 1 the company actually has a net loss of $25,000 in cash, whereas in year 2, the company has a net gain of $163,000 in cash. Why is that? Two primary reasons. For one, in year one there is a major capital expenditure of $150,000. This represents the purchase of a long term asset, like some expensive machinery. That is $150,000 out the door that isn’t touching the income statement (yet) and therefore is not included in the calculation of net income.

In addition, in Year 2 there is a $50,000 increase in cash due to some new debt, presumably a loan of some sort. This also doesn’t hit the income statement, and can only be see here, on the statement of cash flows. These two differences, plus some nominal differences elsewhere on the statement, lead to the substantial discrepancy in cash flows between these years.

If you are really interested in accounting it is crucial you eventually learn the subtleties of cash flow statement, but if you are just looking for a basic understanding of the financial statements suffice it to say that the statement of cash flows is the go to financial statement for examining your cash flows. If you are depending on the income statement for this than you are making a major rookie mistake. (We will be posting an in-depth discussion of the cash flow statement soon should you wish to learn more.)

A zoomed in picture of a pile of money, symbolic of the cash which is tracked by the statement of cash flows, one of the financial statements.
A big old pile of cash – which you track with the statement of cash flows.

Why is all of this important? Well for one, the last thing a business wants to do is to run out of money. Regardless of how big your profits are, running out of money is bad for business. (Very bad.) In addition, it is important to know where your cash is coming from and where it is going, so you can plan accordingly. The statement of cash flows will show you both how much your cash has changed over a period of time (it uses flow variables like the income statement), and what transactions have affected it.

Quick Tip: A classic topic of discussion in business schools is the challenge of a new business with incredibly high profits that fail because they run out of money. Check out this article from Inc. Magazine for three detailed real world examples. Or, to learn even more about the difference between cash flows and profits, check out this article from Harvard Business School.

Like the income statement, the statement of cash flows ties back to the balance sheet. In this case, the statement of cash flows explains the change in the amount of cash (an asset) on the balance sheet over time. So, if at the end of year 1 the balance sheet had $100,000 in cash, and at the end of year 2 it had $50,000, the statement of cash flows will describe in detail why that number went down.

The actual statement of cash flows is broken into three parts: Operating Activities, Investing Activities, and Financing Activities, described below in turn, along with some other key vocabulary.

Operating Activities

These represent cash flows associated with revenue generation, for example cash received from product sales.

Investing Activities

These represent cash flows associated with the acquisition and sale of assets, for example buying a truck (CapEx) or selling a building.

Capital Expenditures (CapEx)

Capital expenditures represent investments in assets that you will use over a long period of time, for example machinery, equipment, or buildings. The amount of the purchase will hit the statement of cash flows initially, then the expense will gradually hit the income statement through depreciation or amortization. This would be categorized on the statement of cash flows under investing activities.

Financing Activities

These represent cash flows associated raising capital, for example acquiring and paying off loans, fundraising from investors, and paying dividends to shareholders.

Concluding Remarks on the Financial Statements

So, there you have it, the three primary financial statements. By examining these statements you can get a very good understanding of the financial standing of a company, be it yours or someone else’s. The income statement provides a picture of revenues, expenses, and profits, the balance sheet breaks down the asset, liability, and equity accounts, and the statement of cash flows sheds light on the cash coming in and out of the company.

As noted earlier, if you want to take a deeper dive into income statements or balance sheets, we’ve got great articles that do just that – Introduction to the Income Statement and What is a Balance Sheet. (Soon we’ll have an Introduction to the Statement of Cash Flows as well, stay tuned.)

If you want to go really deep, like super deep, into these topics then you should read these materials from the CFA Institute. The CFA Institute is an extremely reputable organization in the world of finance and has many great reference materials, not to mention an incredible charter than you can acquire.

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Final point: for more information on why businesses work with companies like us take a look at the first video below. For some great video content on the financial statements, take a look at the second video below.

Why Do Companies Work with Outside Bookkeeping & CFO Services Companies Like My OC Bookkeeper?

Further Learning on the Financial Statements