Choosing the Best Type of Mortgage

A hand holding keys, symbolic of choosing the best type of mortgage.

Choosing the right type of loan when purchasing a home or investment property can be challenging. There are a lot of factors to consider, and the process can be a bit intimidating. In this article we break down mortgages into the two major types – those for investment properties and those for primary residences – and explore the many options within each of those categories. (And a couple that straddle both.)

So, strap on your home buying hat, and let’s get down to the nitty gritty of choosing the best type of mortgage.

Type of Loans for Home Buyers

One of the first questions a real estate lender will ask you is, “Are you intending for the purchased real estate to be your primary residence?” The reason that is important is because mortgages are different for borrowers purchasing a home to live in than they are for borrowers making an investment. In many cases entirely different kinds of loans are used, and for loan types that can be used in both cases, the eligibility requirements and terms vary, so it’s useful to organize mortgages types in this manner. 

Conventional Loans

Conventional loans are the most common type of real estate financing for traditional home buyers (and some investors). Available at most banks, credit unions, and alternative lenders, conventional home loans are not backed by the government. That having been said, most conventional loans are conforming loans, which means that they mimic the eligibility requirements and loan terms of government-insured programs. Offering conforming loans gives lenders the option to sell the loans to government programs like Fannie Mae and Freddie Mac. Loan terms are typically 15 to 30 years, require a down payment from 3 to 20 percent, and have strict credit requirements. The details of these terms, including the size of the down payment and minimum credit score required, will depend on whether the purchase is a first-home, single-family dwelling, or second home.

Government Insured Loans

Often the more attractive loan terms come from government-backed loans, where the participating government-funded program guarantees that the lender will be repaid for the loan even if the borrower defaults. In real estate loans that are fully or partially insured by government funds, lenders are able to offer lower interest rates, lower down payments, and more flexible eligibility requirements. The most common government-backed home loans include the following:

  • VA Loans – backed by the Department of Veteran Affairs, VA loans allow active-duty military personnel, veterans, and eligible family members to borrow funds with little or no down payment and no required mortgage insurance policy.
  • FHA loans – insured by the Federal Housing Administration, FHA loans are a great financing option for first-time homeowners or those with poor credit scores. The down payment required with FHA loans is directly related to the credit score of the borrower and can be as low as 3.5% with a credit score of 600 or above.
The top of the capital building, symbolic of government insured mortgage loans.
You don’t have to go to D.C. to get a government backed mortgage loan – you can get one right here in our beloved Orange County, CA.

Loans for Real Estate Investors

As noted, the financing options for those looking to purchase residential or commercial real estate for income generating purposes, like collecting rent or profiting from the resale of the property at an increased value (flipping), are in many cases different than the options available to regular homeowners. Generally speaking, the eligibility requirements for investors are stricter and may include higher down payments, higher credit scores, and may even include proof of property management experience. There are; however, a wide range of option available, as described below.

  • Owner financing – sellers have the option to act as a private lender to provide temporary financing to those looking to buy their home or building as an investment.  Typical terms of this type of financing include very high, non-refundable down payments and short-term repayment options.
  • Hard money financing – a popular type of loan for house flippers and other real estate investors, hard money loans come from investors expecting short repayment terms and generous returns on their investments. The financing costs for hard money loans are usually much higher than borrowers find through traditional financing methods.
  • Nonqualified mortgages (non-QM) – financing arrangements based on the projected future rental income of the property. Non-QM loans come with higher down payment requirements and above market interest rates but allow investors access to the funds needed to secure a purchase when faced with fewer options.
  • Home equity loans – borrowing funds against the equity in their primary residence is a popular way for real estate investors to get started. Home equity loans do not affect the current mortgage, but let borrowers take out a lump sum of cash to purchase additional real estate. Home equity loans typically have terms that include fixed interest rates and longer repayment schedules.
  • Conventional financing – like for residential homebuyers, conventional loans can be used by purchasers that don’t ever intend to live on the property. The credit and down payment requirements are often higher for investors, but conventional loans often offer better interest rates than less traditional types of funding.
  • VA multifamily loans – military investors can use funds backed by the U.S Department of Veteran Affairs, called VA joint loans or multifamily loans, to purchase multifamily properties with up to seven units. To qualify, borrowers must plan to live in one of the units full-time.
  • FHA loans – available for first-time homebuyers and other residential users, funds backed by the Federal Housing Administration can be used to buy multifamily properties with four or less units, as long as the borrower resides in one of the units for one year.
  • Cash-out financing – mortgages with a higher loan amount than the value of the purchased property – a common way for investors to finance the purchase of the home and fund repairs and renovations at the same time.

The Bottom Line

There are a wide range of options types available for those wishing to purchase real estate and choosing the best type of mortgage can be daunting. When thinking about these various types, it can be helpful to break them up between those typically used by investors, and those typically used by people looking to live in their homes. (Although there is some cross over, as discussed.) Regardless of your motivation, choosing the appropriate financing when purchasing housing is an important decision that shouldn’t be taken likely. Be sure to investigate all of your options and think carefully before taking the plunge. Good luck!

You may be wondering who we are? (We certainly wouldn’t blame you for doing so.) We’re My OC Bookkeeper. We provide bookkeeping and back office services to a wide range of clients, many of whom work in real estate. We’ve worked with realtors, Air BnB entrepreneurs, house flippers, the owners of small apartment complexes, and everything in between. So if you are interested in getting into real estate and need help with your books, reach out and let’s chat.

Interested in checking out another article on real estate? Try our post on Capitalizing vs. Expensing in Property Management or, take a look at our post on accounting methods used in property management.

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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. (After all, getting paid is fairly important.)

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.

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 you have bad Accounts receivable.
A poor AR function will leave you waiting to get paid and short on cash. Be sure to get paid before the sand runs out!! (Or, if need be just flip over the timer and start again…)

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 Depreciation Methods

A beat up old car, symbolic of the impact of depreciation methods in accounting.

Welcome to our introduction to depreciation methods, where we teach you everything you need to know about that pesky thing called depreciation. Admittedly, it may not be the sexiest of concepts, but we think it’s important for every business owner to understand the basics. For one, it’s interesting, but far more importantly, it can significantly impact your bottom line and is an important consideration in tax optimization and business strategy.

So, strap on your thinking cap and let’s dive in to all things depreciation.

What is depreciation?

Depreciation is a term used to describe the allocation of costs over an extended period of time. Costs that can be depreciated are those regarding fixed assets, which are items purchased for a business’s long-term use that have a useful life of one year or more. There are several guidelines and tables available online to learn the correct useful life of an asset. Common fixed assets include equipment, office furniture, machinery, computer software, buildings, and vehicles. Furniture, fixtures, and other smaller assets are typically fully depreciated within seven years, while larger assets, like buildings and roofs, may have useful lives up to 39 years.

Unlike smaller day to day purchases, these large, long term assets aren’t expensed when they are bought. Instead, the expense is spread out over time via depreciation, which works by reducing the value of the asset as it ages or decays. The amount that is expensed in each period is equal to the amount of depreciation in that period, and the net value of the asset on the balance sheet equals the purchase price minus total depreciation to date.

One of the reasons this is important is because it can impact your tax burden. Even though depreciation in a given period isn’t tied to actual cash leaving your bank account, it is still an expense on your income statement. (Accountants refer to this as a non-cash expense.) Higher expenses decrease your net pretax profit, which decrease your taxes, which increase the cash in your bank account. So, the way you manage depreciation has important tax implications.

Aggressive depreciation

Aggressive depreciation methods, that is, depreciation methods that decrease the value of an asset more quickly, increase expenses in the near term, thus lowering net income and the resulting tax liability in the current period in exchange for lower expenses and higher taxes in the future. Less aggressive treatments result in lower expenses today but will increase expenses in the future.

Another impact of the different methods is regarding the net value of assets on the balance sheet. With aggressive depreciation the net value of an asset on the balance sheet will decrease more quickly, and with a slower depreciation method the net value of the asset will decrease more slowly. (Remember, the value of the asset is its purchase price minus total depreciation.) Eventually, however, the differences will balance out and you will end up with the same value.

Deciding whether a company will benefit from more aggressive, or less aggressive, treatments of depreciation depend on the business owner’s goals and the regulatory structure.

An angry cat, symbolic of aggressive depreciation methods.
An aggressive depreciation method isn’t the same as an aggressive cat. Don’t mistake the two.

Types of depreciation methods

As discussed, how assets are depreciated can impact both a business’s bottom line and their balance sheet. According to the Generally Accepted Accounting Principles, or GAAP, there are four different methods. (GAAP is like the constitution of American accounting.) Before choosing the best method, you’ll want to discuss your short-term and long-term business goals with your accountant.

Straight Line Depreciation

The most common way to calculate depreciation expense is to use the straight line method which depreciates an asset by equal amounts each year based on the purchase price, useful life, and salvage value. That is, the value of the asset when you are ready to get rid of it. For example, if a business purchased an $11,000 copier with a useful life of 5 years that will be wort $1,000 at the end of its life, they would record $2,000 of depreciation ($10,000 / 5 years) per year. Straight line depreciation isn’t considered aggressive or passive, it is sort of the baseline methodology.

Declining Balance Depreciation

Declining balance depreciation is considered an aggressive method because it results in higher expenses in the early years and lower expenses in the later years. In this method a constant percentage of deprecation is applied to the net book value of the asset to calculate the expense. For example, if an asset worth $20,000 with a salvage value of $1,000 depreciates 40% per year the calculations would be as follows:

  • Year 1 Depreciation: $20,000 * 40% = $8,000 (So the net asset value is now $12,000.)
  • Year 2 Depreciation: $12,000 * 40% = $4,800 (So the net asset value is now $7,200.)
  • Year 3 Depreciation: $7,200 * 40% = $2,880 (So the net asset value is now $2,880.)
  • Year 4 Depreciation: $2,880 * 40% = $1,152 (So the net asset value is now $1,152.)
  • Year 5 Depreciation: $152 (Because the salvage value is $1,000.)

As you can see, the expense is decreasing each year, and it is stopped when the value of the asset hits the salvage value.

A machine sprays sparks as it is used, symbolic of depreciating machinery.
If you buy machinery for your business, be sure you depreciate it properly! Talk to your bookkeeper or accountant right away. Also, always protect yourself from sparks…

Sum of the Years Method

Another way to calculate depreciation that is more aggressive than the common straight line method, is the sum of the years’ digits method. In this method you use a formula to convert the useful life of the asset to a percentage that changes each year which you then multiply by the original cost minus the salvage value. The formula is a ratio and a bit odd, so bear with us. For the denominator you add up the digits for each year of the useful life. So, if an asset has a 5 year useful life it would be (year) 5+ (year) 4 + (year) 3 + (year) 2 + (year 1) = 5+4+3+2+1 = 15. For the numerator, you use the same digits, starting with the largest one in the first year. So if the asset is worth $20,000, has a salvage value of $1,000 and a useful life of 5 years, the calculation would be as follows:

  • Year 1 Depreciation: $19,000 * (5/15) = $6,333
  • Year 2 Depreciation: $19,000 * (4/15) = $5,066
  • Year 3 Depreciation: $19,000 * (3/15) = $3,800
  • Year 4 Depreciation: $19,000 * (2/15) = $2,533
  • Year 5 Depreciation: $19,000 * (1/15) = $1,266

As you can see, the depreciation decreases each year, but the total equals the purchase price minus the salvage value. (With a little bit of rounding error.)

UOP Depreciation

The units of production method of depreciation is most often used in the manufacturing industry because it calculates the annual expense based on the actual output of the machine or equipment relative to its total capacity over time. For example, if a $10,000 piece of machinery is able to package 10,000 units, then each unit accounts for $1 of the machine’s life. So, if the machine produces 500 units in a given year, depreciation expense will be $500.

Section 179

Not a GAAP method for calculating depreciation, but an important option to consider for business owners, is using the Internal Revenue Code’s (IRC) Section 179. This option allows businesses to expense the entire cost of the asset in the first year it’s purchased. This option lowers the taxable income in that year, which can be particularly beneficial to new business owners.  For the tax year 2023, business owners can expense the cost of fixed assets up to $1,160,000.

Key Takeaways on Depreciation

  • The method a business uses to depreciate assets will depend on the long and short-term goals of the business owner.
  • The most common way to calculate depreciation is the straight-line method.
  • Depreciation expenses lower a company’s tax liability by reducing net income.
  • More aggressive depreciation results in lower taxable income in the short term, but higher taxable income in the future.
  • The net value of an asset on the balance sheet is it’s original value minus accumulated depreciation.
  • In some cases, business owners can deduct the total cost of a newly purchased asset by electing to use IRC Section 179.

So there you have it, everything you ever wanted to know about depreciation. (And potentially some things you never wanted to know.) Want to continue with your learning? A great next step would be to review balance sheets or income statements. (Income statement is another term for profit and loss, in case that one threw you for a loop…)

Who are your authors? We’re My OC Bookkeeper, Orange County’s premier bookkeeping service provider. We do everything from financial modeling to day to day bookkeeping, to complex bookkeeping clean ups. Need help with your books? Reach out today!

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Capitalizing Verse Expensing in Property Management

A row of toy houses, symbolic of our discussion of capitalizing verse expensing in property management.

In property management businesses it can feel like the decision-making never ends. Small business owners dealing in property management, real estate development, or vacation rentals must consider what threshold base rents should be at, whether to use a maintenance company, if leases should be triple net (NNN) or gross, how to treat each financial transaction, and more. Some financial transactions, like monthly utility bills and budgeted contract services like landscaping, are simple. Extraordinary expenses, on the other hand, like repairing a roof, replacing an HVAC system, leasing office equipment, and other large purchases can create some confusion when recording, reconciling the balance sheet, or sending reports to the tax accountant. Whether or not certain costs should be expensed or capitalized is one of the most frequent questions property managers have. That’s why we’ve created this handy primer on capitalizing verse expensing in property management accounting. So read on to learn to learn everything you need to know about which property management cost to capitalize and which property management costs to expense now.

What are the basic differences between capitalizing and expensing?

Every dollar that comes into or out of an organization is recorded in the business’s financial records. When money comes out of the business bank account for any reason, the cost must be recorded to indicate which type of expense it is. Some payments will reduce liability accounts, like the mortgage, or cancel out open payable items, like returning security deposits, but most payments made by property management companies will need to be expensed or capitalized. The Internal Revenue Service (IRS) and Generally Accepted Accounting Principles (GAAP) dictate the treatment of some costs, but for others, the treatment is up to the business owner and tax preparer.

The most significant difference to most property owners is the effect capitalizing or expensing costs will have on their pre-tax profit, taxes, and the value of their total assets. Transactions that are recorded as expenses will reduce the business’s annual net income by their full amount which will decrease the tax base and have no impact on the total value of assets. Transactions that are capitalized, or capital expenditures, are depreciated over time to reduce net income over several years and therefore have less of an impact on taxes in the first year. As capital expenditures are recorded as fixed assets on the balance sheet, they increase the total net worth of a business or business owner, at least until they are fully depreciated. Read on for more details.

A closer look at capital expenditures

Capital expenditures describe purchases that are intended to be used over an extended amount of time and increase the fair market value of the real estate. Items that are capitalized are not included on the business’s income statement, or profit and loss (P&L) reports. Those transactions are listed on the company’s balance sheet, increasing the total value of assets. The assets are depreciated over time, typically determined by the useful life of the asset. Depreciating the cost means that a portion of the initial cost is listed as depreciation expense and listed on the income statement each year that the asset is still in service. Depreciation expense is then subtracted from the total income, along with operating expenses, to calculate Net Income, profit, and taxable liability.

Capital expenditures (CapEx) are typically items that will be used in the course of business for more than one year. They can be ‘tangible’ and ‘intangible’. Tangible capital expenditures are those purchases and repairs that are beyond the normal scope of operations for the property. Intangible CapEx items are expenses incurred that increase the value of the business but don’t involve physical improvements. Some examples of tangible and intangible capital expenses include:

  • Roof replacements
  • Company vehicles
  • Office equipment, including computer hardware and software
  • Parking lot repaving
  • New carpet
  • Maintenance equipment, like a floor buffer, power washer, or landscaping machinery
  • Exterior fencing
  • Monument signs
  • HVAC system replacement, and some repairs or partial replacements like the compressor
  • Elevator replacement or repair
  • Leasing commissions paid to brokers for new leases
  • Legal fees incurred during real estate purchase or development due diligence
  • Loan costs for placing debt on the property
  • Patents

In short – capitalizing purchases increases the value and total assets of a company, while slowly reducing profit via depreciation over the life of the asset, which spreads the tax impact out over multiple years.

A closer look at operating expenses

Typically, items that need to be expensed are costs that benefit daily operations. Operating expenses are summarized on the business’s income statement and used to calculate Net Income (NI), Net Operating Income (NOI), and profit. Many business owners want to have the freedom to capitalize any large ticket transaction, like a major roof repair or the costs to repair a busted sprinkler system. Unfortunately, categorizing purchases as an operating expense (OpEx) or CapEx is determined by more factors than just cost.

Purchases made that are intended to be used by the business in the current accounting period should be recorded as expenses. Repairs to the property that does not increase, but simply restore, the value of the asset should also be expensed. Some examples of operating expenses common to property management include:

  • Real Estate taxes
  • Employee salaries
  • Monthly utility costs
  • HVAC coil replacement
  • Repairing a section of the roof
  • Property management and asset management fees
  • Parking lot sealing and striping
  • Advertising and marketing costs
  • Legal fees under $1,000, like eviction costs
  • Interest charges on debt payments

In short – expensing purchases allows the business owner to reduce their taxable income by the total cost in the same year the money was spent.

A hand holding keys, symbolic of discussing capitalizing expenses in property management.
Capitalizing verse expensing in property management can be confusing. Hopefully these tips on when to expense property management costs will help. Read on!

What does the IRS say about capitalizing vs. expensing?

According to the Internal Revenue Service (IRS), the following general conditions must be met for an item to be capitalized:

  • Necessary cost to correct a design flaw
  • Costs to expand, or increase the physical size of an asset
  • Costs to increase capacity or productivity
  • Costs necessary to rebuild an asset that has exhausted its natural useful life
  • Costs to replace a major component or structural part of the property
  • Costs spent to adapt a land or building for a new business use

Practically applied, capital expenditures improve the operating condition of a property by increasing the useful life, fair market value, or capacity of the land or building. Expenses, on the other hand, are costs necessary to keep the property in proper operating condition or restore it to its previous condition.

How to tell between an expense and CapEx

In property management it can be difficult to determine whether a large purchase or repair can be a capital expenditure.  If the item improves the land or building, thus increasing its value, it can be a capital expense. If the repair or purchase is simply getting the asset back to working order, it should be expensed. For some large ticket items, the business owner can make decisions regarding which items to capitalize based on their short-term and long-term financial goals. For example, if an entrepreneur is interested in marketing the property to sell in the next few years, they will favor capital expenditures that increase the value of their property. However, if an owner plans to hold the property long term for the benefit of collecting passive rental income, expensing items will result in more aggressive tax deductions (thus increasing cash flow in the short-term.) A Certified Public Accountant (CPA) that prepares the federal income tax returns for the business is an excellent resource on the latest guidelines regarding capitalizing versus expensing transactions in property management. (Speaking of resources, check out this great article to learn the basics of property management accounting.)

Key Takeaways

  • Capital expenditures are added to the company’s balance sheet as an asset.
  • The costs of capital expenditures are depreciated over time.
  • Capitalized expenses are costs incurred to improve the property.
  • Expensed purchases are added to the company’s income statement as an operating expense.
  • Expenses reduce net income, taxable liability, and profit in the year that they were purchased.
  • Operating expenses are costs incurred to maintain the property.

Hopefully you’re now a bit of an expert on capitalizing verse expensing in property management accounting. Remember, if you’re wondering, “what real estate costs should I capitalize?”, consider what your short and long terms goals are, and, of course, what the rules are. (And, feel free to come back to our primer on real estate capitalization rules as well…)

Want to learn some more great stuff? Check out our article on hiring employees in California, or this great article on starting a business in Orange County.

Who are we? We’re My OC Bookkeeper. We provide businesses all over Southern California with bookkeeping and business consulting services. We especially love working with property managers and other real estate professionals (don’t tell anyone), but work with all kinds of great companies. Where you’re in Irvine, Newport Beach, or anywhere else in Southern California, we’re standing by to help. Reach out today and let’s do great things together.

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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

Now that you’re an expert on PPP Loans, maybe it’s time to learn about taxes. Check out this great post for everything you need to know about taxes in California. (Our apologies for those of you not in CA. As the best bookkeeper in Orange County we have a bit of a California bias.)

If you’d rather read up on S-Corps – and who doesn’t want to read about S-Corps – then check out our introduction here.

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!

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.

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, or check out this great post on COGS to learn more.)

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, or, to keep pushing your accounting knowledge to new heights, try this great post on contra accounts. (They’re cool, believe us…)

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 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.

Now that you’re a master of liquidity ratios maybe it’s time for some more intermediate accounting concepts. Check out our post introducing contra accounts, or our primer on the difference between cash flows and profits to keep pushing your accounting knowledge to even greater heights.

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 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.) Or, to skip straight to some more intermediate business tips, take a look at our introduction to S-Corps.

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.

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. (Ratios are huge in accounting and finance. Click here to learn about liquidity ratios.)

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, and for another intermediate accounting concept, check out this article on contra accounts.

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.

Introduction to the Income Statement

Computer screen showing revenue, which is part of income statements

Income Statement Basics

Understanding income statements is crucial if you want to know how businesses operate. Whether you are running a small company in Orange County or are just interested in accounting, learning income statement basics is time well spent. So, without further ado,  My OC Bookkeeper presents you with our introduction to income statements 2018. (Also, remember an income statement is the same thing as a profit and loss statement. One name is never enough in accounting…)

The income statement, balance sheet and statement of cash flows combine to create a business’s financial statements. (Check out our introduction to the balance sheet here.) Each component of the financial statements provides a unique kind of information about a business: the balance sheet offers a snapshot of the financial condition at a given moment in time, the income statement tracks the revenues and expenses through time, and the statement of cash flows tells you how close you are to running out of cash. These statements can be used to do everything from checking last month’s profits to building complex financial models and are included in annual reports or 10-Ks. (Check out the U.S. Securities and Exchange Commission website to see some sample public company 10-Ks.)

What Does an Income Statement Show Me?

The income statement uses flow variables. This means that it provides you with information regarding what happened over a period of time, for example throughout the first quarter. (Do you remember our introduction to the balance sheet? We learned there that unlike the income statement the balance sheet provides a snapshot of a company in time, for example on a given day.)

What does an income statement track through time? All of your revenues and all of your expenses. At the very top the statement is the amount of revenue that was earned throughout the period in question. It may just provide a single ‘revenue’ line item, or it could break up the revenues into types, for example sales revenue, marketing revenue, etc.

Now that you know how much you earned you need to know how much you spent. After the revenues the expenses are deducted. Expenses can be all kinds of things. Rent, marketing expense, gas expense, salaries, debt payments, you name it.

After we deduct the expenses we get to the most important thing of all: profits. This comes at the bottom of the income statement – hence the expression ‘the bottom line’.

So the income statement will not only tell you your profits, but also breakdown where they come from and what expenses had to be deducted to get there. This is key information for any small business owner. (Whether you are in Orange County or not.) If you want to succeed you must know where your money is coming from and where it it going.

Income Statement Vocabulary

A more advanced understanding of an income statement starts with vocabulary. We’ve put together some useful definitions below. Don’t worry if you haven’t encountered any of them. Some are reserved for more advanced financial statements. (Check back for some upcoming advanced financial statement training posts.)

Cost of Goods Sold (COGs)

This is a line item which can be deducted from total revenue create a new category: gross profit. COGs represents a grouping of all of the expenses directly related to the actual creation of a product. (As opposed to its sale, for example.) All of the costs of manufacturing your widgets and the materials you used in making them can be included in COGs. For a more detailed explanation of COGS, check out our introduction to Cost of Goods Sold.

Gross Profit

When you deduct cost of goods sold (COGs) from your total revenue to calculate your gross profit you are using ‘gross profit’ accounting . This can be useful when you want to know how much money your product has created after deducting the production expenses ONLY. To do this you just just add two new line items to the statement, i.e. COGS and gross profit. Then you just deduct all of the regular expenses to reach your bottom line.

Depreciation and Amortization

This is a line item on your income statement which deducts value from your assets based on an assumed depreciation / amortization schedule. That just means that the value of assets that you own, i.e. assets on your balance sheet, decrease over time. Factories, tractors, and wind mills all fall apart eventually. A business owner has to account for this loss in value and it is down by deducting it from the income statement. (This might sound a bit strange. Come back around for some advanced financial statement training if you find this provocative.)

What is the difference between depreciation and amortization? Depreciation is for tangible assets like buildings, and amortization is for intangible assets like contracts.

EBITDA

EBITDA stands for earnings before interest, taxes, depreciation, and amortization. Interest, taxes, depreciation, and amortization are usually some of the last things you deduct on the income statement. Before you do so, you may want to get a subtotal letting you know how the business is doing outside of these issues. That’s all EBITDA is. Simple.

EBIT

EBIT stands for earnings before interest and taxes. It’s basically the same thing as EBITDA but it represents your total profit after deducting depreciation and amortization but before deducting interest and taxes.

Gains & Losses

With gains and losses you are getting into some stranger territory but the concept remains quite easy. You get a gain when you sell an asset that is not your product for a gain relative to the price you paid for it. So if you sold an extra widget maker for $100 more than you paid for it you have a gain. If you sold it at a loss you have a loss.

More Learning

So there you have it. Income statements basics 2018. Be sure to also check out our introduction to the balance sheet and our upcoming introduction to the statement of cash flows. Also, check back soon for some advanced financial statement tutorials and feel free to to watch the intro to the income statement video below.

Looking for some more advanced accounting learning? Check out our blog post on COGS or our post on contra accounts.

Are you a small business in the Orange County, CA area? If so, reach out to us at My OC Bookkeeper for some help with all things accounting and tax.