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.

Budget/Forecast

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.

Want to learn more about us, just click on the surfers below.

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

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.

EBIT

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.

Who are we? Why we are My OC Bookkeeper. The best bookkeeping and business advisory firm in Southern California. Reach out to us today and let’s do great things together!

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

What Are The Differences Between Cash Accounting and Accrual Accounting?

A professional using a computer and a notepad for accounting work

One of the first decisions a new business needs to make is which accounting method they will use to record their financial transactions. To make this decision one first must know the differences between cash accounting and accrual accounting. (Which are sometimes also referred to as the cash basis and the accrual basis.) Accounting methods are some of the most important, yet most commonly misunderstood principles of accounting, so let’s break them down.

What are the differences between cash accounting and accrual accounting?

The main difference between cash and accrual accounting regards the timing of recording transactions. In cash accounting, financial transactions are recorded once cash is exchanged. In accrual accounting, however, financial transactions are recorded at the time the revenue and/or expense is earned/incurred, regardless of when money is exchanged.

For example, say you operate a landscaping business. In January you mow a lawn for a client, but they don’t pay you for the service until February. In cash accounting, you would wait until you receive the cash in order to record it, meaning you would record the transaction in your February books. In accrual accounting, however, you would record the transaction the moment the service is rendered; You would record the transaction in your January books.

What if the situation is reversed? What if a client pays for a service before you have provided it? The same rules apply in this scenario. Say you were paid to mow the lawn in January, but you didn’t complete the service until February. In cash accounting, you would record the transaction in your January books, because that’s when you received the cash. If you are using the accrual method, you would record the transaction in February, because that’s when the service is completed.

The same is true regarding expenses. In accrual accounting, you record the expense the moment you incur it. Say you buy a new lawn mower in January, but you bought it on credit and don’t need to pay until February. In cash accounting, the expense would be recorded in February, whereas in accrual accounting, the expense is recorded the moment it is incurred, or rather, in January.

The other major difference between cash and accrual accounting is the types of transactions recorded. In the cash method, only the transactions regarding money exchanged are recorded. However, in accrual accounting, you record all transactions related to the business.

What are the benefits and disadvantages of the different methods?

Because there are fewer types of transactions to record, the cash method is much simpler and cheaper than the accrual method. It is easier to maintain and easier to understand. Another advantage of this method is you always know how much cash is available to you at any given moment. However, while the accrual method does require more work, it provides better financial insights and more accurate reports about the long-term health of your company. In cash accounting, you don’t necessarily track your assets, liabilities or equity. Meaning unless you take steps to monitor them, you may have no way of generating reports about your company apart from cash flow. (But don’t worry, we can easily do this for you!)

Another disadvantage of the cash method is it can sometimes lead to false conclusions about your profitability. Let’s go back to our landscaping business example. Here’s an imagined list of revenue/expenses for January and February.

  • January:
    • Billed customers for 5,000 in services completed in January
    • Received payments from customers 1000
    • Purchased new equipment on credit 800
    • Billed by outside contractors 1000
    • Paid outside contractors 700
  • February
    • Received 4,000 in payments from customers
    • Paid credit card bill 800
    • Paid outside contractors 300

Cash Method

JanuaryFebruaryTotal
Revenue100040005000
Expenses70011001800
Profit30029003200

Accrual Method

JanuaryFebruaryTotal
Revenue500005000
Expenses180001800
Profit320003200

These charts, while representing the same transactions over the same period, present two very different scenarios. If you looked at the cash chart, you would think February was your more profitable month. In reality, you didn’t earn any income at all in February, but rather collected payments for services already rendered.

As you can see in this example, the accrual method is a more accurate depiction of how your company is actually performing. Still, there are downsides to the accrual method as well. For example, because you are recording transactions when the services occur as opposed to when the money actually comes in, your books won’t match your bank statements. Additionally, you will be unaware of what your cash situation is. This can be disastrous for a business if you aren’t monitoring your cash flow in other ways. You may end up short on cash without realizing it and be unable to pay your bills, even though the long-term health of your company is stable.

How do the cash and accrual methods affect my taxes?

It’s important to decide early on which method you want to use because the IRS requires individuals and businesses to file their taxes using the same method each year. In other words, once you file one way you have to file the same way each year. Later if you wish you switch methods, you have to file a special request with the IRS.

The method you choose can also have an effect on your year-end taxes. If you use the accrual method, for example, you may end up paying taxes on money you haven’t actually received. For example, if you use the accrual method and you invoice a service in December 2017 for 1,000, but you don’t end up receiving the money until later, the transaction would still be recorded as part of your 2017 taxes. Therefore, another cash method benefit is that you don’t pay taxes on any income until you actually receive the money.

An old black and white advertisement for where to pay your taxes

What method is right for me?

Most individuals and small business use the cash accounting method. This method is much simpler and faster than accrual accounting. If you don’t have a lot of accounts receivable or accounts payable, the cash method may suffice for your business. Especially if you are a business with a lot of cash transactions and are dealing with customers directly, the cash method may be right for you.

If, however, you are a larger business and you don’t get paid quickly, accrual accounting is probably your best option. In fact, the IRS requires certain types of business to use accrual accounting. If your company makes more than five million in revenue, for example, the IRS requires that you use accrual accounting. Additionally, if you are audited, the process will be a lot easier if you use accrual accounting because you have detailed reports about every financial transaction you’ve made.

There you have it, the basic differences between cash accounting and accrual accounting. Still unsure about which method is right for you? Contact us now for a free initial consultation! Want to learn more? Check out our YouTube channel or our blog for all kinds of great accounting, bookkeeping, and business tips.

Basic Bookkeeping Categories

Bags filled with different colored beans symbolic of the categories bookkeepers use.

Bookkeeping Categories

Bookkeepers do more than simply keep track of profits and losses. They record every financial transaction related to an entity.  It is only with these records that business owners and accountants can analyze the overall well being of a company. Because there is so much varied activity related to a business on any given day, staying organized is paramount to a company’s success, and subsequently, one of a bookkeeper’s most important roles. How do they do it? With bookkeeping categories, that’s how.

All bookkeepers use the same five bookkeeping categories to keep transactions organized. Because all bookkeepers use these same designations, it creates a universal language wherein anyone who understands bookkeeping can judge the financial health of a company. Each category is important for understanding the financial picture of a company.

Profit & Loss Account

The five categories bookkeepers use are assets, liabilities, equity, income, and expenses. These five categories are then divided in two accounts. One of these accounts is called a profit/loss account (also known as a income statement). This account tracks the total amount of revenue coming in versus going out, or in other words, how much money you are making. (Things get a little more confusing with accrual accounting, but most small businesses use cash accounting.) It is made up of income and expenses. Income refers to any revenue coming into the business. This can include product sales, services, consulting income, etc. Expenses refer to the things you pay for in order to keep the business running. This includes payroll, rent, utilities, or any other overhead expense. The purpose of a profit/loss account is to determine your net income (profits). In order to achieve this, you simply subtract your overall expenses from your overall income.

 

Income               –Expenses                            =Net Income
Examples:

product sales, services, consulting income etc.

Examples:

payroll, rent, utilities

Total profits

Balance Sheet Account

Just because your income statement says you’re making lots of money doesn’t necessarily mean that your company is stable.  This is why you also need the three remaining categories. They can tell you a lot about the financial health of your company. These remaining categories are assets, liabilities, and equity. They are grouped into what’s known as your balance sheet account. Your assets are everything you OWN or have the rights to. Some examples you would file into the assets category include bank accounts, cash, accounts receivable (what customers owe you), inventory, and equipment, just to name a few. Your liabilities are the things that you OWE. This would include accounts payable (unpaid bills), credit cards, loans, sales tax payable, etc. Finally, your equity is what the business is worth in a given moment in time. This would include your capital investment (your original investment), retained earnings (remaining profits), and shareholder contributions. When you add your total liabilities to your total equity, it should equal your total assets. This is why it’s called a “balance” sheet account.

 

Liabilities      +Equity           =Assets
Examples: accounts payable, credit cards, loans, sales tax payableExamples: capital investment, retained earnings, shareholder contributionsExamples: banks accounts, cash, accounts relievable, inventory, equipment

 

Asset Liability Ratios

The best and easiest way to determine the financial health of your business is through your balance sheet account. A healthy business has a 2:1 ratio of current assets to current liabilities. Your current assets are assets that will be converted into cash within the next 12 months. Similarly, current liabilities are bills that are due within twelve months. For example, if your current assets total $20,000, and your current liabilities are $10,000, you have a healthy business. If you have a higher ratio, say 3:1 or even 10:1, it may be time to consider investing, or time to pay off loans with your excess capital. If you ratio is less than 2:1, you need to make changes in order to protect your company.

In summary, individuals and business need documentation of every single transaction in order to have a complete understanding of where they stand financially. However, this quickly amounts to an enormous amount of information. In order to save time, bookkeepers organize each transaction into specific categories. With this information in tow, business and individuals are able to make confident and informed decisions about the future of their enterprise.

There you have it. My OC Bookkeeper’s introduction to the most basic bookkeeping categories. Check out our introduction to balance sheets to learn a bit more about balance sheets, and check out our introduction to income statements to learn a bit more about income statements. Or, Investopedia is a great place to learn about all things business, finance, and accounting. And of course, remember to reach out to My OC Bookkeeper – Orange County’s best small business bookkeeping company for all of your bookkeeping and tax needs.

Like videos? Here is a great educational video on bookkeeping categories – for other great accounting videos check out our YouTube channel.

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.

 

What is a Balance Sheet?

A traditional balancing machine symbolic of a discussion of balance sheets.

Balance Sheet Basics

 

It’s a beautiful day, the sun is shining (or not), and the time has come for My OC Bookkeeper to review some balance sheet basics for our dear readers. Understanding balance sheets is central to understanding the health and character of your business, and it doesn’t take a lot of work to develop a strong foundational understanding. So grab your cup of coffee, turn on some nice music, and let’s begin.

The balance sheet, income statement (also known as a profit and loss statement), and statement of cash flows combine to create a business’s financial statements. 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 a business’s annual report or 10-K. (Check out the U.S. Securities and Exchange Commission website to see some sample public company 10-Ks.)

So What Does a Balance Sheet Tell Me?

As noted above, a balance sheet provides you with a snapshot of your business at a given moment in time. Everything your business owns, or owes, is included on the balance sheet as either an asset, a liability, or shareholder’s equity.

By looking at their balance sheet and comparing various pieces of information a small business owner can gain insights into the health of their business. Are my vendors paying off their debts quickly enough? Check the balance sheet. Do I have enough cash available to consider an expansion? Check the balance sheet. Are my assets worth more than my liabilities? Check the balance sheet. Can I afford to hire a new employee? You guessed it, check the balance sheet.

What Categories Are On A Balance Sheet?

One of the central roles of the balance sheet is organizational. By organizing a business’s assets, liabilities, and equity into easy to use categories it makes it easy to understand how the business is functioning and how all of its parts fit together. The first step is separating the assets, liabilities, and shareholders equity. The fundamental accounting equation tells us that assets = liabilities + shareholder’s equity so we use these as our three main categories. If you don’t understand this don’t worry, we will go into more detail in another post. For now just remember that the total value of a companies assets equals the combined value of its liabilities and equity, and that these are the three main categories used to organize a balance sheet.

Let’s break down a companies assets into some subcategories.

Assets

Assets are anything that a business owns that has value and represent our first category. They can include anything from a company car to a factory to a million widgets. Assets are broken down into current assets and long term assets, and then broken down again within those categories.

Current Assets, also known as short term assets, are assets that can be easily converted into cash within one year. Examples include inventory you expect to sell in the near future, cash, or accounts receivables.

Long Term Assets, also known as fixed assets, are assets of a more long term nature that you don’t expect to convert into cash. Examples include a factory, heavy machinery, and a company car.

By organizing all of your assets into categories such as these you can create a simple list of everything of value that your company owns and use this information to make decisions. Remember our discussion of an expansion? We could check our balance sheet and see how much cash we have available to do so. (To find the amount of cash we simply go to assets, then current assets, and then cash. Interested in furniture? We could go to assets, then long term assets, and then look for furniture.) But before making our final decision let’s check out the other half of the balance sheet: liabilities and shareholder’s equity. But before we do that – and we realize that’s two ‘buts’ in a row – check out this post on contra assets for a more advanced balance sheet concept.

Sample balance sheet for small business.

Liabilities and Shareholder’s Equity

This is where we put everything that isn’t an asset. For the time being, let’s focus on liabilities. Liabilities represent any debt or obligation that a business holds. Examples include accounts payable, loans, and deferred revenues. (Props if you know what deferred revenues are. If not, you can learn all about deferred revenues here.)

As was the case with assets, liabilities are first broken down into current and non-current (long term) liabilities and then broken down into subcategories. If they are due within a year, then they are current. If not, they are non-current.

So if we are still interested in a possible expansion, we could check how much cash we have on the assets side of the balance sheet, and then get an idea of how much we have to spend on debts on the liabilities side. By looking at all of our assets and all of our liabilities together we are starting to get a good idea as to the biology of our company.

There’s just one piece left: shareholder’s equity. Equity can be a bit more confusing than the other parts of the balance sheet, but is still pretty straightforward. Just remember that equity is the difference between assets and liabilities. (As per the fundamental accounting equation: assets = liabilities + equity.) So if you have more assets than liabilities, hooray, you will have positive equity.

Advanced Balance Sheet Training

Those are the basics. Let’s quickly summarize: a balance sheet is a snapshot of a company that enables you to examine all of its financial pieces in an organized manner. This information can be used to do all kinds of cool things, from the very basic to the very advanced.

If you are interested in some advanced balance sheet training you have come to the right place. We will be posting an advanced balance sheet tutorial in the near future, so stay tuned.

Are you a small business owner looking for some accounting and tax expertise? My OC Bookkeeper provides the best small business bookkeeping and tax assistance available in Orange County.

To learn more about balance sheets check out the cool video below.