BOOKKEEPING Basics

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BOOKKEEPING

BASICS
Accrual, Double-Entry
Accounting, Debits & Credits,
Chart of Accounts,
Journals
and, Ledger

Part 1
WHAT’S
HERE…
 Introduction  Double-Entry Accounting
 Business Types  Debits & Credits
 Business Organization  The Journal
 Professional Advice  The Ledger
 Accounting and Records  Additional Information
 Accrual Accounting
 Basic Bookkeeping
 Chart of Accounts
INTRODU
CTION
 Accounting is the bookkeeping methodology
involved in creating a financial record of all
business transactions and in preparing
statements concerning the assets, liabilities
and operating results of the business
 Accounting methods and terms have standard
rules known as:
– Generally Accepted Accounting Principles
(GAAP)
INTRODU
CTION
 Causes of recurring business difficulty and
failure include:
– Inadequate planning
– Lack of business knowledge
– Lack of capital
– Poor management, judgment, and decisions
 Successful business managers understand
their business information and make
comparisons from month-to-month and year-
to-year
INTRODU
CTION
 Accounting collects, organizes and presents
business information in a timely manner
and standardized format
 This tutorial outlines accounting “basics” with a
primary focus on manual, double entry,
accrual accounting processes
BUSINESS
TYPES
 Let’s imagine you are going to open a new
business – what will be its purpose?
BUSINESS
ORGANIZATION
 How will you structure the business?
– Sole proprietorship
– Partnership
– Corporation
– Limited Liability Company
PROFESSIONAL
ADVICE
 Accountants
 Attorneys
 Bankers
 Insurance Agents Starting and
 Investment Advisors working a
business without
 Investors
professional
 Partner/s assistance is not
 Government agencies recommended!!
 Vendors / suppliers
 Local business people
 Professional association members
ACCOUNTING AND
RECORDS
 Cash-basis Accounting
 Single-entry record keeping
 Double-entry record keeping
 Accrual-basis Accounting

These each have merit, purpose, and applicability.


The business type/purpose and size and the ownership structure will
determine which accounting method and record keeping system is
most appropriate for your business venture.
ACCOUNTING AND
RECORDS
Typical Business Records:
 Journals  Payroll Records
 General Ledger  Mileage Log
 Petty Cash Record  Travel Record
 Inventory Records  Entertainment Record
 Fixed Asset Log  Customer Records
 Accounts Receivable  Business Checkbook
 Accounts Payable  Filing System
ACCRUAL
ACCOUNTING
 Businesses can record revenue and expenses in
one of two ways – cash-basis or accrual-basis.

 Accrual accounting is used in businesses


involved in production, purchase and sale of
merchandise. Revenue is a factor.
ACCRUAL
ACCOUNTING
 In accrual-basis accounting, revenue is recorded
when earned, expenses are recorded when they
are incurred whether they are paid or not
 When transactions are posted may have nothing
to do with when cash is received or payments are
made
 Cash is not necessarily the same as revenue
BASIC
BOOKKEEPIN
G
 Bookkeeping deals with five major accounting
categories:
– Assets
– Liabilities
– Owner’s Equity (Equity/Capital/ Net Worth)
– Revenue
– Expense
 Accounting is the bookkeeping process that records financial
transactions and creates records and statements concerning
the assets, liabilities, and operating results of a business
BASIC
BOOKKEEPING
 Basic bookkeeping process for each business
transaction:
(1) Determine correct account category (assets, liabilities, net
worth, revenue, or expense)

(2) Identify correct line item account (e.g., Salaries & Wages;
Employer Share of FICA; Sick Leave Expense, Annual Leave Expense, etc.)

(3) Ensure correct amount used when recording


(posting) the transaction
(4) Be consistent and accurate
BASIC
BOOKKEEPING
 Peso signs are not used in journals or
ledgers. They are used in financial reports.
 Commas used to show thousands of dollars
are not required in journals or ledgers.
They are used in financial reports.
 Decimal points are not required on ruled
journals or ledgers. They are used in
financial reports.
CHART OF
ACCOUNTS
 All accounting systems use a Chart of Accounts
– A listing of accounts in a financial system generally using
numeric or alpha-numeric characters to designate the
transactions that comprise the Balance Sheet and Income
Statement
– The chart of accounts is used as the basis for preparing
financial reports from an accounting system
– The reports should be designed to capture financial
information necessary to make good financial decisions
CHART OF
ACCOUNTS
 A Chart of Accounts could include the
following account series (groups):
– 100 - Assets
– 200 - Liabilities
– 300 - Net worth
– 400 - Revenue
– 500 - Expenses
CHART OF
ACCOUNTS
Assets Liabilities Net Revenue Expenses
Worth
Cash Accounts Capital Sales Salaries and
wages
Accounts Withdrawals Services
payable Utilities
receiva incom
Note Supplies
ble e
payable Repairs
Automobile Interest Rent
Equipment Mortgage earnings Office
Building payable Interest
Land Insurance
Salaries Advertising
Supplies payable Depreciation
Accumulated expense
depreciatio Miscellaneou
n s
CHART OF
ACCOUNTS
 Example Chart of Accounts:
100 - Assets 300 - Net worth 500 – Expenses
101 - Cash 301 - Capital 501 - Salaries and Wages
102- Accounts receivable 302 - Withdrawals 502 - Utilities
103 - Automobile 503 - Supplies
104 - Equipment 504 - Repairs
105 - Building
400 - Revenue 505 - Rent
401 - Sales
106 - Land 506 - Office
402- Services Income
107 - Supplies 507 - Interest
403 - Interest
108 - Accumulated 508 - Insurance
Earnings
Depreciation 509 - Advertising
200 - Liabilities 510- Depreciation Expense
201- Accounts payable 514 - Miscellaneous
202 - Note payable
203 - Mortgage
payable 204 - Salaries
payable
DOUBLE-ENTRY
ACCOUNTING
 A double-entry system requires the use of two
or more accounts for each transaction

- Expenses
+ Revenue
Net Worth
Liabilities
Assets

Like a see-saw, these must balance in a


double- entry accounting system.
DOUBLE-ENTRY
ACCOUNTING
 Example 1 – A business starts with an investment of
$75,000 which is recorded (posted) as:

- Expenses
+ Revenue
Liabilities

Capital
$75,000
Cash

Worth
Asset

$75,00

Net
s

0
DOUBLE-ENTRY
ACCOUNTING
 Example 2 – The business buys a $55,000 building
with $5,000 cash and a mortgage which is posted as:

- Expenses
+ Revenue
Net Worth
$50,000
Liabilitie

Mortgag

Payable

$5,000
$5,000
Cash
Asset

Buildin

$50,00
s

0
g

e/
s
-
DEBITS AND
CREDITS
Accountants have used the
terms debit and credit for
debit credit
hundreds of years to describe
where numbers are placed in
Journals and Ledger Books.
 Debit means left
 Credit means right
ALWAYS
!
Latin Dr and Cr:
• Dr for Debit
• Cr for Credit
DEBITS AND
CREDITS
Asset
Debit Credit
+ - Liabilities ALWAYS!
Debit Credit
- + Net Worth
Debit Credit
Revenue
- +
Debit Credit
When recording - + Expenses
transactions in the Debit
Journal and Ledgers, the five major Credit
account categories are increased or +
decreased by debits or credits as shown. -
THE
JOURNAL
 The Journal or General Journal is used to
record all transactions in chronological order
 The Journal is the book of original entry
 Entries are made on a daily basis, according
to the time and date they occur
 The Journal records debits (left side) and
credits (right side) as illustrated on the next
slide
THE
JOURNAL
Date Description of Entry PR Debit Credit
20XX
Mar 1 Cash 40000
Capital 40000
Invested in the business

2 Rent 600
Cash 600

Indent Credits Skip between entries

Explain transaction Record account number after


amount posted to ledger
THE
JOURNA
L
Date Description of Entry PR Debit Credit
20XX
Apr 1 Truck 28000
Cash 10000
Note payable 18000
Purchase a new truck

April 1 – bought new truck. Invested $10,000 cash in truck with remainder on a note payable.
The truck cost $28,000.
Truck Cash Note Payable

28000 10000 18000


Plus Minus Plus
(increase) (decrease) (decrease)
THE
JOURNA
L,
PAGE 4 OF 5
Sales Cash
Journal Receipts
Journal
Purchase
Journal Cash
Disbursement
Journal

General Journal
Types
of
Journals
THE
JOURNAL
Sales Journals Record only sales on credit

Purchases
Journals
Record everything bought on credit

Cash Receipts
Journals Record all incoming cash

Cash Disbursements
Journals Record all outgoing cash

General Journal Everything not recorded in the other Journals


THE
LEDGER
Journal Cash  Each business
transaction is recorded in
the Journal, then posted
Accounts
Payable (placed) into the
applicable Ledger book.
Capital  The Ledger has all the
accounts listed in order
(assets, liabilities, net
Rent
worth, revenue, and
expenses).
THE
LEDGER
Transactions are typically recorded as follows:
 After reviewing details of the transaction, determine the
accounts affected
– Two or more accounts will be affected in a double-entry
system
 Decide if the applicable accounts are increased or
decreased by the transaction
 Place the correct amount on the proper side of the “T”
account to reflect the increase or decrease
Truck Cash Note Payable
28000 10000 18000
Plus Minus Plus
(increase) (decrease) (decrease)
WHAT’S
HERE…
 The Accounting Cycle
 T-Accounts
 Trial Balance
 Adjusting Entries
 Closing Entries
ACCOUNTING
CYCLE

Starts here:

Journal Entries

Balance Sheet
and Adjusting Entries
Income Statement

Closing Entries
ACCOUNTING
CYCLE

Step 1 Business transactions occur that result in


source documents such as receipts,
bills, checks, etc.
Step 2 Business transactions are recorded in the
Journal chronologically by account name
Step 3 Information is posted (copied) from the
Journal to the General Ledger (book in
which
accounts are recorded)
ACCOUNTING
CYCLE

Journal
Steps 1 and 2 – Transactions occur resulting in
business revenue and expense details that are
recorded in the Journal

Cash
Step 3 – Information from Journal
Accounts is posted to applicable ledgers
Accounts
Payable Recurring transactions are grouped together
into like accounts (categories) such as
cash, receivables, payables, equipment,
etc.
ACCOUNTING
CYCLE

Step 4 A trial balance is prepared which lists, in


order, the ending monthly balances of all
general ledger accounts

Trial Balance
Cash
Assets
Accounts Liabilities
Net Worth
Accounts Revenue
Payable Expense
ACCOUNTING
CYCLE

Journal
Step 5 Adjusting entries are
completed at the end of
the accounting period
(e.g., monthly) to match
Cash
proper revenue with
Accounts expenses in that period
Accounts
Payable Step 6 Adjusting entries from the
Journal are posted into the
General Ledger
ACCOUNTING
CYCLE

Step 7 An adjusted trial balance is prepared that


reflects only the adjusting entries. (If an error
has occurred, it was made in posting.)

Cash Adjusted
Accounts Trial Balance
Accounts
Payable
ACCOUNTING
CYCLE

Journal
Step 8 All temporary (nominal)
accounts are closed and
have a zero balance at the
beginning of the next
Cash
accounting period (month)
Accounts
All closing entries at the
Accounts
Payable end of the accounting
period are recorded in the
Journal
ACCOUNTING
CYCLE

Journal Step 9 Closing entries from the


Journal are posted to the
General Ledger
Step 10 A post-closing trial balance
Cash is prepared which only
Accounts shows permanent
Accounts accounts
Payable
Post-Closing
Trial
Balance
ACCOUNTING
CYCLE

Step 11 Monthly (or periodic) financial statements are


prepared:
 Income Statement
Revenue – Expenses = Net Profit/Loss
 Balance Sheet
Assets = Liabilities + Net Worth

The Balance Sheet equation cannot balance until net income (or loss) is added to the
Balance Sheet from the Income Statement.
T-
ACCOUNTS,
PAGE 1 OF 7

Cash Account No. 101


Date Date
Item PR Debit Item PR Credit

20XX 20XX
Jan 1 J1 2500 Jan 2 J1 250
Jan 3 J1 175
2500 452
Jan XX Balance 2048
Standard Ledger
Account … the
“T” Account Footing (adding) helps balance the account.

Ending balance is difference between the footings.


T-
ACCOUNTS,
PAGE 2 OF 7

Assets = Liabilities + Net Worth Revenue - Expenses


Debit Credit Debit Credit Debit Credit Credit Debit
+ - - + + + -
Balance Balance

Withdrawals
Balances are the differences Debit Credit
+ -
between debits and credits in
the accounts.
Debits LEFT
Credits RIGHT
Normal balance for all asset
accounts are debits.
Normal balance for liability
accounts are credits.
T-
ACCOUNTS,
PAGE 3 OF 7

On Jan 1, 20XX, the business owner invested $5000 cash and $100 office
equipment in the business.
Cash Equipment Capital
Debit Debit Credit Debit Credit
Credit
100 5100
5000

On Jan 15, 20XX, the business bought a used truck for $1000 cash and a
note payable for $4000.
Cash Truck Note Payable
Debit Credit Debit Credit Debit Credit

5000 1000 5000 4000


T-
ACCOUNTS,
PAGE 4 OF 7

On Jan 17, 20XX, the business earned $2000 for services.


Cash Revenue
Debit Credit Debit Credit
5000 1000 2000
2000

On Jan 20, 20XX, the business paid utilities on the building for $200.
Cash Utilities Expense
Debit Credit Debit Credit
5000 1000 200
2000 200
T-
ACCOUNTS,
PAGE 5 OF 7

On Jan 21, 20XX, the business paid its monthly building/office rent of
$500.
Cash Rent Expense
Debit Credit Debit Credit
5000 1000 500
2000 200
500

On Jan 22, 20XX, the business bought office supplies for $250.
Cash Office Supplies
Debit Credit Debit Credit
5000 1000 250
2000 200
500
250
T-
ACCOUNTS,
PAGE 6 OF 7

On Jan 24, 20XX, the business owner withdrew $100 cash to pay personal
expenses.
Cash Withdrawals
Debit Credit Debit Credit
5000 1000 100
2000 200
500
250
100
T-
ACCOUNTS,
PAGE 7 OF 7

At the end of the month the business transactions were summarized.

Cash Office Equipment Business Capital


Debit Credit Credit Debit Credit
Debit Credit
Utilities Debit
5000 1000 5100 200
100
2000 200
500
250 Truck Withdrawals Rent
100 Debit Credit Debit Credit Debit Credit
Balance 5000 100 500
4950

Office Supplies Note Payable Revenue


Debit Credit Debit Credit Debit Credit
250 4000 2000 …to Trial Balance
TRIAL
BALANCE,
PAGE 1 OF 2

Business Name
Trial Balance When the Trial Balance
Date matches (equals),
Debit Credit
everything is fine.

Cash $4,950 But, when it doesn’t the


Supplies 250 bookkeeper must backtrack
Equipment 100 and verify all entries
Vehicle 5,000 against the business
Note Payable 4,000 transaction documentation
Capital 5,100
Withdrawal 100
until the discrepancy is
Revenue 2,000 discovered.
Utilities 200
Corrections are entered and
Rent 500
annotated in the Journal,
TOTALS $11,100 $11,100 posted to the applicable
ledger, and the Trial Balance.

Debits = Credits
TRIAL
BALANCE,
PAGE 2 OF 2

 Prepared at the end of the accounting period


 Prepared from the general ledger
 Each account balance is recorded in order
starting with assets, liabilities, net worth,
revenue and expenses
 Totals for debits and credits are compared and
should equal
 Journals, ledgers and business transaction
documentation are reconciled
ADJUSTING
ENTRIES,
PAGE 1 OF 11

 Made at the end of the month or accounting


period
 Made to:
– Current Assets
– Long-Term Assets
– Liabilities
– Revenue
– Expense
ADJUSTING
ENTRIES,
PAGE 2 OF 11

 Cash is never used in an adjusting entry


 An expense or revenue account is used in
every transaction
 Expenses will normally be debits and revenue
accounts will be credits
 Revenue and Expense Accounts that have
been earned, but remain unrecorded, must be
adjusted
ADJUSTING
ENTRIES,
PAGE 3 OF 11
Date Description of Entry PR Debit Credit

20XX 1. Adjustments are recorded


10 Cash 50000
in the Journal .. Then
Capital 50000

Invested in the business


posted to ledgers

10 Supplies 3500

Cash 3500

Shirts for resale Cash


Accounts
Accounts
Payable
Adjusted
Trial
Balance
2. An adjusted trial balance is
prepared to guard against
errors.
ADJUSTING
ENTRIES,
PAGE 4 OF 11

 Asset
– Accounts such as prepaid insurance, office supplies,
prepaid rent have been paid in advance and recorded as
assets. These should be expensed as used.
 Liabilities
– A unique liability may be created when services are paid in
advance for something the business has not yet done.
This receipt of cash increased the cash account and
a liability called Unearned Revenue which remains in this
account until “earned”.
As it is “earned” it is transferred out of this account
and into Revenue.
ADJUSTING
ENTRIES,
PAGE 5 OF 11

 Accrued Expense
– These are expenses that have been incurred, but
not yet paid.
 Accrued Revenue
– A job will not be completed for several months and
the business won’t get paid until the end of the
job. At the end of the first month, an adjusting
entry is needed for the amount of earnings in the
current month, even though the job is not yet
completed and no bill has been sent.
Adjusting Entries,
Business Name: Date Page 6 of 11
Trial Balance

Debit Credit
Cash 1000.00 This sample trial balance will be
Accounts Receivable 5000.00 used to demonstrate end-of-
Prepaid Insurance 600.00 month/period adjusting entries
Office Supplies 400.00 for:
Equipment 10000.00
• Current Assets
Automobiles 24000.00
Buildings 80000.00
• Long-Term Assets
Land 25000.00 • Current Liabilities
Accounts Payable 25000.00 • Accrued Expense
Notes Payable 15000.00 • Accrued Revenue
Unearned Revenue 1500.00
While each of the examples are
Mortgage Payable 80000.00
Capital 27500.00
separate, all of these that are
Withdrawals 12000.00
applicable would be made and
Revenue (earnings) 90000.00 an Adjusted Trial Balance
Wage Expense 48000.00 prepared.
Utilities Expense 12000.00
Adjustments will appear in blue.
Advertising Expense 6000.00
Repair Expense 15000.00
TOTAL 239000.00 239000.00
Business Name:

Adjusted Trial Balance


Date

Debit
ADJUSTING ENTRIES,
Credit

PAGE 7 OF 11
Cash 1000.00
Accounts Receivable 5000.00
Adjusting Current Assets:
Prepaid Insurance 600.00
Office Supplies 400.00 Date P.R. Debit Credit

300.00
Equipment 10000.00 Dec 31 Office Supplies Exp 100

Automobiles 24000.00 Office Supplies 100

Buildings 80000.00
Land 25000.00
Accounts Payable 25000.00
Notes Payable 15000.00
Current assets are adjusted by removing the used amount
Unearned Revenue 1500.00 from the asset account and transferring it to the expense
Mortgage Payable 80000.00 account.
Capital 27500.00
Withdrawals 12000.00
Revenue (earnings) 90000.00
Wage Expense 48000.00
Office Supplies Expense 100.00
Utilities Expense 12000.00
Advertising Expense 6000.00
Repair Expense 15000.00
TOTAL 239000.00 239000.00
ADJUSTING ENTRIES,
Business Name: Date
Adjusted Trial
Balance
Debit Credit

Cash 1000.00

PAGE 8 OF 11 Adjusting Long-Term Assets:


Accounts Receivable 5000.00

Prepaid Insurance 600.00


Date P.R. Debit Credit
Office Supplies 400.00

Equipment 10000.00

Accumulated Depreciation 2000.00


Dec 31 Depreciation Expense, J16 2000
Equip
Automobiles 24000.00
Accumulated Depreciation J17 2000
Accumulated Depreciation 5000.00

Buildings 80000.00

Accumulated Depreciation 4000.00 Dec 31 Depreciation Expense, J18 5000


Auto
Land 25000.00

Accounts Payable 25000.00


Accumulated Depreciation J19 5000

Notes Payable 15000.00

Unearned Revenue 1500.00 Dec 31 Depreciation Expense, J20 4000


Bldg
Mortgage Payable 80000.00

Capital 27500.00 Accumulated Depreciation J21 4000


Withdrawals 12000.00

Revenue (earnings) 90000.00

Wage Expense 48000.00


Long-term assets need to be adjusted for the amount of
Utilities Expense 12000.00
depreciation (use) for the accounting period. AN account
Advertising Expense 6000.00 called Accumulated Depreciation is used. This account is a
Repair Expense 15000.00 contra-asset account (credit balance) instead of a the
Depreciation Expense 2000.00 normal debit balance of an asset.
Depreciation Expense 5000.00 The difference between cost and depreciation is known as
Depreciation Expense 4000.00 book value. (e.g., equip cost 10000 – 2000 depreciation
TOTAL 239000.00 239000.00 = 8000 book value.)
Business Name:

Adjusted Trial Balance


Date

Debit
ADJUSTING ENTRIES,
Credit

PAGE 9 OF 11
Cash 1000.00
Accounts Receivable 5000.00
Adjusting Current Liabilities:
Prepaid Insurance 600.00
Office Supplies 400.00 Date P.R. Debit Credit

Equipment 10000.00
Automobiles 24000.00 Dec 31 Unearned Revenue 500

Buildings 80000.00 Revenue 500

Land 25000.00
Accounts Payable 25000.00
Notes Payable 15000.00
Unearned Revenue 1500.00
Earnings of $500 are recorded as revenue from the
1000.00 liability account. The liability account was created when
Mortgage Payable 80000.00 the company received cash in advance, but had not
earned the amount. When the amount is earned, it is
Capital 27500.00
transferred to the revenue account.
Withdrawals 12000.00
Revenue (earnings) 90000.00
90500.00
Wage Expense 48000.00
Utilities Expense 12000.00
Advertising Expense 6000.00
Repair Expense 15000.00
TOTAL 239000.00 239000.00
Business Name:

Adjusted Trial Balance


Date

Debit
ADJUSTING ENTRIES,
Credit

PAGE 10 OF 11
Cash 1000.00
Accounts Receivable 5000.00
Adjusting Accrued Expense:
Prepaid Insurance 600.00
Office Supplies 400.00 Date P.R. Debit Credit

Equipment 10000.00
Automobiles 24000.00 Dec 31 Wage Expense 1500

Buildings 80000.00 Wage Payable 1500

Land 25000.00
Accounts Payable 25000.00
Wage Payable 1500.00
Notes Payable 15000.00
This entry would be made by a company that pays
Unearned Revenue 1500.00 payroll on the 5th and 20th of the month. The last days of
Mortgage Payable 80000.00 the month would be recorded as a payable, because the
expense had been incurred, but the company will not
Capital 27500.00
make a payment until the 5th.
Withdrawals 12000.00
Revenue (earnings) 90000.00
Wage Expense 48000.00
49500.00
Utilities Expense 12000.00
Advertising Expense 6000.00
Repair Expense 15000.00
TOTAL 239000.00 239000.00
Business Name:

Adjusted Trial Balance


Date

Debit
ADJUSTING ENTRIES,
Credit

PAGE 11 OF 11
Cash 1000.00
Accounts Receivable 5000.00
Adjusting Accrued Revenue:
6000.00
Prepaid Insurance 600.00 Date P.R. Debit Credit

Office Supplies 400.00


Equipment 10000.00 Dec 31 Accounts Receivable 1000

Automobiles 24000.00 Revenue 1000

Buildings 80000.00
Land 25000.00
Accounts Payable 25000.00
Notes Payable 15000.00
This entry is made for a job that is not completed by the
Unearned Revenue 1500.00 end of the accounting period, but needs to be recorded
Mortgage Payable 80000.00 since the service was performed in the accounting period.
Capital 27500.00
Withdrawals 12000.00
Revenue (earnings) 90000.00
91000.00
Wage Expense 48000.00
Utilities Expense 12000.00
Advertising Expense 6000.00
Repair Expense 15000.00
TOTAL 239000.00 239000.00
CLOSING
ENTRIES,
PAGE 1 OF 4

Journal All Closing entries at the end of the accounting


period are recorded in the Journal then posted to
the Ledger Accounts.

Withdrawals

Revenue

All ledger
accounts Post-Closing Expenses
with Trial
balances are Balance
listed in the
Post-Closing
Trial
CLOSING
ENTRIES,
PAGE 2 OF 4

 At the end of each month, the revenue,


expense and withdrawal accounts are closed
to zero balance
 Closing entries move the difference between
revenue and expense from the income
statement to net worth (owner’s equity)
CLOSING
ENTRIES,
PAGE 3 OF 4

 Assets = Liabilities + Net Worth


Income
Statement

The Balance Sheet equation can not balance


without the amount of profit or loss from the
Income Statement
CLOSING
ENTRIES,
PAGE 4 OF
 All 4 accounts start over at the end of each month. The revenue accounts are clos
revenue
the Expense and Income Summary
 All expense accounts are closed into the Expense and Income Summary
 The Expense and Income Summary account is closed to equity
 The Withdrawal Account is closed to equity
Accounting Basics, Part 3

The Income Statement,


Balance Sheet and
Basic Financial Analysis

Part 3
WHAT’S
HERE…
 Introduction
 Financial Statements
 Income Statement
 Balance Sheet
 Sample Statements
 Impacting the Business
 Analyzing Financials
INTROD
UCTION,
PAGE 1 OF 3

 This training picks up where Part 2 stopped.


 Part 1, started with the basics by discussing:

• Business Types • Chart of Accounts


• Business Organization • Double-Entry Accounting
• Professional Advice • Debits & Credits
• Accounting and Records • The Journal
• Accrual Accounting • The Ledger
• Basic Bookkeeping
INTROD
UCTION,
PAGE 2 OF 3

 Part 2, illustrated and discussed:


– The Accounting Cycle
– Adjusting Entries
– Closing Entries
– Trial Balance
– Closing Balance
INTROD
UCTION,
PAGE 3 OF 3

 This training illustrates and discusses:


– Financial Statements
– The Income Statement
– The Balance Sheet
– Analyzing Financials
FINANCIAL
STATEMENTS
Journal Withdrawals Closing entries are recorded
in the Journal at the end of
Revenu the accounting period.
e Entries are then posted
Expense to Ledger Accounts.
Ledger
Ledger accounts are then
listed in the Post-Closing Trial
Balance.
Then the Financial
Statements are prepared.
Post-Closing
Trial Balance
Income Balance
Assets Statement Statement
Liabilities Revenue
Net - Expenses
Profit
Net Income/ Assets = Liabilities
or Loss + Net Worth
INCOME
STATEMENT,
PAGE 1 OF 3

 Information from the Post-Closing Trial Balance is


entered in the Income Statement at the end of
the accounting period:
Income Earnings of the business
Statement

Costs of the business such as utility


+ Revenue bills, insurance, wages, advertising, etc.
- Expenses

= Net Income or
Loss Net income (or loss) is moved to the
Balance Sheet through the closing
entries.
INCOME
STATEMENT,
PAGE 2 OF 3

 The Income Statement is also known as the Operating


Statement
 Composed of two account categories:
– Income shows sales-related gross revenue
– Expense show all costs associated with the sales such as
Cost of Goods Sold and Personnel costs
 The two operating statement categories, plus to the
three Balance Sheet account categories, are the main
categories of accounts
INCOME
STATEMENT,
PAGE 3 OF 3

 Income (Operating) Statements cover a period of time


 Income and Expense are always recorded separately
 Both are used to record gross amounts – gross income
and gross expense
 Profit or loss is not a consideration in the individual
account elements – it is determined after the entries
are made
THE
BALANCE
SHEET,
PAGE 1 OF 4
 The Balance Sheet can be prepared after the end-of-
month adjustments are entered in the Journal and
Ledgers and the adjusting Trial Balance prepared.
 The Balance Sheet shows what the business owns;
what it owes; and its earnings (profits) or losses
 The Balance Sheet does NOT provide a clear
breakdown of actual business activity
THE
BALANCE
SHEET,
PAGE 2 OF 4
 The Adjusted Trial Balance accounts include:
Cash Notes Payable
Accounts Receivable Unearned Revenue
Prepaid Mortgage Payable
Office Supplies Capital
Equipment Withdrawals
Accumulated Depreciation
Vehicles
Accumulated Depreciation
Land
Accounts Payable
These are the Balance
Sheet Accounts
THE
BALANCE
SHEET,
PAGE 3 OF 4
 The Adjusted Trial Balance accounts include:
Revenue
Wage Expense
Utilities
Expense
Repair Expense
Advertising Expense These are the Income
Statement Accounts

The Income Statement Accounts are listed at the bottom of the


adjusted trial balance, starting with revenue.
THE
BALANCE
SHEET,
PAGE 4 OF 4

Balance Sheet Statement

Assets = Liabilities + Net Worth(*)

Cash, Accounts Amounts owed The difference


Receivable, others between Assets
Equipment, and Liabilities. This
Buildings, Land, is the part of the
etc., elements that business “owned”.
help the business
generate income
(*) AKA Owner’s Equity
SAMPLE
STATEMENTS
,
PAGE 1 OF Name
Business 2
Income Statement
For the Month
Ended XXX XX,
20XX
Service Income $16,520
Interest Income
Revenue: 250
Total Revenue $16,770
Expenses:
Rent $ 1,500
Utilities 900
Supplies 4,000
Wage 10,000
Total Expenses $ 16,400

NET INCOME (LOSS) $ 370


SAMPLE
STATEMENTS
,
PAGE 2 OF Name
Business 2
Balance Sheet
For the Month
Ended XXX XX,
ASSETS LIABILITIES
20XX
Cash $ 670 Accounts Payable $ 500
Accounts Receivable 3,500 Notes Payable 1,000
Supplies 2,500
Total Liabilities $ 1,500
NET WORTH
Owner Capital $5,000
Net Income 370
-Withdrawals 200
Owner Capital (ending) 5,170
$ 6,670 $ 6,670
IMPACTING
THE BUSINESS
 A business owner can make the business grow
by:
– Investing personal cash and assets
– Generating revenue from operations
– Debt (borrowing to buy for the business)
 A business owner can make a business
decline by:
– Withdrawals for personal cash or assets
– Generating expenses from operations
– Too much debt
ANALYZING
FINANCIALS,
PAGE 1 OF 16

 In addition to the Balance Sheet and Income


Statement, business owners / managers need to
examine:
– Cash Flow
– Inventory
– Cost of Good Sold
– Profitability
– Measures of Debt
– Measures of Investment
– Vertical and Horizontal Financial Statement Analysis
– Ratios
ANALYZING
FINANCIALS,
PAGE 2 OF 16

 Financial Analysis typically considers:


– Items in a single year’s statement
– Comparisons for periods of time
– Comparisons to other similar businesses
 Net Working Capital is the excess of current
assets over current liabilities (from the Balance
Sheet). It is indication of a business’s risk or
lack of.
ANALYZING
FINANCIALS,
PAGE 3 OF 16

 A traditional method of “analyzing” financials is


through relationships (ratios)
– Balance Sheet = $100,000
 Cash = $20,000
 Accounts Receivables = $30,000
 Fixed Assets = $50,000

– Ratios: Ratio Relationship Percentage


 Cash: .2 .2:1 20%
 Accounts Receivables: .3 .3:1 30%
 Fixed Assets: .5 .5:1 50%
ANALYZING
FINANCIALS,
PAGE 4 OF 16

 Liquidity / Net Working Capital:


– Indicates ability to meet financial obligations
– More net working capital equates to less risk
2006 2005
Current Assets 28,000.00 18,500.00
Current Liabilities -17,800.00 - 6,200.00
Net Working Capital 10,500.00 12,300.00

In this example, the business is at more risk in 2006 than in 2005,


Even though its assets increase by nearly $10k, its current liabilities
also increased – by $11,600!
ANALYZING
FINANCIALS,
PAGE 5 OF 16

 Current Ratio:
Current Ratio = Current
Assets Current
Liabilities
2006 2005
28000 18500
= 1.57 = 2.98
17800 6200

The current ratio is a more dependable indication of liquidity than net working
capital. Comparing current year’s to past year’s, the larger the ratio, the
lower the risk.

A ratio of 2.0 is considered acceptable for most businesses.


ANALYZING
FINANCIALS,
PAGE 6 OF 16

 Quick Ratio:
Current Ratio = Current Assets -
Inventory Current
Liabilities
2006 2005
28000 - 10000 18500 - 6800
= 1.01 = 1.88
17800 6200

Since inventory is difficult to liquidate quickly, it is subtracted from Current


Assets. In this tougher test of liquidity, a ratio of 1.00 or greater is usually
recommended. As you can see, the 2006 business example is very
marginal. The business needs to reduce liabilities or increase assets.
ANALYZING
FINANCIALS,
PAGE 7 OF 16

 Profitability: Gross Profit Margin


Gross Profit
Gross Profit Margin =
Sales

2000
2006 = 25%
8000 The gross profit margin indicates the
percentage of each sales dollar remaining after
2500
2005 = 43% the business has paid for its goods.
5800 The higher the profit margin, the better.
This business did better in 2005 than in 2006.
ANALYZING
FINANCIALS,
PAGE 8 OF 16

 Profitability: Operating Profit Margin


Income from Operations
Operating Profit Margin =
Sales

1000
2006 = 13%
8000 This ratio ignores interest and taxes.
It represents pure operations.
1200
2005 = 21% The higher the Operating Profit Margin, the
5800 better.
This business did better in 2005 than in
2006.
ANALYZING
FINANCIALS,
PAGE 9 OF 16

 Profitability: Net Profit


Margin
Net Profit
Net Profit Margin =
200 Sales
2006 = 3% The net profit margin is a measure of the
8000 business’ success with respect to earnings on
sales.
975
2005 = 17% The higher the Net Profit Margin, the more
5800 profitable the business.
Clearly the example business is not doing
well.
ANALYZING
FINANCIALS,
PAGE 10 OF 16

Profitability Analysis:
 If the business’ profit ratios are too low, you
should ask:
– Is there enough mark-up on goods? (Check
gross profit margin)
– Are operating expenses too high? (Check
operating profit margin.)
– Are interest expenses too high? (Check net
profit margin.)
ANALYZING
FINANCIALS,
PAGE 11 OF 16

 Debt Measures: Debt


Ratio
Total Liabilities
Debt Ratio =
48800 Total Assets
2006 = 70% This ratio indicates the amount of “other
72900 people’s money” being used to generate profit
26400 The more indebtedness, the greater the risk
2005 = 50% of
52500 failure!
Clearly the example business is not doing
well.
ANALYZING
FINANCIALS,
PAGE 12 OF 16

 Investment Measures: Return-on-Investment


Net Profit
ROI =
Total Assets

In addition to salary from the business, the


200
2006 = 0.3% owner should be earning additional money on
72900 his/her business investment.

975 The higher the ROI, the better.


2005 = 2%
52500 Clearly, the ROI in this example is poor.
ANALYZING
FINANCIALS,
PAGE 13 OF 16

 Vertical Analysis:
– A percentage analysis of the current and past year’s (or
period’s) Balance Sheets and Income Statements on a single
statement
– Balance Sheet:
 Each Asset is shown as a percentage of total assets
 Each liability is shown as a percentage of total
liabilities and equity
– Income Statement
 Each element is shown as a percent of net sales.

See example income statement on next page.


Business Name: Date
Comparative Income Statement
For Years Ended 12/31/2006 and 12/31/2005

1998 1997
Amount Percent Amount Percent

Sales $8,000 100.0% $ 6,000 100.0%


Cost of Goods Sold -6,000 75.0% - 3,900 65.0%

Gross Profit $ 2,000 25.0% 2,100 35.0%


Analyze Financials;
Selling (Variable) Expense Vertical Analysis:
Advertising $ 100 1.3% $ 50 .8%
Freight 50 .6% 40 .7% Example.
Salaries 150 1.9% 150 2.5% Page 14 of 16
Total Selling Expense $ 300 3.8% $ 240 4.0%

Administrative (Fixed0 Expense


Rent $ 450 5.6% $ 250 4.2%
Insurance 150 1.9% 125 2.1%
Utilities 150 3.8% 100 1.7%

Total Administrative Expense $ 750 9.3% $ 475 8.0%

Income From Operations $ 950 11.9% $ 1,385 23.0%


Interest Income 0 0.0% 0 0.0%
Interest Expense - 720 9.0% - 450 7.5%

Net Income Before Taxes $ 230 2.9% $ 935 51.5%


Taxes - 150 1.9% - 180 3.0%

Net Profit (Loss) After Taxes $ 80 1.0% $ 755 12.5%


ANALYZING
FINANCIALS,
PAGE 15 OF 16

 Horizontal Analysis:
– A percentage analysis of the current and past year’s (or
period’s) increases and decreases in the statement items
shown on a single statement
– The actual increase or decrease of an item between
current and past year (period) is listed
– The percentage increase or decrease is listed in the last
(right hand) column

See example on next page.


Business Name: Date
Comparative Income Statement
For Years Ended 12/31/2006 and 12/31/2005

1998 1997 Increase / Decrease


Amount Percent

Sales $8,000 $ 6,000 $ 2,000 33.3%


Cost of Goods Sold 3,900 -2,100 53.8%
6,000
Gross Profit $ 2,000 2,100 ($ 100) (4.8%)
Analyze Financials;
Horizontal Analysis:
Selling (Variable) Expense
Advertising $ 100 $ 50 $ 50 100.0%
Example.
Freight 50 40 10 25.0% Page 16 of 16
Salaries 150 150 same same
Total Selling Expense $ 300 $ 240 $ 60 25.0%

Administrative (Fixed0 Expense


Rent $ 450 $ 250 $ 200 80.0%
Insurance 150 125 25 20.0%
Utilities 150 100 50 50.0%
Total Administrative Expense $ 750 $ 475 $ 275 57.9%

Income From Operations $ 950 $ 1,385 ($ 435) (31.4%)


Interest Income 0 0 0 0.0%
Interest Expense 720 450 270 60.0%
Net Income Before Taxes $ 230 $ 935 ($ 705) 75.4%
Taxes 150 180 30 16.7%
Net Profit (Loss) After Taxes $ 80 $ 755 ($ 675) (89.4%)
SUMMARY,
PAGE
 1 OF 3 statement is one tool to help you manage your business
The financial
 If financial results don’t meet expectations, the owner must act
 Is the data accurate and valid?
 What can be done to immediately cut expenses?
 What can be done to increase productivity of

 assets?
SUMMARY,
PAGE 2 OF 3

 If return on investment is too low, what can


you do to increase return from existing
assets?
 If profit is too low, is mark-up adequate and
competitive? Also, are the operating
expenses too high, proportionately? And
are interest costs too high … too much
debt?
SUMMARY,
PAGE 3 OF 3

 Is liquidity low? This runs the risk of


insolvency. Examine the composition
of current assets and current liabilities.
 Use the vertical and horizontal analyses to
identify trends and compositions that may
signify trouble.

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