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accounting

      With cash-basis accounting, you record all transactions in the books when cash actually changes hands, meaning when cash payment is received by the company from customers or paid out by the company for purchases or other services. Cash receipt or payment can be in the form of cash, check, credit card, electronic transfer, or other means used to pay for an item.

      Cash-basis accounting can’t be used if a store sells products on store credit and bills the customer at a later date. There is no provision to record and track money due from customers at some time in the future in the cash-basis accounting method. That’s also true for purchases. With the cash-basis accounting method, the owner only records the purchase of supplies or goods that will later be sold when he actually pays cash. If he buys goods on credit to be paid later, he doesn’t record the transaction until the cash is actually paid out.

      

Depending on the size of your business, you may want to start out with cash-basis accounting. Many small businesses run by a sole proprietor or a small group of partners use cash-basis accounting because it’s easy. But as the business grows, the business owners find it necessary to switch to accrual accounting in order to more accurately track revenues and expenses.

      

Cash-basis accounting does a good job of tracking cash flow, but it does a poor job of matching revenues earned with money laid out for expenses. This deficiency is a problem particularly when, as it often happens, a company buys products in one month and sells those products in the next month. For example, you buy products in June with the intent to sell, and pay $1,000 cash. You don’t sell the products until July, and that’s when you receive cash for the sales. When you close the books at the end of June, you have to show the $1,000 expense with no revenue to offset it, meaning you have a loss that month. When you sell the products for $1,500 in July, you have a $1,500 profit. So, your monthly report for June shows a $1,000 loss, and your monthly report for July shows a $1,500 profit, when in actuality you had revenues of $500 over the two months.

      For the most part, this book concentrates on the accrual accounting method. If you choose to use cash-basis accounting, don’t panic: You’ll still find most of the bookkeeping information here useful, but you don’t need to maintain some of the accounts, such as Accounts Receivable and Accounts Payable, because you aren’t recording transactions until cash actually changes hands. If you’re using a cash-basis accounting system and sell things on credit, though, you’d better have a way to track what people owe you.

Recording right away with accrual accounting

      With accrual accounting, you record all transactions in the books when they occur, even if no cash changes hands. For example, if you sell on store credit, you record the transaction immediately and enter it into an Accounts Receivable account until you receive payment. If you buy goods on credit, you immediately enter the transaction into an Accounts Payable account until you pay out cash.

      

Like cash-basis accounting, accrual accounting has its drawbacks. It does a good job of matching revenues and expenses, but it does a poor job of tracking cash. Because you record revenue when the transaction occurs and not when you collect the cash, your income statement can look great even if you don’t have cash in the bank. For example, suppose you’re running a contracting company and completing jobs on a daily basis. You can record the revenue upon completion of the job even if you haven’t yet collected the cash. If your customers are slow to pay, you may end up with lots of revenue but little cash.

      

Many companies that use the accrual accounting method also monitor cash flow on a weekly basis to be sure they have enough cash on hand to operate the business. If your business is seasonal, such as a landscaping business with little to do during the winter months, you can establish short-term lines of credit through your bank to maintain cash flow through the lean times.

      Seeing Double with Double-Entry Bookkeeping

      All businesses, whether they use the cash-basis accounting method or the accrual accounting method, use double-entry bookkeeping to keep their books. A practice that helps minimize errors and increase the chance that your books balance, double-entry bookkeeping gets its name because you enter all transactions twice.

      

When it comes to double-entry bookkeeping, the key formula for the balance sheet (Assets = Liabilities + Equity) plays a major role.

      In order to adjust the balance of accounts in the bookkeeping world, you use a combination of debits and credits. You may think of a debit as a subtraction because you’ve found that debits usually mean a decrease in your bank balance. On the other hand, you’ve probably been excited to find unexpected credits in your bank or credit card that mean more money has been added to the account in your favor. Now, forget all that you ever learned about debits or credits. In the world of bookkeeping, their meanings aren’t so simple.

      The only definite thing when it comes to debits and credits in the bookkeeping world is that a debit is on the left side of a transaction and a credit is on the right side of a transaction. Everything beyond that can get very muddled. Don’t worry if you’re finding this concept very difficult to grasp. You get plenty of practice using these concepts throughout this book.

      Before getting into all the technical mumbo jumbo of double-entry bookkeeping, here’s an example of the practice in action. Suppose you purchase a new desk that costs $1,500 for your office. This transaction actually has two parts: You spend an asset – cash – to buy another asset – furniture. So, you must adjust two accounts in your company’s books: the Cash account and the Furniture account. Here’s what the transaction looks like in a bookkeeping entry:

      In this transaction, you record the accounts impacted by the transaction. The debit increases the value of the Furniture account, and the credit decreases the value of the Cash account. For this transaction, both accounts impacted are asset accounts, so, looking at how the balance sheet is affected, you can see that the only changes are to the asset side of the balance sheet equation:

      Assets = Liabilities + Equity

      Furniture increase = Cash decreases = No change to total assets

      In this case, the books stay in balance because the exact dollar amount that increases the value of your Furniture account decreases the value of your Cash account. At the bottom of any journal entry, you should include a brief explanation that explains the purpose for the entry. The first example indicates this entry was “To purchase a new desk for the office.”

      To show you how you record a transaction if it impacts both sides of the balance sheet equation, here’s an example that shows how to record the purchase of inventory. Suppose you purchase $5,000 worth of widgets on credit. (Haven’t you always wondered what widgets were? You won’t find the answer here. They’re just commonly used in accounting examples to represent something that’s purchased.) These new widgets add value to your Inventory Asset account and also add value to your Accounts Payable account. (Remember, the Accounts Payable account is a Liability account where you track bills that need to be paid at some point in the future.) Here’s how the bookkeeping transaction for your widget purchase looks:

      Here’s how this transaction affects the balance sheet equation:

      Assets = Liabilities + Equity

      Inventory increases = Accounts Payable increases = No change

      In this case, the books stay in balance because both sides of the equation increase by $5,000.

      

You can see from the two example transactions how double-entry bookkeeping helps to keep your books in balance – as long as you make sure each entry into the books is balanced. Balancing your entries may look simple here, but sometimes bookkeeping entries

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