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General Ledger
Income Statements
Balance Sheets
Depreciation
Amortization
Inventory Accounting
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The general ledger is the core of your company’s financial records. These
constitute the central “books” of your system, and every transaction flows
through the general ledger. These records remain as a permanent track of the
history of all financial transactions since day one of the life of your company.
Sub-ledgers and the General Ledger
Your accounting system will have a number of subsidiary ledgers (called
sub-ledgers) for items such as cash, accounts receivable, and accounts payable.
All the entries that are entered (called posted) to these sub-ledgers will
transact through the general ledger account. For example, when a credit sale
posted in the account receivable sub-ledger turns into cash due to a payment,
the transaction will be posted to the general ledger and the two (cash and
accounts receivable) sub-ledgers as well.
There are times when items will go directly to the general ledger without any
sub-ledger posting. These are primarily capital financial transactions that have
no operational sub-ledgers. These may include items such as capital
contributions, loan proceeds, loan repayments (principal), and proceeds from
sale of assets. These items will be linked to your balance sheet but not to your
profit and loss statement.
Setting up the General Ledger
There are two main issues to understand when setting up the general ledger. One
is their linkage to your financial reports, and the other is the establishment
of opening balances.
The two primary financial documents of any company are their balance sheet
and the profit and loss statement, and both of these are drawn directly from the
company’s general ledger. The order of how the numerical balances appear is
determined by the chart of accounts , but all entries that are entered will
appear. The general ledger accrues the balances that make up the line items on
these reports, and the changes are reflected in the profit and loss statement as
well.
The opening balances that are established on your general ledgers may not
always be zero as you might assume. On the asset side, you will have all
tangible assets (the value of all machinery, equipment, and inventory) that is
available as well as any cash that has been invested as working capital. On the
liability side, you will have any bank (or stockholder) loans that were used, as
well as trade credit or lease payments that you may have secured in order to
start the company. You will also increase your stockholder equity in the amount
you have invested, but not loaned to, the business.
The General Ledger Creates an Audit Trail
Don’t let the word audit strike fear in your heart; I am not talking about a tax
audit. Although, if you are called to respond to an outside audit for any
reason, a well-maintained general ledger is essential.
But you will also want an internal trail of transaction so that you can trace
any discrepancy (such as double billing or an unrecorded payment) through your
own system. You must be able to find the origin of any transaction in order to
verify its accuracy, and the general ledger is where you will do this
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An income statement, otherwise known as a profit and loss statement, is a
summary of a company’s profit or loss during any one given period of time, such
as a month, three months, or one year. The income statement records all revenues
for a business during this given period, as well as the operating expenses for
the business.
What are income statements used for?
You use an income statement to track revenues and expenses
so that you can determine the operating performance of your business over a
period of time. Small business owners use these statements to find out what
areas of their business are over budget or under budget. Specific items that are
causing unexpected expenditures can be pinpointed, such as phone, fax, mail, or
supply expenses. Income statements can also track dramatic increases in product
returns or cost of goods sold as a percentage of sales. They also can be used to
determine income tax liability.
It is very important to format an income statement so that it is appropriate
to the business being conducted.
Income statements, along with balance sheets, are the most basic elements
required by potential lenders, such as banks, investors, and vendors. They will
use the financial reporting contained therein to determine credit limits.
1. Sales
The sales figure represents the amount of revenue generated by the
business. The amount recorded here is the total sales, less any product returns
or sales discounts.
2. Cost of goods sold
This number represents the costs directly associated with making or
acquiring your products. Costs include materials purchased from outside
suppliers used in the manufacture of your product, as well as any internal
expenses directly expended in the manufacturing process.
•
Gross profit
Gross profit is derived by subtracting the
cost of goods sold from net sales. It does not include any operating expenses or
income taxes.
3. Operating expenses
These are the daily expenses incurred in the operation of your business.
In this sample, they are divided into two categories: selling, and general and
administrative expenses.
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Sales salaries
These are the salaries plus bonuses and
commissions paid to your sales staff.
•
Collateral and promotions
Collateral fees are expenses incurred in the
creation or purchase of printed sales materials used by your sales staff in
marketing and selling your product. Promotion fees include any product samples
and giveaways used to promote or sell your product.
•
Advertising
These represent all costs involved in creating
and placing print or multi-media advertising.
•
Other sales costs
These include any other costs associated with
selling your product. They may include travel, client meals, sales meetings,
equipment rental for presentations, copying, or miscellaneous printing costs.
• Office
salaries
These are the salaries of full- and part-time
office personnel.
• Rent
These are the fees incurred to rent or lease
office or industrial space.
•
Utilities
These include costs for heating, air
conditioning, electricity, phone equipment rental, and phone usage used in
connection with your business.
•
Depreciation
Depreciation is an annual expense that takes
into account the loss in value of equipment used in your business. Examples of
equipment that may be subject to depreciation includes copiers, computers,
printers, and fax machines.
•
Other overhead costs
Expense items that do not fall into other
categories or cannot be clearly associated with a particular product or function
are considered to be other overhead costs. These types of expenses may include
insurance, office supplies, or cleaning services.
4. Total expenses
This is a tabulation of all expenses incurred in running your business,
exclusive of taxes or interest expense on interest income, if any.
5. Net income before taxes
This number represents the amount of income earned by a business prior to
paying income taxes. This figure is arrived at by subtracting total operating
expenses from gross profit.
6. Taxes
This is the amount of income taxes you owe to the federal government and,
if applicable, state and local government taxes.
7. Net income
This is the amount of money the business has earned after paying income
taxes.
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A balance sheet is a snapshot of a business’ financial condition at a
specific moment in time, usually at the close of an accounting period. A balance
sheet comprises assets, liabilities, and owners’ or stockholders’ equity. Assets
and liabilities are divided into short- and long-term obligations including cash
accounts such as checking, money market, or government securities. At any given
time, assets must equal liabilities plus owners’ equity. An asset is anything
the business owns that has monetary value. Liabilities are the claims of
creditors against the assets of the business.
What is a balance sheet used for?
A balance sheet helps a small business owner quickly get a
handle on the financial strength and capabilities of the business. Is the
business in a position to expand? Can the business easily handle the normal
financial ebbs and flows of revenues and expenses? Or should the business take
immediate steps to bolster cash reserves?
Balance sheets can identify and analyze trends, particularly in the area of
receivables and payables. Is the receivables cycle lengthening? Can receivables
be collected more aggressively? Is some debt uncollectable? Has the business
been slowing down payables to forestall an inevitable cash shortage?
Balance sheets, along with income statements, are the most basic elements in
providing financial reporting to potential lenders such as banks, investors, and
vendors who are considering how much credit to grant the firm.
1. Assets
Assets are subdivided into current and long-term assets to reflect the
ease of liquidating each asset. Cash, for obvious reasons, is considered the
most liquid of all assets. Long-term assets, such as real estate or machinery,
are less likely to sell overnight or have the capability of being quickly
converted into a current asset such as cash.
2. Current assets
Current assets are any assets that can be easily converted into cash
within one calendar year. Examples of current assets would be checking or money
market accounts, accounts receivable, and notes receivable that are due within
one year’s time.
• Cash
Money available immediately, such as in
checking accounts, is the most liquid of all short-term assets.
•
Accounts receivables
This is money owed to the business for
purchases made by customers, suppliers, and other vendors.
•
Notes receivables
Notes receivables that are due within one year
are current assets. Notes that cannot be collected on within one year should be
considered long-term assets.
3. Fixed assets
Fixed assets include land, buildings, machinery, and vehicles that are
used in connection with the business.
• Land
Land is considered a fixed asset but, unlike
other fixed assets, is not depreciated, because land is considered an asset that
never wears out.
• Buildings
Buildings are categorized as fixed assets and
are depreciated over time.
•
Office equipment
This includes office equipment such as
copiers, fax machines, printers, and computers used in your business.
•
Machinery
This figure represents machines and equipment
used in your plant to produce your product. Examples of machinery might include
lathes, conveyor belts, or a printing press.
•
Vehicles
This would include any vehicles used in your
business.
•
Total fixed assets
This is the total dollar value of all fixed
assets in your business, less any accumulated depreciation.
4. Total assets
This figure represents the total dollar value of both the short-term and
long-term assets of your business.
5. Liabilities and owners’ equity
This includes all debts and obligations owed by the business to outside
creditors, vendors, or banks that are payable within one year, plus the owners’
equity. Often, this side of the balance sheet is simply referred to as
“Liabilities.”
•
Accounts payable
This is comprised of all short-term
obligations owed by your business to creditors, suppliers, and other vendors.
Accounts payable can include supplies and materials acquired on credit.
•
Notes payable
This represents money owed on a short-term
collection cycle of one year or less. It may include bank notes, mortgage
obligations, or vehicle payments.
•
Accrued payroll and withholding
This includes any earned wages or withholdings
that are owed to or for employees but have not yet been paid.
•
Total current liabilities
This is the sum total of all current
liabilities owed to creditors that must be paid within a one-year time frame.
•
Long-term liabilities
These are any debts or obligations owed by the
business that are due more than one year out from the current date.
•
Mortgage note payable
This is the balance of a mortgage that extends
out beyond the current year. For example, you may have paid off three years of a
fifteen-year mortgage note, of which the remaining eleven years, not counting
the current year, are considered long-term.
•
Owners’ equity
Sometimes this is referred to as stockholders’
equity. Owners’ equity is made up of the initial investment in the business as
well as any retained earnings that are reinvested in the business.
•
Common stock
This is stock issued as part of the initial or
later-stage investment in the business.
•
Retained earnings
These are earnings reinvested in the business
after the deduction of any distributions to shareholders, such as dividend
payments.
6. Total liabilities and owners’ equity
This comprises all debts and monies that are owed to outside creditors,
vendors, or banks and the remaining monies that are owed to shareholders,
including retained earnings reinvested in the business.
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The concept of depreciation is really pretty simple. For example, let’s say
you purchase a truck for your business. The truck loses value the minute you
drive it out of the dealership. The truck is considered an operational asset in
running your business. Each year that you own the truck, it loses some value,
until the truck finally stops running and has no value to the business.
Measuring the loss in value of an asset is known as depreciation.
Depreciation is considered an expense and is listed in an income statement
under expenses. In addition to vehicles that may be used in your business, you
can depreciate office furniture, office equipment, any buildings you own, and
machinery you use to manufacture products.
Land is not considered an expense, nor can it be depreciated. Land does not
wear out like vehicles or equipment.
To find the annual depreciation cost for your assets, you need to know the
initial cost of the assets. You also need to determine how many years you think
the assets will retain some value for your business. In the case of the truck,
it may only have a useful life of ten years before it wears out and loses all
value.
Straight-line depreciation
Straight-line depreciation is considered to be the most
common method of depreciating assets. To compute the amount of annual
depreciation expense using the straight-line method requires two numbers: the
initial cost of the asset and its estimated useful life. For example, you
purchase a truck for $20,000 and expect it to have use in your business for ten
years. Using the straight-line method for determining depreciation, you would
divide the initial cost of the truck by its useful life.
The $20,000 becomes a depreciation expense that is reported on your income
statement under operation expenses at the end of each year.
For tax purposes, some accountants prefer to use other methods of
accelerating depreciation in order to record larger amounts of depreciation in
the early years of the asset to reduce tax bills as soon as possible.
You need, additionally, to check the regulations published by the federal
Internal Revenue Service and various state revenue authorities for any specific
rules regarding depreciation and methods of calculating depreciation for various
types of assets
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In the course of doing business, you will likely acquire what are known as
intangible assets. These assets can contribute to the revenue growth of your
business and, as such, they can be expensed against these future revenues. An
example of an intangible asset is when you buy a patent for an invention.
Calculating amortization
The formula for calculating the amortization on an
intangible asset is similar to the one used for calculating straight-line
depreciation. You divide the initial cost of the intangible asset by the
estimated useful life of the intangible asset. For example, if it costs $10,000
to acquire a patent and it has an estimated useful life of ten years, the
amortized amount per year equals $1,000. The amount of amortization accumulated
since the asset was acquired appears on the balance sheet as a deduction under
the amortized asset
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Inventory accounting may sound like a huge undertaking but in reality, it is
quite straightforward and easy to understand. You start with the inventory you
have on hand. No matter when you sell product, the value of your inventory will
remain constant based on accepted and rational methods of inventory accounting.
Those methods include weighted average, first in/first out, and last in/first
out.
Weighted average
Weighted average measures the total cost of items in
inventory that are available for sale divided by the total number of units
available for sale. Typically this average is computed at the end of an
accounting period.
Suppose you purchase five widgets at $10 apiece and five widgets at $20
apiece. You sell five units of product. The weighted average method is
calculated as follows:
Total Cost of Goods for Sale at Cost (divided)
Total Number of Units Available for Sale =
Weighted Average Cost per Widget
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Five widgets at $10 each = $50
Five widgets at $20 each = $100
Total number of widgets = 10
Weighted Average = $150 / 10 = $15
$15 is the average cost of the 10 widgets
First in/first out
First in, first out means exactly what it says. The first widgets you
bring into inventory will be the first ones sold as product. First in, first
out, or FIFO as it is commonly referred to, is based on the principle that most
businesses tend to sell the first goods that come into inventory.
Suppose you buy five widgets at $10 apiece on January 3 and purchase another
five widgets at $20 apiece on January 7. You then sell five widgets on January
30. Using first in, first out, the five widgets you purchased at $10 would be
sold first. This would leave you with the five widgets that you purchased at
$20, which would leave the value of your inventory at $100.
Last in/first out
This method, commonly referred to as LIFO, is based on the assumption
that the most recent units purchased will be the first units sold. A “widget” is
an imaginary item that could be just about any product. The advantage of last
in, first out accounting, or LIFO, is that typically the last widgets purchased
were purchased at the highest price and that by considering the highest priced
items to be sold first, a business is able to reduce its short-term profit, and
hence, taxes.
Suppose you purchase five widgets at $10 apiece on January 4 and five more
widgets at $20 apiece on February 2. You then sell five widgets on February 20.
The value of your inventory, using LIFO, would be $50, since the most recent
widgets purchased, at a total value of $100 on February 2, were sold. You were
left with the five widgets valued at $10 each.
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