There are three primary forms of business organizations. 1) The sole proprietorship - you own it; you have ALL the risk. 2) The partnership - you share the thrill and the agony with your partners. 3) The corporation - anyone who provides money to you in return for a share of ownership shares the good and bad of your business.
So, what does that really mean? Some of it is obvious, some not.
In a sole proprietorship, you put all the investment into the business. If you have $10 thousand to use to open a business, that's your initial investment; your owner's equity. You get to plan your whole operation and run it. Any profit you make is taxable. Remember that profit is taxed after ALL expenses: materials for your product and the postage stamps to mail invoices and checks. If you lose money, it eats up part of your equity, leaving you with a smaller net worth. If you get sued, you have no protection at all. Your business and all equipment, your home, your investments, your car, your boat and everything else you own can be used to pay the results of a settlement against you. The income tax side of this is pretty simple as well. The federal Schedule C has to be completed as part of your return. Some expenses are specified on the Schedule C. Others are left for you to list on your own. The profit on the Schedule C get reported on the form 1040. There are more tax items associated with a business but they will be discussed in another entry.
In a partnership, you have other people to share this with, but you will most likely also get investment from them, making your business more stable at the outset. The people you have as partners, whether 1 or 20, will also be your resource for sharing the functions of setting up and running the business. This makes a business start-up easier in some respects, but it is necessary to have mutual understandings and similar philosophies to prevent argument and conflict in how to run the various portions of the business. Most often, a partnership will begin with a partnership agreement that spells out various roles each partner will play and how income and losses will be shared. Sometimes, one partner invests more than another. This may lead to an agreement to share profits and losses according to the proportion of each partner's investment. When a partnership prepares its tax return, it is prepared on a form 1065 and has supporting schedules called K-1's. The K-1 is the form that is prepared in multiple pages, one for each partner. The activity on a K-1 has a variety of places it gets reported on the 1040. This helps the accounting profession remain secure and keeps IRS employees secure in their work.
A corporation is an entity (a.k.a. a business) that is owned by one or more stockholders or shareholders. The ownership is based on the amount of money invested by the stockholder. The nice thing about a corporation is that if a corporation is sued, the stockholders' personal assets may not be used toward paying a settlement or judgment resulting from the law suit. The accounting is much the same as other business structures, but the results of business affect "Retained Earnings", a part of the equity or capital of the corporation. If, at the end of the year a business earns a profit, a portion of the profit may be paid to the stockholders as dividends. The amount of profit the corporation keeps for its own use is called "Retained Earnings". Here is where double-taxation comes in. The profit a corporation earns is taxed as corporate profit - ALL of it. The amount of that ALREADY TAXED profit that gets paid to stockholders is taxed AGAIN as dividends. The corporation is required to report a minimum amount of dividends on a form 1099-DIV to you and to the IRS. That way the IRS knows to expect this on your personal return. The corporation files its taxes on a form 1120. There are various forms of corporations that have varying levels of liability and also have tax and legal advantages. Be sure to discuss the options with your accountant to be sure you are making the best choice if you choose to incorporate.
Enough for now. Be sure to write back.
Sunday, February 22, 2009
Sunday, November 2, 2008
Recent studies
I've been updating my accounting knowledge recently. One of the many accounting courses I haven't had yet is a course in auditing. Here is a little of what I have picked up so far.
Auditing is a service accountants perform to assure readers of financial statements that the information they are reading is reliable for making investment decisions. Auditing also includes operational assurance and compliance assurance. An operational audit is to confirm that parts of a business' procedures are being run efficiently and effectively. It is possible to have one without the other. A compliance audit is to confirm that specific rules - GAAP, IRS or other guidelines - are being followed correctly.
When auditing financial statements provided by a client, an auditor is required to have adequately educated and informed personnel participating in an audit. The audit is to have a specific scope and enough evidence must be gathered to warrant the auditor giving an opinion on the information being audited. Once the audit is complete, an opinion of the results is issued by the auditor. The opinion, presented in a report in the format of a letter to the client, may be unqualified, unqualified with explanations or modifications to a format standardized by the AICPA, qualified or else adverse/disclaimer. The AICPA (American Institute of Certified Public Accountants) has specific requirements about what determines what level of opinion the auditor may issue. Once the opinion is issued, it is up to the reader of the audited financial statements to determine how much trust to put in the financial statements so the appropriate investment decision can be made.
That's enough for now. Have a good week.
Auditing is a service accountants perform to assure readers of financial statements that the information they are reading is reliable for making investment decisions. Auditing also includes operational assurance and compliance assurance. An operational audit is to confirm that parts of a business' procedures are being run efficiently and effectively. It is possible to have one without the other. A compliance audit is to confirm that specific rules - GAAP, IRS or other guidelines - are being followed correctly.
When auditing financial statements provided by a client, an auditor is required to have adequately educated and informed personnel participating in an audit. The audit is to have a specific scope and enough evidence must be gathered to warrant the auditor giving an opinion on the information being audited. Once the audit is complete, an opinion of the results is issued by the auditor. The opinion, presented in a report in the format of a letter to the client, may be unqualified, unqualified with explanations or modifications to a format standardized by the AICPA, qualified or else adverse/disclaimer. The AICPA (American Institute of Certified Public Accountants) has specific requirements about what determines what level of opinion the auditor may issue. Once the opinion is issued, it is up to the reader of the audited financial statements to determine how much trust to put in the financial statements so the appropriate investment decision can be made.
That's enough for now. Have a good week.
Tuesday, September 16, 2008
Banking and cash management
In starting your business, be sure to begin with establishing a bank account designated purely for business purposes. This will make it simple to keep business activity - deposits and payments - separate from personal activity. It will allow you to find business transactions more easily. It will allow you to pay yourself and know more readily that a certain payment is not for business use. In addition, it becomes a tool to help in building a business relationship with a bank and its staff as your business develops. Another thing to keep in mind comes from conversation with a former employer. This person told me that a bank will work diligently to attract you as a new customer but after that, you are often "forgotten". On the banks side, the sale has been made. You have been brought in as a customer. The employer mentioned this to his banker and it was confirmed by the banker. Consequently, be open to moving from one bank to another - only as necessary - to get the best service, interest on your deposits and investments and to get the best financing rates you can. Remember: the goal is to do all you can to keep your bottom line as big as possible.
Other things to consider is the variety of services available from your bank. Multiple accounts. Bill payments. Investments. And, if necessary, loans. (I'm extremely big on avoiding debt at any cost!) Having a separate account for payroll and payroll taxes will be a smart move, adding cash on a regular basis to cover necessary net payroll, federal taxes - income & FICA and unemployment, state income and unemployment taxes, and local taxes. These tax payments come due mostly on a quarterly basis until your liabilities are large enough to require payments to help keep your cash flow - and the government's cash flow - running smoothly. Having a separate account for payroll will also allow you to keep a clearer picture of what you will need to consistently keep your vendors paid. This will help you maintain good relationships with vendors and will also give you leverage in negotiating better pricing, purchasing arrangements, and payment terms. All of these will contribute to keeping your bottom line larger. As you can guess, this will make room for you to make a better product, do better marketing and advertising, provide better benefits and pay for your employees, and take more home for yourself.
Last is the subject of financing. This goes back to relationship with your bank and its staff. As your business grows, it may be necessary and maybe even advantageous to borrow money to make payments. If you have been managing your money well, your bank will know you have sufficient assets and a good credit history. Using this to your advantage will mean borrowing money at a lower interest rate, saving you a lot of money which can then be used toward a downpayment for a location of your own instead of a rental. Or, maybe you can buy a piece of machinery that will make your operation more productive. In any event, handling your money carefully will give you greater control and lots of advantages to be as profitable as you can.
Have a good week.
Other things to consider is the variety of services available from your bank. Multiple accounts. Bill payments. Investments. And, if necessary, loans. (I'm extremely big on avoiding debt at any cost!) Having a separate account for payroll and payroll taxes will be a smart move, adding cash on a regular basis to cover necessary net payroll, federal taxes - income & FICA and unemployment, state income and unemployment taxes, and local taxes. These tax payments come due mostly on a quarterly basis until your liabilities are large enough to require payments to help keep your cash flow - and the government's cash flow - running smoothly. Having a separate account for payroll will also allow you to keep a clearer picture of what you will need to consistently keep your vendors paid. This will help you maintain good relationships with vendors and will also give you leverage in negotiating better pricing, purchasing arrangements, and payment terms. All of these will contribute to keeping your bottom line larger. As you can guess, this will make room for you to make a better product, do better marketing and advertising, provide better benefits and pay for your employees, and take more home for yourself.
Last is the subject of financing. This goes back to relationship with your bank and its staff. As your business grows, it may be necessary and maybe even advantageous to borrow money to make payments. If you have been managing your money well, your bank will know you have sufficient assets and a good credit history. Using this to your advantage will mean borrowing money at a lower interest rate, saving you a lot of money which can then be used toward a downpayment for a location of your own instead of a rental. Or, maybe you can buy a piece of machinery that will make your operation more productive. In any event, handling your money carefully will give you greater control and lots of advantages to be as profitable as you can.
Have a good week.
Thursday, September 11, 2008
More on the Chart of Accounts
Continuing on from my last entry, I would like to explain a little more about setting up your chart of accounts.
Usually, an accountant will have a preferred format for a "standardized" account list or chart of accounts. As I mentioned previously, a lot of accounting packages allow you to use account names without assigning numbers to the individual accounts. My personal preference is to use a numbering system that sets up your account list in the sequence of the accounting equation: Assets, Liabilities, Equities, Revenue and Expenses. There are numerous ways of doing this. Often the easiest route is to simply use a three- or four-digit system until your records require something more sophisticated. I like to have lots of room, so I will use a four-digit system, establishing Assets as beginning with 1, Liabilities beginning with 2, Equities with 3, Income with 4 and Expenses with 5. It is common for "Other Income" and "Other Expenses" to begin with 9, segregating them significantly from the remainder of the categories. Some people prefer a simpler structure, using only three digits. An accounting firm will likely use a simpler system since they may be providing only the information required for the tax return, resulting in putting several of the accounts you use into one larger, single bucket.
As you develop your list, you will want to look ahead at areas that you will anticipate having more accounts that other areas. You may have a lot of fixed asset accounts or inventory accounts, so you will likely want to give those groups a greater range of numbers than your cash or receivables accounts. If you only have one or a few cash accounts, you can get away with accounts 1001, 1005 and 1010, leaving room to add more in between at a later date, if necessary. On the other hand, you may have a variety of types of receivables and use all of the 1100's to keep them together. I think you get the idea. This will work with Equities, also. Rather than using all of the 3xxx account numbers, you may only want to use the 2900's for these accounts. Similarly, the Revenue accounts might be all of the .xxx's or 4xxx's. The next accounts might be the "Cost of Goods" accounts, assigned the 5xxx's, after the revenue accounts have been assigned the 4's.
Once you get into your departmental structuring, you can go down the line, using 6xxx, 7xxx, 8xxx groupings for each department. If you have several parts of a department making all of one parent department, the 7xxx's may be all of the, so you could use the 7's for Sales & Marketing and then break it down to 71xx for Sales, 72xx for Marketing, 73xx for Advertising, etc.
In any event, it's your chart of accounts. Make it easy for others, like your banker or your accountant, to understand and for you to know where to find certain things on your financial statements. Set it up to follow the KISS method: Keep It Simple, Stupid.
Usually, an accountant will have a preferred format for a "standardized" account list or chart of accounts. As I mentioned previously, a lot of accounting packages allow you to use account names without assigning numbers to the individual accounts. My personal preference is to use a numbering system that sets up your account list in the sequence of the accounting equation: Assets, Liabilities, Equities, Revenue and Expenses. There are numerous ways of doing this. Often the easiest route is to simply use a three- or four-digit system until your records require something more sophisticated. I like to have lots of room, so I will use a four-digit system, establishing Assets as beginning with 1, Liabilities beginning with 2, Equities with 3, Income with 4 and Expenses with 5. It is common for "Other Income" and "Other Expenses" to begin with 9, segregating them significantly from the remainder of the categories. Some people prefer a simpler structure, using only three digits. An accounting firm will likely use a simpler system since they may be providing only the information required for the tax return, resulting in putting several of the accounts you use into one larger, single bucket.
As you develop your list, you will want to look ahead at areas that you will anticipate having more accounts that other areas. You may have a lot of fixed asset accounts or inventory accounts, so you will likely want to give those groups a greater range of numbers than your cash or receivables accounts. If you only have one or a few cash accounts, you can get away with accounts 1001, 1005 and 1010, leaving room to add more in between at a later date, if necessary. On the other hand, you may have a variety of types of receivables and use all of the 1100's to keep them together. I think you get the idea. This will work with Equities, also. Rather than using all of the 3xxx account numbers, you may only want to use the 2900's for these accounts. Similarly, the Revenue accounts might be all of the .xxx's or 4xxx's. The next accounts might be the "Cost of Goods" accounts, assigned the 5xxx's, after the revenue accounts have been assigned the 4's.
Once you get into your departmental structuring, you can go down the line, using 6xxx, 7xxx, 8xxx groupings for each department. If you have several parts of a department making all of one parent department, the 7xxx's may be all of the, so you could use the 7's for Sales & Marketing and then break it down to 71xx for Sales, 72xx for Marketing, 73xx for Advertising, etc.
In any event, it's your chart of accounts. Make it easy for others, like your banker or your accountant, to understand and for you to know where to find certain things on your financial statements. Set it up to follow the KISS method: Keep It Simple, Stupid.
Wednesday, August 27, 2008
Expense analysis
Analyzing your expenses will be the tool you use to see where you're spending money. This is done through a review of the figures on the month-end income statement. As mentioned before, the income statement is the list of the revenues and expenses of your business. This is prepared monthly, often with a comparison to the budget figures you developed so far.
All of the income categories are totaled and represented as 100%. From here, expenses are calculated as a percentage of total income. Naturally, there will be certain expenses that are significantly large in comparison to other expenses. This will be identifiable in dollar figures and by percentage of total income. Watching the percentage will help you to see peaks and valleys if the item has regular fluctuations. An example would be labor. In construction, labor will be high during the summer, building up during the spring and then falling until winter. This would compare to high labor costs during the Christmas season and lower labor costs during the remainder of the winter for a retail store. If your labor is consistently steady, you will expect similar dollar amounts and percentages throughout the year. If this changes, you should catch it as a problem and identify what caused the change and then make any necessary corrections.
Over the course of time, you will prepare your budget according to expected highs and lows in all areas and be able to aim for specific income, expense and profit levels each month and as a cumulative figure at the end of the year. As years pass, you will see recurring percentages for expenses and be able to know if there is a problem or weakness in a particular. This will trigger corrective actions as variances arise.
In the end, you should have set up your budget to anticipate all the highs and lows you can and expect to have profits at a certain level. There should be a percentage target for your profit. As you control this, you will be continuously searching for ways to reduce total expenses and increase profit - the goal of any business.
All of the income categories are totaled and represented as 100%. From here, expenses are calculated as a percentage of total income. Naturally, there will be certain expenses that are significantly large in comparison to other expenses. This will be identifiable in dollar figures and by percentage of total income. Watching the percentage will help you to see peaks and valleys if the item has regular fluctuations. An example would be labor. In construction, labor will be high during the summer, building up during the spring and then falling until winter. This would compare to high labor costs during the Christmas season and lower labor costs during the remainder of the winter for a retail store. If your labor is consistently steady, you will expect similar dollar amounts and percentages throughout the year. If this changes, you should catch it as a problem and identify what caused the change and then make any necessary corrections.
Over the course of time, you will prepare your budget according to expected highs and lows in all areas and be able to aim for specific income, expense and profit levels each month and as a cumulative figure at the end of the year. As years pass, you will see recurring percentages for expenses and be able to know if there is a problem or weakness in a particular. This will trigger corrective actions as variances arise.
In the end, you should have set up your budget to anticipate all the highs and lows you can and expect to have profits at a certain level. There should be a percentage target for your profit. As you control this, you will be continuously searching for ways to reduce total expenses and increase profit - the goal of any business.
Friday, August 22, 2008
The Chart of Accounts
Something not previously covered is the chart of accounts that make up your general ledger in your accounting software. The concept is plenty simple and has plenty of room for you to make it fit your way of thinking and working. The accounts will follow the accounting equation: Assets, Liabilities, Equity (or Capital), Income and Expenses. I prefer to set up my chart of accounts numerically but it isn't a requirement. Most accounting software will allow you to add accounts "on the fly", identifying them by category as you enter them. The thing that is a problem with this method is that it's easy to duplicate accounts and not know it. This can occur with a numerical system too.
In setting up the chart of accounts, it's typical to follow a common pattern. Here is a generalized sample. As your business develops, you will add accounts within these groups. I hope it's not too confusing.
ASSETS
***Current Assets
***Long term Assets
***Property (Land)
***Plant (the building(s))
***Inventory
LIABILITIES
***Current Liabilities
(ex.: payables, payroll, payroll taxes, current portion of long-term loans)
***Long term Liabilities
Portions of loans due more that one year out
EQUITIES
***Owner's Equity / Capital
***Less: Owner's drawing
***Net Equity or Retained Earnings.
REVENUE
***All sales accounts
EXPENSES
***Segregated by department
The software will put these accounts and any sub-accounts you create into the above categories as you set up the accounts. It will also do the math based on your financial setup.
That's all for tonight. Catch you next time.
In setting up the chart of accounts, it's typical to follow a common pattern. Here is a generalized sample. As your business develops, you will add accounts within these groups. I hope it's not too confusing.
ASSETS
***Current Assets
***Long term Assets
***Property (Land)
***Plant (the building(s))
***Inventory
LIABILITIES
***Current Liabilities
(ex.: payables, payroll, payroll taxes, current portion of long-term loans)
***Long term Liabilities
Portions of loans due more that one year out
EQUITIES
***Owner's Equity / Capital
***Less: Owner's drawing
***Net Equity or Retained Earnings.
REVENUE
***All sales accounts
EXPENSES
***Segregated by department
The software will put these accounts and any sub-accounts you create into the above categories as you set up the accounts. It will also do the math based on your financial setup.
That's all for tonight. Catch you next time.
Tuesday, August 19, 2008
Budgeting
Budgeting can be an involved process, especially the first time through. As you work through your numbers, you are sometimes shooting in the dark because you don't have enough historical information to work with. That's OK. With your first budget, you are building your foundation and each year you add another layer of brick and mortar and build your insight to how your business functions and where you can make adjustments to increase or decrease costs.
I think the best place to start is with your expenses, particularly if you are working on your first budget. If you already have some figures from previous months or the preceding year's activity, you are at a nice starting point. Look at these figures and study what is higher and lower than you expected. Then look at what percentage each expense is of the total of the expenses. From seeing this information, you can get a feel for where you need to plan your amounts for the next year. It will be good to look at the items that have caused a particular expense to be unusually high. It may turn out that something got put into account A instead of account B. Correcting these errors will give you a new picture and a better view of where your costs really are. In the future, you will be watching the performance of your actual expenses vs. your budgeted amounts and make the corrections throughout the year so you don't have a lot of fixing up to do at the last minute.
Now that you have your corrected figures, you can look again at where your highs and lows are. Decide from this information if you spent too much in a particular area. You may have been too frivolous or you may have room to negotiate lower prices. You can also decide to actually spend more in one area or another. Remember that this is alright. In spending more, you are putting emphasis on items that may help you generate more income. The key to this is to still get the best prices so you get as much out of your dollar as you can, spending the savings on something else that you may need as well....even if it's money in your pocket (profit) to help you pay your bills at home more easily.
Before I go too far with the expense side of the picture, we have to remember to plan expenses so they remain within the income you will earn. If you plan your expenses well enough, it will be easier for you to set sales targets AND profit targets. If you budget your expenses to increase by 50% but you will only be able to plan on an increase of 30% in sales, you will have a problem. This will be the trigger to get you to re-evaluate your expense budget for realistic figures. Having a budget will eventually allow you to set aggressive sales goals and plan for expenses and profit that will match.
More on this to come. Let me know if you have any questions or comments.
I think the best place to start is with your expenses, particularly if you are working on your first budget. If you already have some figures from previous months or the preceding year's activity, you are at a nice starting point. Look at these figures and study what is higher and lower than you expected. Then look at what percentage each expense is of the total of the expenses. From seeing this information, you can get a feel for where you need to plan your amounts for the next year. It will be good to look at the items that have caused a particular expense to be unusually high. It may turn out that something got put into account A instead of account B. Correcting these errors will give you a new picture and a better view of where your costs really are. In the future, you will be watching the performance of your actual expenses vs. your budgeted amounts and make the corrections throughout the year so you don't have a lot of fixing up to do at the last minute.
Now that you have your corrected figures, you can look again at where your highs and lows are. Decide from this information if you spent too much in a particular area. You may have been too frivolous or you may have room to negotiate lower prices. You can also decide to actually spend more in one area or another. Remember that this is alright. In spending more, you are putting emphasis on items that may help you generate more income. The key to this is to still get the best prices so you get as much out of your dollar as you can, spending the savings on something else that you may need as well....even if it's money in your pocket (profit) to help you pay your bills at home more easily.
Before I go too far with the expense side of the picture, we have to remember to plan expenses so they remain within the income you will earn. If you plan your expenses well enough, it will be easier for you to set sales targets AND profit targets. If you budget your expenses to increase by 50% but you will only be able to plan on an increase of 30% in sales, you will have a problem. This will be the trigger to get you to re-evaluate your expense budget for realistic figures. Having a budget will eventually allow you to set aggressive sales goals and plan for expenses and profit that will match.
More on this to come. Let me know if you have any questions or comments.
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