Understanding Accounting

Remember, a business entity is distinct and separate from its owner or owners. Small business proprietors may be tempted to use their existing personal checking account for business transactions. Part of insuring accuracy in a financial statement of a business is having the reconciled checking account balance shown on the books match that for the bank statement. This isn't possible if you have personal transactions in your bank account.

Paying personal bills from the business checking account is not recommended because the payee trail is not accurate for the business, you will not have a record of this payment for your personal files, and the transaction may be questionable. With certain businesses, this may be a legal issue.

Making purchases for use of the business from the cash in our pockets can cost us. Many times those expenses never get recorded on the books, or get recorded at some later date when the receipt is found (in the glove compartment of the truck, for example). See the section on Controls for handling these cash transactions.

Purchasing business and personal items at the same time from the same supplier will cause those items to appear on the same bill. It is possible that either the personal items will not be deducted from the bill prior to recording on the books of the business or the entire bill will be paid personally and the business items never expensed on the business books.

Removing items from the business for personal use and not recording the value of the transaction on the books makes it appear as though the business uses more supplies, products, or services than it really does.

Paying employees can become complicated if you don't check the labor laws in your state and conform to the current federal laws. When you pay money to an individual to labor on behalf of your business, that person is either an employee, an independent contractor, or casual labor. You must record and withhold taxes accordingly. Payments to a single individual in a year which total under the minimum required may be expensed as casual labor. The ability to pay a person as a contractor depends upon meeting certain qualifications. All other payments to individuals are considered payments to employees. The government applies heavy penalties for errors in this area. You also cannot pay certain employees a set annual salary when they should be paid as hourly workers eligible for overtime pay.

Posting transactions to the wrong account can lead us to believe we are doing better in some ways and worse in others. For example, a refund of overpayment on a bill should be credited to the appropriate expense account. This is not income. It is a reduction of a specific expense. If recorded as income, we'll think we had higher income and higher expenses than actually occurred.

A refund to a customer for a sale should be debited to the appropriate income account. This is not an expense. It is a reduction in income. A business may want to track the amount of refunds and allowances and will create a separate account for this purpose. The account is created as an income account with a debit balance.

The specifics of how to pay yourself from your business must be discussed with your accountant since this affects the tax situation for the business and for you personally. Any transactions between closely related parties, such as you and your business, need to be handled carefully. Different types of entities require different types of transactions.

In a proprietorship or partnership, for example, you would write a check to yourself. This is posted as a credit to cash and debit to your capital drawing account. You file a Schedule C with your 1040 tax return to pay taxes on your business income.

In a C corporation:

1. You may pay yourself a salary.

2. You may have personally purchased the land and buildings used by the business. You can then charge a fair market rate for rent.

3. You may have personally loaned the business money. You can then receive loan payments with interest.

4. You may earn dividends.

As a separate legal entity, the corporation files its own tax return to pay taxes on business income.

Most businesses need to make adjustments to their books—entries that are not normal business transactions. For instance, an adjustment is made to expense depreciation on assets. An adjustment is made to expense a monthly portion of the prepaid insurance. Errors in entering transactions are corrected through an adjustment. Errors are never corrected by going back and erasing, crossing out, or adding.

Adjustments are usually made at the end of a reporting period while preparing financial statements. The balances in the Ledger are transferred to a multi-columned paper to create a "Working Trial Balance." This is the balance sheet and income statement in raw form. Adjustments are made here and carried over to a "Trial Balance." The Trial Balance becomes the basis for the Financial Statements. An adjustment becomes an "adjusting entry" which is numbered and entered in the Journal. From the Journal, the adjusting entries are transferred to the Ledger. The balances in the Ledger will now equal the balances in the Trial Balance.

While most anyone, given clear instruction, can enter transactions in the books of accounting, an understanding of accounting is necessary to make adjustments. This text does not address the finer points of accounting, the making of adjustments, or the closing of accounts. The intention of this text is to provide an understanding of the importance of good records, what constitutes a business transaction, and accurate recording. From accurate reports created by a trained bookkeeper, a CPA or accountant can make short work of preparing tax returns, and that can save you money.

Computerized accounting systems are like any other system that relies on computer entry and processing; garbage in, garbage out applies. Although these systems can speed up recording and compilation of transactions and some claim to analyze and automatically record transactions, they cannot make decisions for you, cannot make adjustments, or check that the transaction is actually a business transaction and being posted to the correct account. Even with the rise of artificial intelligence (AI), computerized accounting systems do not make up for a lack of accounting knowledge. They can, in fact, exacerbate poor accounting skills simply because data entry is so easy.

Some accounting software packages will allow you to post transactions on any date. If the program also orders entries based on date, errors will result and be extremely difficult to find.

Quality software should warn you if you accidently enter a date earlier than your last entry. As each reporting period ends, balances are derived and financial statements are prepared. Those balances should never be changed. That accounting period is considered closed. Your accounting program, if it posts transactions based on date, may allow transactions to be posted to a closed period. Your financial statements for that period and the current period will not be accurate. A manual paper accounting system does not allow corrections in prior periods. Errors are corrected when they are found. Even if the errors were made in a prior period, they are adjusted for in the current period. To go back and change transactions in a manual accounting system would be ridiculous. Unfortunately, it can be much too easy in a computerized accounting system.