REALLY, REALLY SIMPLE ACCOUNTING
By J. M. Blazer
More than 18 million people are running their own businesses.
Millions more are considering it. In 2003, these sole proprietorships
accounted for $969 billion in revenue. If you are starting your own
business, you are going to add to those numbers.
All of these entrepreneurs need to keep records. Why? Because
the Internal Revenue service says so. “Your records must be permanent,
accurate, complete, and must clearly establish your income, deductions,
credits, and employee information”.
The law requires records, but the law doesn’t require you to keep
your records in any particular way. Nor does it tell you how to run your
business.
Of course you want to know how your business is doing. So for
your own enlightenment, you must have some understanding of the
bookkeeping. This booklet will help you with that, but it is NOT going to
even attempt to make you a bookkeeper or accountant.
In fact they would be very foolish if they did. This booklet tells you
what you need to know, and nothing more, so you can spend your time
growling and improving your business, not doing bookkeeping.
You’ve heard of debits, credits, left, right, increase, decrease. And
you know of profit and loss statements, balance sheets, income
statements, and statement of condition.
Forget about them. All you need to know is whether you had a
profit or loss. This system will show you that, as often as you want.
BANKING
Bookkeeping is only the recording phase of accounting. It
accumulates the data needed to prepare financial reports. Good records
are needed for good management. You will need to know what your
receipts and expenses actually are. In some cases, it could be important
to know the type, or source of revenue. You must decide if it is
worthwhile to provide certain categories and classifications.
Accounting is analyzing, interpreting, summarizing, and reporting
the information that has been gathered. This helps in planning and
making decisions.
First, you should have a separate bank account for all your
business transactions. It is not required, but it is sure easier. It makes
sense not to mix your personal and business receipts and expenditures.
If you make any money at all, you are going to pay taxes on it. So don’t
have a mess at the end of the year trying to separate taxable income and
deductible expenses.
Don’t pay by cash if it can be avoided, but if absolutely necessary,
be sure you get a paper receipt. Don’t use a credit card, it fouls up your
records because the statement is always a month later than the
transaction. But if you must, get a card for the business only, and keep
it that way---business purposes only!
Don’t write checks to yourself or to “cash”. Don’t write any checks
until you have some type of bill, voucher, or receipt to verify its business
purposes. If you don’t have one, and can’t get one, and still have to write
the check, then make your own voucher on a blank sheet of paper.
Remember, to be deductible as a business expense, an expenditure must
be “ordinary and necessary, and directly connected to your business”.
Copies of invoices you send to customers and that have been paid
by the customer, bank deposit tickets showing the checks you have
received, are all verification of your receipts. The bills, invoices,
statements that you have paid, are verification of your expenses. These
are called “documents of original entry”, but you don’t have to remember
that.
All small businesses should be on a “cash basis”. That means
revenue is recorded when you actually receive the cash. So there is no
need to “Accounts Receivable” or “Bad Debts”. Charging off bad debts is
eliminated. You will have bad paying customers, but they will never get
into your books until they do pay.
ACCOUNTS AND FILLING
What is an account? An account is a name we give to a grouping
of the same or similar transactions. For instance, payment of rent
creates a “Rent Account”. Your checkbook is your Cash Account, and
you should keep it up to date and balanced. But as we are only
interested in revenue and expense here, leading to the determination of
profit or loss, we won’t be using a cash account here.
By naming the account, we know where to allocate, or assign, the
similar items and transactions. Besides depositing the receipts, and
paying the bills, you need to keep these documents some place in an
orderly fashion. Get file folders at any stationery store and label them for
the types of receipts and expenses that you will have.
After you have properly recorded the transaction, all the paperwork
generated by that transaction will go into the appropriate file folder.
Thus your supporting documents, or “backup” will be readily available
when necessary.
You may set up an account (that is, name it), then never use it.
Obviously we don’t want that. Only when you think you are going to
have a lot of the same kind of transactions, start an account for them.
But seldom occurring events can be combined under one comprehensive
title. For receipts, “Sales” can cover everything. Only if it is absolutely
necessary to know, would you divide it into the different type of sales.
For expenses, the IRS has been gracious enough to name several
accounts for us, and in alphabetical order. Use them, but only the ones
you really need. “Advertising” is the first listed on Schedule C, but if you
don’t do any advertising, don’t use it. Try to keep your accounts to not
more than five or six. You can combine many expenses under one title,
like “Advertising” if you don’t do much, “Bank and service charges” and
“Dues and publications” can all go into the “Office expense” account.
“Legal and professional services” is another account that could cover a
myriad of expenses. After all, it doesn’t really mater what you call it, as
long as it is a legitimate expense. And “Supplies”, that covers everything.
If you stick to the IRS titles, the Schedule C will be an absolute
snap to complete.
RECORDING
Now you need a place to list all the transactions affecting your
newly named accounts. You list them in chronological order, total them
at the end of your accounting period, and you will know exactly how
much you received and how much you spent. Your accounting period
can be any length of time you want---a day, a week, a month, a year.
From now on, we’ll assume an accounting period of a month, because
that is the norm, and we’re keeping this simple. At one page a month,
twelve pages equal the year. For the same reason, avoid using a “fiscal
year”; a calendar year is just fine, even if your business is seasonal.
The best thing for this listing is a columnar pad that you can
obtain at any stationery store. This is a pad containing vertically and
horizontally lined sheets. The horizontal lines are called rows, and the
vertical lines are called columns. Be sure the pad you get has at the very
least 32 rows, and at least 12 amount columns, plus an explanation or
description column. (See sample sheet)
Put a name or label at the top of each amount column,
corresponding to the labeling of your file folders. For instance, column
12 could be “Sales”. If absolutely necessary to separate categories of
revenue, you could use two or three columns. Draw a wide vertical line
between revenue and expense columns, to help avoid mixing them up.
Now label as many expense columns as you need for the different types
of expense, according to your naming of accounts.
From the bills, checks, and receipts you have obtained with each
days transactions, you enter the amounts in the proper column on that
day’s row. According to the need and nature of your business, you may
need more than one row, but by combining the similar transactions and
entering totals, you can keep the use of rows to a minimum. That’s why
we want more than 30 rows for 30 days. Each row could contain a single
transaction or many transactions. Explanation of entries can be used,
but is not really necessary. Remember, if you have a question or need to
verify an entry or amount, go to the file folder for the original receipt or
bill.
At the end of the month, total all columns. Combine the revenue
column totals, if more than one, and this is your total revenue. Combine
the totals of the expense columns. The revenue total, minus the expense
total, is your gain, or profit. Or loss, if the expenses came to more than
the revenue. By adding each sheet’s (or month’s) totals you obtain the
revenue and expense totals for the year, and these totals transfer right to
the same named lines of the IRS Schedule C., and that tax form is done.
In addition, all totals can be carried forward to the next months
sheet, combined with that month’s business for an accumulated
accounting of how you’re doing.
COST OF GOODS SOLD
If your business requires that you keep inventories of products you
sell, then you will need to know what the products you sold cost. Mainly
because the IRS wants it that way.
It’s not as complicated as you might think. Make a count of all the
product you have on hand. Calculate the cost of the total amount of
product, that will be your “Beginning Inventory”.
On your tabular sheets you will need to have separate columns for
Purchases, Labor, Materials and supplies. They will be included along
with all the other expense accounts in figuring your monthly revenue,
expense, and gain and loss.
But at the end of the year, totals of these accounts will be
separated for tax purposes. On the back of Schedule C is the format.
On Line 35 is the beginning inventory. Line 36 Purchases. Line 37,
Labor, if you had any. Line 38, Materials. Line 39, we skip, because we
don’t want to explain what the “Other costs” were. If you had any, they
would fit in one of the other categories anyway. And these costs up on
Line 40, calculate the inventory at the end of the year, and subtract on
Line 41, and you will have your Cost of Goods Sold on Line 42.
Carry that forward to the front of Schedule C, Part 1, Line 4.
Subtracted from Gross Receipts, Line 1, gives you the Gross Profit on
Line 5, and if nothing is on Line 6, the Gross Income on Line 7. All your
other expense columns are deducted in Part II to arrive at your Net Profit
or Loss.
The key here is correctly figuring the values of inventory.
Assuming the beginning inventory is correct, understatement of the
inventory at the end of year will increase the cost of goods sold, and thus
incorrectly reduce your gross profit. Conversely, an overstatement of
inventory will reduce the cost of goods sold and thus falsely increase
your gross profit. Any error will be compounded because the ending
inventory of one year is carried over to the next year as the beginning
inventory, thus the profit or loss will be misstated for two years.
Naturally, the net profit will now be different from the profit or loss
as figured on your columnar pad, the difference being the result of any
change in inventory values, less the totals of the three columns that were
used to calculate cost of goods sold.
DEPRECIATION
Depreciation is an annual deduction allowed to recover the cost of
business property having a useful life of more than one year.
Depreciation starts when the property is first placed in service.
Recognizing that recovering the cost of property is an incentive to
investment, thus stimulating the economy, government has become more
and more lenient with depreciation.
There are several different methods you are allowed to use. You
calculate it yourself, using one of the methods according to your needs.
“Straight Line” is merely dividing the cost by the number of years of
useful life. “Double Declining Balance” allows a much larger amount to
be taken the first year, smaller amounts in the later years. But you can’t
deduct a full year’s depreciation if the property was placed in service
after March, because of Mid-Quarter and Mid-month conventions. Get
the instructions from IRS Form 4562. They are very helpful, providing
tables for the proper deduction and useful life. After you have figured it,
the amount is entered on Form 4562, in the proper section, then
transferred to Schedule C as an expense.
Rules are much different for “Listed Property”. Listed property is
simply property this is not used 100% for business. For instance, if you
have a truck you use in your business, but also go to the grocery store in
it, you technically have listed property, and that requires a whole lot of
figuring---mileage records, dates, times, percentages, etc. We don’t want
that. So get another car, use that for personal trips, and then you have a
legitimate claim that the truck use is 100% business.
Fortunately, IRS has provided a solution that makes it very simple.
It’s called “Section 179” property. This allows you to deduct the entire
cost---within limits, of course. The dollar limit for an ordinary small
business sis 2002 was $24,000. For 2003, so far is $25,000 and is
expected to increase to $27,000, and will probably continue increasing in
subsequent years.
There is also an income limit which limits the deduction to the
taxable income of the business, or the taxable income from all
businesses combined, if more than one. Two other restrictions, the
property must have been purchased, and the deduction can only be
taken in the year of purchase.
In your favor, you don’t have to deduct the full cost of the property.
You can claim a portion of the cost and depreciate the rest. This gives
you a break if the income limit applies, or if you already have enough
expense for this year and want to save some deduction for next year.
You won’t need a column for depreciation on your sheets. You will
figure it out at the end of the year. Then subtract it from the gain as
calculated on your sheets for the year. Or add it to a loss. Then your
column sheet gain or loss will be the same as on Schedule C.
DEPRECIATION COMPUTATION
2001 Dodge Pickup truck, Horse Trailer Hitch Installed
Placed in service, October 6, 2001
Modified Accelerated Cost Recovery System (MACRS) Straight
Line
Business investment use, 100% GDS recovery period,
five years.
Mid Quarter Convention applied
Cash Price $18,477.22
Less: Trade in old truck 2,200.00
Balance to be depreciated $16,277.22
2001 Depreciation, per Pub. 946 table 2.5% $ 406.93
2002 Depreciation 20% 3,255.44
2003 Depreciation 20% 3,255.44
2004 Depreciation 20% 3,255.44
2005 Depreciation 20% 3,255.44
2006 Depreciation 17.5 2,848.51
EMPLOYEES
To be deductible, an employees’ pay must be an ordinary and
necessary business expense. In addition, it must be reasonable, be for
services actually performed, and incurred in the tax year.
You cannot deduct your own salary or any personal withdrawals
you make from the business. You are NOT an employee of the business.
If you have employees you will have to report---and pay---
employment taxes, which include the following, Social Security,
Medicare, Federal unemployment, and State employment. Besides
employer taxes, you also have to obtain from each employee a W-4 form
and withhold their taxes from pay and, in turn, pay that to the Federal
and State agencies. Reporting periods are monthly, quarterly, and
yearly.
To do it properly, you should also have a third bank account just
for payroll and to accumulate payroll taxes. The amounts you owe, and
the amounts you withheld from the employees IS NOT YOUR MONEY!
More businesses have failed and/or been charged with crimes over
mixing and using this money for their business needs. For this bank
account, get a special checkbook with payroll stubs for you and the
employee. And you’ll have to have a special payroll journal, with sheets
divided quarterly for each employee, and a summary sheet, to record
each payday, total quarterly, and again yearly, to furnish the state, the
IRS, and the employee with a W-2 form.
Does it sound complicated? Well, it is. And it has no place here,
or in a small sole proprietor business. So avoid employees as long as
possible. There are several ways to do that.
Independent contractors. Be sure you have justification when
defining help as independent contractors, not employees. There is not
problem if the help you get is from a professional company. In some
businesses, such as agriculture, you can use transient and casual
workers. If you can show that this practice is prevalent in your industry,
you can even use the same person practically and exclusively and still be
perfectly legal. An example would be jockeys and grooms at a horse race
track.
Temporary employee companies. They send the employee when
you want him (or her), for as long as you want. You pay them, and they
pay their employee.
Staffing companies. Similar to temporary help companies, but
more of a permanent assignment. Their company is the employer, and
takes care of the wages and taxes.
Any bookkeeping or accounting service. They take care of the
payroll and taxes for you. And any other service you want.
Your spouse. As part of the joint enterprise, not an employee.
In any event, you should not be spending your time with such
mundane, time consuming work. You’re the boss, the entrepreneur!
SELF EMPLOYMENT TAX
Don’t’ think that because we’ve kept everything simple, and
avoided tax complications wherever possible, that you’re home free. The
IRS has another little trick you can’t avoid. If you made $400 or more,
they want their cut.
The Form SE is what you use to figure that tax. It has line by line
instructions, so it is fairly easy to complete. When the final figure is
reached---the tax, on Line 5
---it is carried over to the Form 1040, Line 56.
There is another little gimmick that sounds good, like they are
giving you back one half of the tax. Not so.
When you have figured the tax and carried it forward to the Form
1040, there is one more line, Line 6. This line has you take one half of
the tax and carry it forward to Line 29 on the Form 1040.
But this line is not a reduction in tax. It is merely a credit against
gross income. Thus, if the SE tax was $200, your income would be
reduced $100. As the first $12,000 of income is taxed at ten per cent,
this results in a $10 reduction in tax, not $100.