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2 BUSINESS SETUP W hen you start a small business, there are a lot of things to worry about, such as inventory and production, or scheduling jobs and paying bills. Will your business be a corporation that issues stock? Will you have to borrow money to finance start-up costs? How many employees will you need? With all these questions to answer, many new owners aren’t sure what to do about accounting (and ironically, accounting is an integral part of the answers to all these questions). A lot of owners mistakenly think that a checkbook is a proper accounting system. It’s not. The system you choose should be one that makes the process as easy and intuitive as possible so that you keep up with accounting duties. It can be relatively simple, or it can be more complex in how it’s set up and what it delivers—it all depends on your needs. Whatever system you go with, you’ll need to be able to keep track of all the money coming in and going out of your business. The largest differentiator between systems is whether they’re manual or computerized. In a manual system, you use an assortment of “journals”—either on paper or simple spreadsheets—and make entries manually for every transaction. Computerized systems and software do all the calculations for you, but entail a bit more of a learning curve at the start. Either is fine for a beginning small business, but once you get going you’re going to want a computerized system just for the ease and benefits of having it automatically add or subtract customer payments from the total owed and keep running totals of sales and expenses. We’re going to look at a few transactions below in terms of journal entries. But first let’s discuss the accounting cycle. THE ACCOUNTING CYCLE Every business transaction (a sale, a purchase, paying a bill) is recorded in an accounting journal. At the end of an accounting period (month, quarter, year) the entries are summarized and posted (moved, transferred) into a ledger, and then summarized. The balances in the ledger are then listed in a financial statement. Accountants use many types of journals—cash disbursement, cash receipts, payroll, general (noncash transactions), and sales. With the advent of the computer and accounting software programs, almost no one uses journal books anymore. The computer automatically summarizes all transactions into journals and posts these totals into a general ledger for you. Actually, your checkbook is a cash journal. Many people use Excel spreadsheets to keep track of their sales, checks, and deposits. This spreadsheet would then be an accounting journal. The phrase “posting a journal entry” just means writing down the transaction into a journal—or spreadsheet. A journal entry always has two sides: a debit and a credit. For example, when you pay your electric bill, you have two sides to the transaction—a decrease in cash and an increase in utilities expense. Remember the accounting equation? The left side (assets) has debit balances, and the right side (liabilities and equity) has credit balances. Debits and credits are simply the transactions that make up the flow of money into and out of your business. In the examples below, you’ll see that both sides of the transaction—the debit and the credit—are included. Don’t let this intimidate you; it just means that there are two sides to every business transaction. You wouldn’t actually write your journal entries out like this, but we’ll go step-by-step below just for the sake of illustration. In reality, you would just add a transaction in your checkbook ledger for the electric bill you just paid. Let’s look at some business transactions and see how they affect accounting. Say you started a business checking account with $3,000 in personal funds. This goes into your general journal (paper or computerized), with the following debit and credit entries. Again, the accounting equation stipulates that a debit must equal a credit. So in this case: DEBIT: CASH IN CHECKING CREDIT: OWNER’S EQUITY $3,000 $3,000 This is the journal entry made for a sole proprietor and would show up on your balance sheet. An S corporation owner would post that initial investment as a loan from the business to her. She gave the company money, so it owes her that money back. DEBIT: CASH IN CHECKING CREDIT: STOCKHOLDER LOAN $3,000 $3,000 On a Balance Sheet these transactions would be included in the above accounts, as shown below. BALANCE SHEET AS OF MARCH 31, 2020 CASH IN CHECKING ACCOUNTS RECEIVABLE $5,600 $25,000 INVENTORY $4,500 PREPAID INSURANCE $3,000 PREPAID TAXES $1,300 UNEARNED REVENUE $800 OFFICE EQUIPMENT $1,800 EQUIPMENT $6,000 VEHICLES $26,000 BUILDING & IMPROVEMENTS $201,000 LESS ACCUMULATED DEPRECIATION $-20,000 TOTAL ASSETS $255,000 ACCOUNTS PAYABLE $2,800 SALES TAX PAYABLE $1,200 PAYROLL TAXES PAYABLE FICA/FEDERAL WITHHOLDING $3,100 STATE WITHHOLDING $1,200 LOCAL WITHHOLDING $600 401(K) WITHHOLDING $200 EMPLOYEE HEALTH WITHHOLDING $900 CREDIT CARD PAYABLE $1,500 VEHICLE LOAN PAYABLE $4,000 BUILDING LOAN PAYABLE $1,000 STOCKHOLDER LOAN $165,000 NOTE PAYABLE OWNER $40,000 TOTAL LIABILITIES $222,300 OWNERS EQUITY: COMMON STOCK PREFERRED STOCK $500 $2,200 RETAINED EARNINGS $60,000 DIVIDENDS $-30,000 TOTAL EQUITY TOTAL LIABILITIES & EQUITY $32,700 $255,000 INCOME STATEMENT FOR MONTH ENDED MARCH 31, 2020 SALES $300,000 SALES RETURNS & ALLOWANCES $-15,000 NET SALES $285,000 INTEREST INCOME TOTAL REVENUE $100 $285,100 COST OF GOODS SOLD: MATERIALS PURCHASES RETURNS $114,000 $-1,500 SUBCONTRACT $36,000 TOTAL COGS $148,500 GROSS MARGIN $136,600 EXPENSES: ADVERTISING EXPENSE $6,500 RENT EXPENSE $3,800 FEDERAL INCOME TAX EXPENSE INSURANCE EXPENSE $600 $3,500 UTILITIES EXPENSE $6,000 DUES & SUBSCRIPTIONS EXPENSE $2,000 GROSS WAGES EMPLOYEE DISABILITY INS. EXP. FICA EXPENSE $78,000 $1,400 $5,355 FEDERAL UNEMPLOYMENT EXP. $1,100 STATE UNEMPLOYMENT EXPENSE $1,300 EMPLOYEE HEALTH INS. EXPENSE $4,000 INTEREST EXPENSE $6,000 BAD DEBT EXPENSE $2,000 DEPRECIATION EXPENSE $6,000 TOTAL EXPENSES $127,555 PROFIT/LOSS $9,045 MAKING JOURNAL ENTRIES Now let’s take a quick look at how debit and credit transactions are entered into a journal. If you’re using a manual accounting system, you’ll need a pad of 13-column accounting paper, available at any office supply store. Label one page “cash receipts journal” and another “cash disbursements journal.” Let’s say you want to record your recent sales using a manual system. In your cash receipts journal, label the columns to match the types of sales you have in your business (see Table 17). Label the columns with the date, who the money came from, the invoice number being paid, and the amount of payment. Then add a few columns for a specific business use. In this example, the small business owner fixes cars, so she wants to break out income into these categories—supplies, parts, labor, and miscellaneous. There is no right or wrong way to categorize your sales—it’s absolutely up to you. You may want to lump together all the types of income and break it out by location instead. It all depends on how you want to see your income patterns. Table 17. Sample cash receipts journal You will also use your cash receipts journal for any miscellaneous income to your business. You may have an interest-bearing checking account. If so, the interest income would be posted into your cash receipts journal. If you made that journal entry like accountants do, it would look like this: CASH INTEREST INCOME $10 $10 Recording the receipt of interest on checking account Next, on the sheet marked “cash disbursements journal,” fill in the columns to match your business expenses. It should look something like this (see Table 18). The information we’re trying to capture in this accounting journal is the date, amount, and purpose of each cash disbursement, be it a check or an automatic transaction through your bank. Table 18. Sample cash disbursement journal In Table 18, take a look at the columns. You need columns for for the check number, the date, the name and description, and the amount. Then there are columns for expenses you incur frequently, such as supplies, rent, and utilities. At the end of the sheet, label the next-to-last column “other,” and use it for any expense or disbursement you don’t have a column for. Use the last column to put in a description. Use one page a month. List each business transaction as it happens, and keep all deposit slips, receipts, check stubs, and so on in a file folder or large envelope for that month. That way you will have something to back up each transaction. This is important at tax time (both because it makes doing taxes easier, and it minimizes chances of being audited). Keep these journals and file folders or envelopes for three to seven years. Every time you make a deposit or receive cash, write it down in your cash receipts journal. Every time you spend money for the business, write it down in your cash disbursements journal. Then, at month’s end, total up all your columns, and you’ll have all your sales and expenses for the month. That’s a simplified version of a manual bookkeeping system. When your business grows, or if you feel more comfortable using a computerized system, then you can think about using a software program instead of a spreadsheet to record your transactions. Computerized accounting programs are made to do all the posting of journal entries for you. All you have to do is enter a check or record a deposit. The software does the rest. One last task of business setup is creating a filing system. You should get a file cabinet or box, and organize it with files for your bills to pay, invoices owed to you, receipts, expenses paid, and so forth. Your system should make organizational sense to you and kept current. You should also keep a reference file for all contracts, employee paperwork, receipts for assets purchased, lease contracts, customer information, and vendor information. Keep these files for as long as you’re in business. Then, set up a file for accounting records and keep all receipts, sales invoices, bank statements, credit card statements, bills paid, and tax returns. Keep these records together by year, and keep them for seven years. STOCK If you’re the owner of a corporation, you will be purchasing shares of stock from it. Two classes of stock are used in small businesses: common and preferred. Common stock is used more than preferred stock. Common stock’s value appreciates as the business’s value grows, and the owners of common stock get voting rights and dividends. Preferred stock’s value doesn’t change, but its owners get preference in receiving dividends. And if the business fails, the owners of preferred stock get preference in receiving their investment back over common stock owners. Large corporations listed on the stock exchange have many investor-owners and keep watch over their stock values all the time. Small companies, however, usually only have one or maybe a handful of owners, and the issuance of stock is merely the initial investment of cash into the business. Stock is issued “at par,” or at face value. If stock sells for less than the face value, it’s considered “under par.” Large corporations may issue (sell) thousands of stocks to bring money into the corporation. These stocks will be issued at various stated values, but many companies issue stock at low par values, say of $1.00 or less. Most small corporations with one owner will issue the owner 500 shares of $1.00 par common stock. The owner will pay $500 for the stock, which starts the company with some operating cash, and the owner officially has a net worth of $500. The journal entry for this transaction would look like this: DEBIT: CASH CREDIT: COMMON STOCK $500 $500 If the company were to have multiple owners, and issue both common and preferred stock, you would see a journal entry more like this: DEBIT: CASH CREDIT: COMMON STOCK CREDIT: PREFERRED STOCK $5,500 $1,000 $4,500 This would reflect the issuance of 100 shares of $10 par common stock, and the issuance of 300 shares of $15 par preferred stock. This transaction will show on your balance sheet, as seen in Table 19. It will affect the asset and equity section by increasing your balance in your cash account and in your common stock account. As with all balance sheets, notice that the total assets equal the total of all liabilities and equity accounts. BALANCE SHEET ASSETS: CASH IN CHECKING $5,500 TOTAL ASSETS $5,500 LIABILITIES: NONE $0 EQUITY: COMMON STOCK $1,000 PREFERRED STOCK $4,500 TOTAL LIABILITIES & EQUITY $5,500 Table 19. Initial issuance of stock on the Balance Sheet SETTING UP PAYROLL Many small businesses start with just one owner and no employees, but if you’re starting a restaurant, for example, you will need some help. Hiring employees and setting up payroll is not something to be taken lightly. In fact, you will need to be aware of, and adhere to, many laws and regulations. You should have application forms, employee review forms, and so on. Keep employee records in a safe place, preferably a locking file cabinet. Keep them for 10 years, or as long as you’re in business. First, check out the Department of Labor website and your state website for minimum wage laws and overtime regulations. You will also need an I-9 Form for each employee to prove that he or she is legally able to work in the United States. Next, go to the IRS website and apply for an Employer Identification Number (EIN). This is the number that will identify your business to the IRS as an employer and taxpayer. Finally, go to the website for EFTPS, or Electronic Federal Taxpayer Payment System. Here you will sign up to make your payroll tax payments online. You will find the rules for payments on the IRS website. Basically, you have to pay the employer taxes either every time you pay your employees (semi-monthly payer) or each month (monthly payer). It depends on the level of employment taxes you’ll be paying. Usually anything over $50,000 in six months makes you a semi-monthly depositor. There are many options for payroll—you can calculate it yourself using the tax tables available online from the federal and state tax departments, or you can outsource it to one of the many available payroll firms like Paychex or ADP. Here are all the types of employer taxes: • Federal Withholding Taxes These are taxes withheld from the employee’s wages and paid to the IRS based on the employee’s wage. You’ll use tax tables that list amounts due based on the wage amount, the employee’s marital status, and the employee’s number of exemptions (dependents). • Social Security and Medicare Taxes These taxes are both paid to the IRS, but they are typically calculated separately. Social Security is calculated at 6.2 percent of the employee’s taxable wages. Medicare is calculated at 1.45 percent. There are limits on these taxes, and they change every year, so check the IRS website each year to keep current. These taxes are withheld from the employee’s wages, plus paid by you, the employer (and so is considered a “fringe benefit” for employees). The total is then remitted to the IRS. • State Withholding Taxes You can find information on your state withholding tax on your state’s website. Some states collect school district taxes as well. Look for the Department of Taxation, and search for Employment Taxes to find the tax tables for your state. You will need to file paperwork with your state tax department to submit and pay employment taxes for your employees. • Local Withholding Taxes The city or town in which your business operates will usually have a tax that you will have to withhold from your employees’ paychecks and pay to the locality for them. Your employees may also live in a different locality that requires them to pay a local tax on their wages. You can withhold and pay that tax for them if you choose. Go to your city website and search for employment taxes, or business taxes, and look for withholding taxes. You will need to apply to withhold and pay local withholding taxes as well. There are also employment taxes that are not withheld from the employee’s wages, but rather are paid by you, the employer. • Federal Unemployment Tax This tax is calculated quarterly, and needs to be paid to the IRS when the amount reaches $500. Right now the tax is paid for each employee up to $7,000 in wages. Go to the IRS website for details. • State Unemployment Tax This tax is calculated and paid quarterly to your state taxation department. It is paid on each employee’s wages up to a certain amount, depending on your state. • Workers’ Compensation Insurance This isn’t really a tax but an insurance fund that employers pay to cover injuries to employees at work. Some states allow a business to self-insure. Employers pay a certain percentage of each employee’s wages, depending on the job. Check your state website for more information. Then there are other fringe benefits or withholdings for your employees, such as child support payments, garnishments, health savings account deposits, and medical premium payments.