Part 2 – Double-Entry Bookkeeping
WHAT IS DOUBLE-ENTRY BOOKKEEPING?
Alright, Double-Entry Bookkeeping is the standard that everyone in the world uses for accounting. It dates back to around 1300ad, which is pointless information that I’m just putting in here for no reason. Here are the basics:
For any transaction that involves money, or even thinks about involving money, there is a record of this transaction.
We keep a set of books that we use to record these transactions.
The transactions are recorded different accounts within books. Examples:
An expense account called, “Electricity.”
An Income Account called, “Rental Income.”
A bank account.
Any transaction is always recorded using a minimum of 2 accounts, using at least 1 Debit and at least 1 Credit.
Debiting or crediting an account means that you either decreased or increased that account. (I’ll explain this clearly in the Debit/Credit section.)
For every Debit, there has to be an equal Credit. If you think of Debits and Credits as positives and negatives, every transaction has to have a positive Debit and a negative Credit… but that’s crazy, never think of Debits and Credits as positives and negatives again! That’s how people get in trouble.
That’s the basic definition of Double-Entry Bookkeeping. If you took the time to read this definition, you’re probably either bored or a novice at accounting. If the latter, then you will still be confused about Debits and Credits, but, for now, just take them for what they are (don’t worry, I don’t even know what I mean with that sentence) and you’ll understand them in the Debits/Credits section.
A FEW DEFINITIONS
Some of these definitions are important, but not necessary to understand the rest of the accounting overview.
Bookkeeping vs. Accounting – Unimportant
“Bookkeeping” and “Accounting” are used almost interchangeable, and there’s nothing so wrong about that.
Bookkeeping is the backbone of accounting. It describes the action of recording all financial transactions. The end result of Bookkeeping is to give us a bottom-line balance (or value) of each account.
Accounting is the next step, which is taking the account values and extracting information. The information is used to do everything from understanding the current status of the company to planning for the future and preparing taxes. Some of the most important results of accounting are the financial statements, which I’ll explain later.
Cash vs. Accrual Accounting – Ehhh, not really important to know the difference, just know which one you use.
Basically, no one uses cash accounting anymore, but it is much easier. The only people/companies that still use cash accounting are farmers and some real estate companies. (I’m not saying “farmers” as some type of insult, they really use it. Also, unimportant side note: I used to have a building where we used cash accounting and I was very unhappy when we sold it ‘cause cash accounting is soooo easy… but don’t cry for me yet, I ended up being happy when I split up the profits, so everything worked out okay in the end J.) The difference between cash and accrual accounting can be simplified as a difference in the point at which transactions are recorded in the books. Both types of accounting have their advantages and disadvantages, but accrual accounting gives the best representation of a company’s financial standing. In this blog, I will mainly describe accrual accounting.
Cash accounting, oddly enough, is described in its name. Cash accounting records transactions (revenue and expenses) when cash is either received or paid.
Cash include physical cash or any form of payment, such as a check. In regards to something like a check, the transaction is recorded when the check is received and not when the funds become available.
Cash accounting is much less abstract than accrual accounting because you are really just using common sense to figure out when to record a transaction. You are recording things like making a payment and receiving payments. You are not recording things like the depreciation of an asset that has a 5 year life.
Income is recorded when payment is received. So, if a tenant is occupying an apartment you may charge them rent on the 1st of the month, but you don’t count any income until they pay their rent. If a tenant pays 2 months of rent in advance, you and you charge them rent on the 1stof the month, when the tenant is charged, and not when the payment is received.
*Security deposits can be tricky with cash accounting. You do not include a security deposit as income if you are required to return the deposit to the tenant at the end of the lease. If the deposit will be used to pay the tenant’s last month of rent, the deposit is considered income when you receive it. If a tenant does damage while occupying the unit or does not live up to the terms of the lease and you use part or all of their deposit to pay for the damages, the portion of the deposit used is considered income at the time the determination is made.
Expenses are recorded when they are paid. So, if the end of the year is coming up and you have a lot of income, you can go out and prepay for expenses that will occur in the next year. IE: You can overpay your utilities, advertising, landscaping, etc…
You get an accurate representation of the money you’ve spent and received.
IE: If you’re trying to pay your mortgage, cash accounting will tell you that you’ve received enough money cover the payment. Accrual accounting will tell you that you did work for people who owe you money and you can pay your mortgage, you just don’t have the money in your bank account.
Cash accounting can be better for taxes because you only pay taxes on the cash that you have received. If a tenant is 2 months behind on rent, you don’t pay taxes on the money they owe you… this makes sense. In accrual accounting, if a tenant is 2 months behind on rent, you still have to pay taxes on the money they owe you because a service was performed for an expected payment… this is crazy.
If you have a big expense, such as replacing a roof, you can write-off the whole expense 1 year. That means that if your revenue for the year was $1,000 and your only expense was a roof replacement that cost $600, you only pay taxes on $400 of income.
When you are trying to understand the financial standing of your company and how you the company performed for the year, cash accounting is not accurate. The biggest problem is matching a company’s expenses to the income the expenses were used to produce.
Example: If you manufactured cars and get a large order. You would need to go out and spend money on all of the materials, engines, etc… At the end of the year, you may not be ready to deliver and accept payment on any cars. So, your finances would say that you spent a ton of money and made nothing.
Example: If you prepay for 1 year of advertising for an apartment building, the expense is counted when you paid for the advertising. So that period will show an inordinately high advertising expense.
IMPORTANT: When purchasing a property, if the property uses cash accounting, it is very important to look far back at the property’s finances. A real example that happened (not to me) was that someone bought a property that was fully occupied and showed almost no advertising expenses. The story that the purchaser didn’t know was that the previous owner knew he was going to sell the property, so he prepaid for a tremendous amount of advertising and filled up the property. The previous owner prepaid for over a year of advertising. The new owner never saw the expense because the full expense was counted over a year ago. The previous owner didn’t do anything illegal, he was just immoral… this trick can be used for anything that anyone can prepay for, so beware.
Accrual accountinghas almost no regard for the transfer of cash, which seems illogical. Accrual accounting records transactions when a good is received or a service is performed, for which a set payment is expected. Accrual accounting is also abstract and takes into account ideas like depreciation and amortization.
Income is counted at the time a service is performed. So, if a tenant is occupying an apartment, you record the income on the 1st of the month, when the tenant is charged, and not when the payment is received. If a tenant pays for 2 months of rent in advance, the 2 months of rent is not considered income until the tenant is actually charged for occupying the apartment. (The prepaid rent is seen as money you owe because you have not earned it yet. It is viewed as a liability. An easy way to understand this is to picture the 2 month prepayment as a loan.)
Expenses are counted when the service is performed or the goods are received. So, if you prepay for Jan, Feb & March advertising, you count ⅓ of the expense in Jan, ⅓ in Feb and ⅓ in March. On the other side, if a landscaper mows your property’s lawn, but doesn’t send a bill for 3 months, the expense is counted at the time the lawn was mowed. The date that you receive or pay the bill is irrelevant.
Depreciation/Amortization is an abstract idea that is not used in cash accounting, but it is paramount in accrual accounting. It is described later in this “A few definitions” section.
You can accurately match expenses to revenue and determine if you are making or loosing money.
You also get an accurate representation of the company’s financial future because you can accurately account for money that you owe and money that you are expecting to receive.
Accrual accounting is much more complicated and takes a lot more work. (Unless you’re using Total Management, then there’s almost nothing for you to do.)
You have to pay tax on money you are expecting to collect. This means that you may owe taxes on money that you don’t have.
If you have a big capital expense, like replacing a roof, you can’t write it off all at one time. You have to depreciate the expense over the life of the building. That means that if your revenue for the year was $1,000 and your only expense was a roof replacement that cost $600, you may depreciate the roof over 27.5 yrs. This means that you can only count an expense of $21.82 for the year. You have to pay tax on $978.18 of income, which is much higher than the cash accounting method, which would only show $400 of income. However, when you’re paying your taxes, you should feel all warm inside because for the next 27.5 years, you’ll know how to match the roof expense to the revenue!
Accounts Receivable (A/R) & Accounts Payable (A/P) – Accounts Receivable and Accounts Payable are only used in accrual accounting. As we know, in accrual accounting, income and expenses are calculated at the time a good is received or a service is performed. However, when a good is received or service performed, payment is not always made. A/R & A/P are the accounts we use to track what is owed to us and what we owe.
Revenue/Income/Net Income/Profit – Definition
Revenue and income are used almost interchangeably and are almost the same. They are used to describe money that you earned. No expenses are taken into account when calculating revenue or income. IE: If I buy a bicycle for $100 and sell it the same day for $90, I may have lost money, but my revenue or income is still $90.
I think the confusion between all these terms is due to net income. Net Income and Profit are the same. They both refer to “The bottom line.” They look at revenue minus expenses. So in the bicycle example, the income was $90, but the net income was -$10.
Books – Just a term
The books are a loose term, referring to the record of a company’s financial transactions.
The Journal and General Ledger – Informational
The journal and the general ledger are very similar items.
The journal is like a book, it tells a story… just not a very interesting one. It is a record of a company’s financial transactions in the order that they happened. Transactions are listed, with all the accounts that were used and the amounts of their debits and credits.
The general ledger is organized by account… still not interesting. Accounts are listed and under the account, all debits or credits that were made to the account are listed.
Chart of Accounts – A good term to know
The chart of accounts is just a list of all the accounts that a company uses.
Capital Expense – Important
A capital expense can be easily understood as an expense that increases the life or value of an asset (you’re property.) This does not include repairs. An example would be repairing and replacing a roof. If you repair a few shingles on a roof, the building’s value or life of the roof may be increased, but it was just a repair. If you replace the roof on a building, the life of the building is increased and the expense needs to be depreciated.
Depreciation and Amortization – I hate this, but it’s important
Depreciation and Amortization are identical actions that calculate the decline in value of an asset; the term only refers to the type of asset.
Depreciation is for a tangible asset that you can see or hold, such as a truck or a property.
IE: You re-carpet an apartment for $1,000 and the depreciable life of the carpeting is 5yrs. You depreciate the carpeting over 5yrs and count an expense of $1,000/5yrs (or $200) per year.
Amortization is for an intangible asset, such as a mortgage.
IE: You have a $1,000 no interest loan that has a life of 27.5yrs. You amortize the loan over 27.5yrs and decrease the value of the loan by $1,000/27.5yrs (or $36.36) per year.
Land is not considered as an asset that looses value, so it is not depreciated.
Cooking the books – No reason for this to be in here
Cooking the books is when a company presents false information on the financial conditions of the company. If you’re reading this blog, you probably don’t know enough accounting to cook the books and get away with it.
A forensic accountant is the accountant that will go through the books to find the inconsistencies. They sound kinda’ cool… like the type of accountants that would be in CSI if CSI was about boring crimes. In the end, they’re really equally cool to all accountants, but in my image of them, they still have a badge and a gun.