business record keeping

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Business Recordkeeping

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Accounting Basics

In past columns, we've hit the highlights of general business records. It's now time to turn attention tofinancial (or accounting) records.

This is an area in which I have no particular expertise... I'm an engineer -- not an accountant. Soaccountant readers -- if I say things in this series that you feel are wrong or misleading, please let meknow by phone, note or article and I'll pass them on in subsequent columns.

Business accounting causes a great deal of confusion -- if not out-and-out fear and avoidance -- among

many beginning entrepreneurs. And needlessly so. It's just not that complicated. Accounting is notrocket science. It's based on a brilliantly-elegant concept from the Middle Ages -- double-entrybookkeeping.

Someone way back when recognized:

1) that the "value" of any financial entity could be described in terms of only five "accounts" -- assets,liabilities, equity, and accumulated revenue and expense.

2) that every financial transaction (i.e., "change in value" of the entity) affects at least two suchaccounts, and can be recorded in the form: assets plus, liabilities minus, equity minus, revenue minus,

expense plus, equals zero, and

3) that if every transaction sums to zero, the sum of all the transactions must equal zero!

No matter how many transactions you've recorded -- and in a thriving business you'll have many --you'll know you've recorded them correctly -- if and only if they sum to zero.

Let's look at an example.Assets are what you own, e.g., cash in bank.Liabilities are what you owe.Equity is your "net worth".

Revenue is what you get in.Expense is what you pay out.

Suppose you set up a company and put $1,000 into it. We need an asset account -- cash (Cash In Bank)-- and an equity account -- equity (Paid-In Capital). The transaction is cash/1000+ equity/1000-. Yourcompany books now show its equity is $1,000 and it's all in the bank.

Note: Your accountant will describe this transaction as "debit cash, credit equity". When you hear
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accountants use the words "debit" and "credit", just mentally translate debit to "+ (plus)" and credit to "-(minus)".

Now say someone pays you $200 to do something for them. We need a revenue account -- revenue --and the transaction is cash/200+ revenue/200-.

And you spend $100 to buy something. We need an expense account -- expense -- and the transaction iscash/100- expense/100+. Your company books now show:

Assets (cash) 0+1000+200-100 => 1100

Liabilities 0 => 0

Equity 0-1000 => -1000

Revenue 0-200 => -200

Expense 0+100 => 100

Still sums to zero.

Your "Balance Sheet" is the top 3 lines with Revenue and Expense netted into Equity:

Assets (cash) 1100

Liabilities 0

Equity -1100

Your "Earnings Statement" is the negative of the bottom 2 lines:

Revenue 200

Expense -100

Net Earnings 100

That's cash-basis accounting-- and that's all there is to it.

Accrual Accounting

In the real world, most business isn't conducted in cash -- rather you "invoice" them and they "invoice"you. You'd kinda like to keep track of what it is you're owed and what you owe. So accrual accountingis used -- which is really just an extension of the above. We add two more accounts: An asset account --receivable -- that keeps track of what you're owed and a liabilities account -- payable -- that keeps trackof what you owe.

When you invoice someone for something you sold (for say $200), the transaction is receivable/200+revenue/200-, and when they pay you, it's cash/200+ receivable/200-.

Likewise, when someone invoices you for something you bought (for say $100), the transaction is payable/100- expense/100+, and when you pay them, it's cash/100- payable/100+.

If you net these two pairs of transactions together, you'll see that you have the same end result as if theyhad paid you, or you had paid them, in cash -- but in the interim, you know what's coming in and what'sgoing out.


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These last 4 transactions are common to every business and -- for many businesses -- constitute 99% ofthe transactions you'll ever need.

You may add some assetaccounts, like Money Market, so you can track the cash in your bank andmoney market accounts separately... Or some liability accounts, like Bank Loan (what you owe the

bank), Accrued Payroll (what you owe employees), and Accrued Payroll Taxes (what you owe thegovernment on that payroll)... Some revenue accounts, like Consulting, Product, Lease Income, etc., ifyou want to track different revenue sources separately... Some expense accounts, like Rent, Utilities,Supplies, Product Materials, etc., if you want to track different expense categories separately... But thebasic transactions are all the same.

Paper Accounting

In the last column, we talked about Cash, Receivables and Payables transactions. Early in your business,these transactions can just be recorded in a General Journal. Essential data is date, acct/amt acct/amt ...,and comments (e.g., who did you pay or who paid you).

In the old days (i.e., before computers), the General Journal was just a sheaf of columnar accountingpaper where your most-used accounts had their own columns and the last column contained the rest (inacct/amtformat).

At the end of each accounting period (e.g., at month-end), you'd take a calculator and total the amounts

for each account and check that the account-totals totaled to zero -- which they never did -- whereuponyou'd have to go back, find the transactions that didn't total to zero, correct them, and re-total the wholething until they did come to zero. (You'd have to do this even if they totaled to only a penny -- becausethat penny could have resulted from two large errors whose difference was a penny.)

General Ledger

After verifying that the account-totals for the period in fact totaled to zero, you'd then "post" (i.e., copy)the account-totals to a General Ledger-- which was just another sheaf of columnar accounting paper,one sheet per account number, from which you could then compile your Balance Sheet and EarningsStatement. (Of course, after posting the General Ledger, you'd have to again total all the amounts you

just posted, checking that they still totaled to zero, so you'd know you'd copied them correctly.)

As your business grows, just recording everything in the General Journal can get unwieldy.

Customer Ledger

You now have dozens ofcustomers with dozens of transactions with each of them. The question is nolonger "how much do they owe you", but "who owes you how much". So instead of recording customer


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transactions in the General Journal, you set up a Sales Journal (to record all invoices going tocustomers) and a Cash Receipts Journal (to record payments received from those customers).

At the end of each accounting period, you total the amounts for each account in these journals, and postthem to the General Ledger (adding now a notation of what journal they came from) -- but you also post

them to aReceivables Ledger(one sheet per customer) so you have a ready reference of how much eachcustomer currently owes you.

Vendor Ledger

And you now have dozens ofvendors with dozens of transactions with each of them. And the questionis no longer "how much do I owe them", but "who do I owe how much to". So instead of recordingvendor transactions in the General Journal, you set up a Purchase Journal (to record all invoicesreceived from vendors) and a Purchase Disbursements Journal (to record all payments to thosevendors).

And at the end of each accounting period, you total the amounts for each account in these journals, andpost them to the General Ledger -- but you also post them to aPayables Ledger(one sheet per vendor)so you have a ready reference of how much you currently owe each vendor.

Employee Ledger

And you may now have dozens ofemployees with dozens of transactions with each of them. And thequestion is no longer "how much do I owe in payroll and payroll taxes", but "who do I owe how muchto". So instead of recording employee transactions in the General Journal, you set up a Payroll Journal(to record all pay accrued by employees and all payroll taxes owed thereon) and a PayrollDisbursements Journal (to record all payments to those employees and the government).

And at the end of each accounting period, you total the amounts for each account in these journals, andpost them to the General Ledger -- but you also post them to aPayroll Ledger(one sheet per employee)so you have a ready reference of how much you currently owe each employee and each governmententity.

Other Ledgers

And you might add other Journals and other subsidiary Ledgers (e.g., Employee Advances, EmployeeVacation, etc.) depending on the extent to which you need ready reference to their constituent balances.Candidates for subsidiary Ledgers are any asset, liability orequity accounts that you want to regularly

break out by the entities (customers, vendors, employees, stockholders, etc.) that comprise their balance.

All the transactions in all these Journals needed to be totaled to zero (to be certain you had recordedthem correctly) and when they are posted to the Ledgers, they needed to be totaled again (to be sure youtransferred them correctly).

Source Documents


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The past two columns have talked about accounting -- how financial transactions are recorded (inJournals) and summarized (in Ledgers) and how the number and types of Journals and Ledgers maygrow as your business grows.

One thing we didn't talk about was what happens to all the pieces of paper that you recorded these

transactions from -- the customer invoices and payments, vendor invoices and payments, employee timesheets and payments, etc., etc... You guessed it -- they get bound -- chronologically -- into Manilafolders.

These pieces of paper are your "source documents". They're the supporting documentation for eachfinancial transaction you make. They're what you'll show the IRS auditor when he questions the validityof a transaction, i.e., was that payment really a valid business expense.

Note: If you can't "prove" that the payment was a valid business expense, he can, and probably will,disallow it. Every expense he disallows goes right to your bottom line, increases your supposed "profit"and, therefore, your "tax due" -- which, of course, makes the time he spent with you that much more

worthwhile -- and, of course, makes it that much more likely you'll see him again next year.

If you don't have a source document for a transaction, e.g., you pay cash to someone and don't get areceipt, make one. Every source document should show whatyou did and, if it's not obvious, why youdid it. It's a whole lot easier to jot that down when you do it (or when you record the transaction) than totry to remember several years later with an IRS auditor hanging over your shoulder.

When To Close

Another thing we didn't talk about is how often we should "close the books", i.e., post the Journal(s) tothe Ledger(s). If you're keeping your accounting records only for the government (e.g., tax records), or

to show the bank or investors, a month-end closing is probably adequate.

But if you're using the financial records to manage your business -- as you really should be -- you reallyneed to "close" more frequently -- like weekly. Keep in mind the axiom, "You can't manage what youcan't measure".

Financial recordkeeping gives you the means to manage your finances -- your cash, the monies yourhave coming in and going out, and when. Of all the things you have to "manage" in a business, how it'sdoing financially has to rank way up near the top of the list.

The only difference between a "business" and a "hobby" is that a business makes money and a hobby

doesn't. If you don't diligently manage your finances, it's likely you'll watch your business dream turninto a very-expensive hobby -- and one you can no longer afford.

With paper accounting, there's a lot of work in closing weekly (well worth it -- but still a lot of work).With computer accounting, a week-end closing is no big deal. The computer can do all that posting anderror-checking -- that used to take hours -- in microseconds.

With the computer, it really doesn't matter whether you record your transactions in ordinary text files


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and use programs or "scripts" you write to use the data -- or with the spreadsheet or database tools youmay be familiar with -- or with full-fledged "accounting packages".

In all cases, "closing" reduces to printing out your Journal data (hardcopy record for auditor or taxpreparer -- or for your own use if you neglect recommended "computer backup" procedures), and any

other Ledgers or summary reports that you find useful in hardcopy form -- a 5-minute job.

In subsequent columns, we'll review the Journals we've previously mentioned in much more detail -- butwe'll focus on the data that should be recorded and the uses of that data, rather than the actual mechanicsof the recording or reporting. This (hopefully) will make it useful whether you choose to use paper orcomputer -- or how you choose do it with computer.

Chart of Accounts

When we introduced financial transactions (back in the Accounting Basicscolumn), we showed them

as, e.g.,

cash/1000+ equity/1000-cash/200+ revenue/200-cash/100- xpense/100+receivable/200+ revenue/200-payable/100- xpense/100+

The names (cash, equity, revenue, etc) are the "accounts" and the numbers are the "amounts" and thetransactions are shown in "acct/amt acct/amt ..." format.

In practice, "accounts" are typically represented by numbers (e.g., cash might be account 110, money

market, 115, receivables, 130, payables, 420, etc.). There's nothing magic about that -- it's just generallyeasier to remember that 110 is cash than it is to remember whether we've chosen to represent cash as"cash", or "csh", or "ch". (A good practice is to use 3-digit numbers for assets, liabilities and equity, and4-digit numbers for revenue and expenses).

Note: The balances in your 3-digit accounts get carried over from year to year. The balances in your 4-digit accounts get "closed out" at the end of each year (into Retained Earnings) and start the new yearafresh at zero.

The "key" that relates account numbers to account names is called the Chart of Accounts.

The Chart of Accounts for a small product-line manufacturer might look like that shown below. This isjust an example. Yours might contain fewer, different, or more accounts -- depending on what you findimportant to track (i.e., measure).

The accounts are shown as account-number account-name, e.g., 101 Petty Cash, etc. The uppercasenames, e.g., ASSETS (0-399), etc., are account summaries that you may wish to print out on yourBalance Sheet and Earnings Statement (e.g., ASSETS (0-399) says that the amount to be shown forASSETS on your Balance Sheet is to equal the sum of the balances in all account-numbers from 0
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through 399).

We'll talk about most of these accounts in subsequent columns.

General Journal

We introduced the General Journal in an earlier column, Paper Accounting. We said that all financialtransactions could be recorded in a General Journal -- and in fact in the early months of a company,probably should be. We said that the essential data to be recorded are the date, the transaction (acct/amtacct/amt ...), and comments (e.g., who you paid or who paid you).

The date is the date (mo/dy/yr), right? Not necessarily. If you're closing your books monthly, mo/dy/yris ok -- the mo-entry clearly identifies the month. But if you're closing them weekly, it can get a littleawkward.

How do you identify what transactions belong to "this" week? Or "last" week? Or "this week" last year?You now need a "key" that relates each week in the year -- Sunday through Saturday, or however youchoose to define a "week" -- to a beginning and ending mo/dy/yr. If you're doing paper accounting, that"key" is a calendar -- perhaps with week-numbers, e.g., 1-53, written on it. If you're doing computeraccounting, however, your software must recognize what constitutes a "week" -- which may affect whatyou want in the date-field.

For example, I use a week-number fordate -- and did years ago when I was still paper accounting. Myweek-number format is , e.g., this year, 1998, my week-numbersrun from 801-853. This method clearly identifies which transactions belong to which week. The onlyreason forlast-digit-of-yearis to avoid confusion with prior year transactions (which may have carried

over as the result of year-end reversals, open receivables or payables, etc.) and next year transactions(so that I don't have to set up a next-year folder or computer file until I'm ready to close the currentyear).

But how do you distinguish 1988 transactions from 1998 transactions? By the label on the Manilafolder, "General Journal - 1988" -- or in the case of the computer, the directory name is "GeneralJournal" and the file under it containing 1988 data is named "1988".

How do you know what day the transaction happened? For most businesses, that's a "don't care". Itreally doesn't make any difference whether incoming transactions (e.g., vendor invoices) were receivedon Tuesday... or Wednesday... or Thursday (after all the Post Office is not that dependable). It does

make a difference what "week" they were received because payment is going to be due about 4 weekslater. And most businesses do their outgoing transactions (e.g., bill payment, payroll, etc.) only once aweek. And if you really need to know the exact day something was received, you can always go back tothe source document (assuming you do date-stamp incoming mail).

For businesses that do care about day (e,g., retail, where you'd like to compare this Monday's sales withthe equivalent "Monday" of prior years), a day-of-week encoding (e.g., 1-7) can to be added to thejournal. For example, in my retail businesses, I used day-number as the first digit of my sales-receipt
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numbers, which numbers ended up in the equivalent of the comments-field above.

The General Journal requires two Manila folders (whether you're doing paper or computer accounting).One is for the hard-copy Journal. Even if you're keeping the Journal on computer, you need a hard-copyfor auditors and others -- and to backup your backup. The other is for the source documents -- the

piece(s) of paper you recorded the transactions from.

One passing suggestion -- my comments-field always starts off with a sequence-number (within theweek). Then I annotate the upper-right-hand corner of each source document with , e.g., 826-1, 826-2, etc. This makes it easier to go back and find aparticular source document, especially if there are a lot of them.

The General Journal records all transactions not recorded elsewhere, i.e., in other journals. Sincesubsequent columns will be describing these other journals, we'll leave the details of the transactions tothose columns.

Payables Accounting

Payables deal with paying vendors (including the government). If your payments are few or mostly incash, it's probably best to just record them in the General Journal. The typical transaction is , where include who you paid.

However, if you make many payments... generally to invoices received... with payments generally madeby check... it pays to set up a Payables system.

A Payables system involves aPurchase Journal-- in which all vendor invoices received are recorded --

and aPurchase Disbursements Journal-- in which all payments to those vendors are recorded.

Purchase Journal

The typical record in the Purchase Journal is ,where include vendor (name or number) and any other data you may wish to record, likedate-scheduled-to-pay, vendor-invoice-number, etc.

Note: Keep in mind that if you use vendor numbers you will need a "key" -- paper listing or computerfile -- associating the vendor numbers with vendor names, and perhaps other vendor data, e.g.,address/phone/fax of where you order from, where you pay to, any special payment terms you have with

that vendor, etc.).

Purchase Disbursements Journal

The typical record in the Purchase Disbursements Journal is , where include vendor (name or number) and any other datayou may wish to record. Note that the transactions in these two Journals, netted together, reduce to the


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cash/expense transaction we showed in the first paragraph.

If you're doing paper accounting, it's recommended you set up a separate checking account used only forPayables. The reason for this is that your Purchase Disbursements Journal then becomes a sequentiallisting of your check numbers -- making it immediately obvious if any have been lost or stolen.

If you're doing computer accounting, that's not as important because the computer can detect missingcheck numbers. (But make sure you have, get, or write software that can.)

Payables Ledger

With paper accounting, the transactions in these Journals are periodically (weekly or monthly)summarized into a Payables Ledger, by vendor(see earlier article, Paper Accounting). This lets youeasily see how much you owe to who, compile Payables Aging Statements for your bank, etc.

Note: A Payables Aging Statement is a list of active vendors with the amount due them in columns

labeled, e.g, Current, Over 30 days, Over 60 days, Over 90 days, etc.

Computer

With computer accounting, it's not necessary to keep Purchase and Purchase Disbursements transactionsin separate files since much of the data is redundant. Rather they can be recorded directly in what, in apaper system, would be considered a Payables Ledger.

Essential data is . Using an undefined , e.g., 0000, allows to serve as date-scheduled-for-payment until such time as payment is actually made (whereupon becomes

the real payment date and becomes the real check number).

From this data, the computer can look at to compile a hard-copy Purchase Journal and at (and ) to compile a hard-copy Purchase Disbursements Journal... or to print aPayables Aging Statement... or to print the actual checks themselves.

Other useful data can be included in -- for example, the last 4 or 5 digits of vendors'invoice numbers. This makes it easier to check the payment status of an invoice when vendors call... Orcoding that allows you to distinguish different classes of invoices from the same vendor, e.g., utilitybills for different facilities paid to the same vendor... Or coding that allows you to distinguish the "real"vendor from the payee, e.g., when the invoices are to be paid to a factor... Or coding that allows you to

distinguish which line-items of a Purchase Order are being billed by the invoice... Etc.

Caution: The Ledger format shown above applies only if you pay "whole" invoices. If you may make"partial" payments on invoices, you'll need to add a "keying" system as we'll describe under underReceivables Accounting.

Transactions
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The "..." shown in the Payable Journal transaction field denotes that the may be dividedamong multiple expense accounts. For example, with the Post Office now in retail, you might buy bothstamps and mailing supplies from them. The transaction would be,payable/amt- postage/amt+supplies/amt+ -- assuming you wished to account postage and supplies separately.

When you buy something from a remote vendor, you could account it as, payable/amt- expense/amt+.Or as,payable/amt- expense/amt+ freight-in/amt+, if you wanted to watch your incoming shippingcosts (a good policy)... Or as,payable/amt- expense/amt+ freight-in/amt+ sales-use-tax/amt+, if part ofthe bill was sales-use tax... Etc.

And, under U.S. tax law, not everything you buy can be directly expensed, i.e., accounted to anexpense-account.

For example, inventory (products bought for resale, materials bought to manufacture products to besold, etc.) can't be expensed until sold -- and in the meantime are accounted in an inventory asset-account, e.g.,payable/amt- inventory/amt+.

Depreciable property (buildings, machinery and equipment, furniture and fixtures, etc.) may only beexpensed over time (i.e., depreciated) -- and is accounted in a property asset-account, e.g.,payable/amt-property/amt+.

New Accounts

How do you know when you need to add a new account to your Chart of Accounts? Whenever it'srequired to be reported separately on a tax return. And -- if you're using your financial records tomanage your finances -- whenever a definable expense becomes "significant". For example, if yourSelling Expenses are running about 10% of sales, if your advertising expense... or literature expense...

starts approaching 1% of sales, those expenses should certainly be called out as separate accounts.

Non-Payables Disbursements

And what payments might not be made out of Payables? Any payments made with other than Payableschecks e.g., cash payments (minimize -- checks are a better record), transfers into Payables checking(i.e., checks written with Cash-in-Bank or Money-Market checks to replenish Payables checking),Payroll (if you have a Payroll checking account), replenishment of Payroll checking, etc.

If you have a Payables account, try to make all payments with Payables checks -- even where thatrequires simultaneous Purchase and Purchase Disbursement transactions (e.g., paying a shipper -- at the

door -- for a C.O.D. delivery).

Payables Processing

The major problem faced in payables processing is avoiding overpayments -- especially paying thesame invoice multiple times.


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After many years of dealing with other companies' payables processing, I can assure you that mostcompanies are atrocious at this -- regardless of size. For example, when I was manufacturing, whenevera company would send in a Purchase Order, we'd return a Sales Order confirming their order andscheduled delivery. Then when we'd ship the order, we'd send them an Invoice. And later, if they hadn'tpaid within terms, we'd send them a Statement reminding them of their open invoices.

It is unbelievable how many companies paid not only against the Invoice -- but against the Sales Orderandagainst the Statement -- they'd triple pay on one order! And the invoiced amounts were notinsignificant -- seldom less than $1,000. And all would occasionally do it -- even very large companieslike the Big 3, Armco Steel, Hewlett Packard, Bell Labs, etc.

We had a policy that, whenever we received an overpayment, we would notify the company and askhow they wanted to handle it.But once and only once -- it's hard enough dunning companies forunderpayments -- it's unreasonable to expect to have to dun for overpayments. Even more unbelievable,less than 10% ever responded to these notices -- happily the small companies were much more likelythan the large.

As you'll see when we get into Receivables, the Bad Debt account is the account into which youexpense uncollectible amounts. I neverhad a year in which my Bad Debt account did not show"revenue"!

Note: In fairness to large companies, their poor performance is not simply a matter of ineptitude. Largecompanies purposefully try to balance the costs of overpaying against the administrative costs of tryingto avoid doing so. They do periodic sample audits to see how much they're overpaying -- and so long astheir overpayments remain only a few percent of their total payments, they consider that "good enough".(Of course, my experience leaves me questioning just how good their sample audits really are.)

Anyway, you may think you're not overpaying -- but, if you're paying more than a very few bills, theodds are overwhelming that you are. I'm sure I have. There's no way to totally avoidthe problem -- thebest you can do is try to minimize it, with consistent procedures, similar to those outlined below.

Payables Procedures

Each day, take the vendor invoices received that day and prepare them as source documents. This mayinvolve attaching other sheets -- like the packing slip (or other receiving record) evidencing actualreceipt of the goods being invoiced. (Not only do you not want to double-pay, you don't want to pay forthings you didn't receive!)

Additional attachments could include a copy of the catalog page from which the goods were ordered...or a copy of your Purchase Order... whatever you'd like to see when you later refer to the invoice. Theprocessing may also involve annotating the invoice with the transaction to be recorded, checking itagainst recent payments to the vendor to verify that it hasn't been paid, etc.

If you -- the (sole) owner -- are doing this yourself, you may decide no other "approval to pay" isneeded. However, if someone else is doing it, the source documents should come to you for approval --


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and they should come to you with sufficient data that you can knowledgeably approve them.

After approval-to-pay, the financial transactions they represent should be recorded in your PurchaseJournal (paper) or Payables Ledger (computer), and filed in a week-to-be-paid folder (e.g., labeledPurchase Disbursements Journal, week-number).

At the end of each week, you pull the current week-to-be-paid folder, write/print, sign and mail thechecks. Again, if this is being done by someone other than the owner, the owner should sign the checks.The week-to-be-paid folder then -- automatically -- becomes the historical week-paid folder, containingthe complete backup for all Payables checks written that week. Passing suggestion -- before writing thechecks against this folder, consider re-arranging the folder to put the source documents in vendor-number order. This makes it easier to later find the source document by either check-number or vendor-number.

Receivables Accounting

Receivables deal with the payments received from your customers or clients. If these payments are few,it's probably best to just record them in the General Journal. The typical transaction is , where include who paid you.

However, if you receive many payments, generally against invoices you've issued, it pays to set up aReceivables system. (Note: If your business is retail, none of this applies. We'll talk about the handlingand recording of incoming retail cash in a later column),

A Receivables system involves a Sales Journal-- in which all invoices outgoing to customers arerecorded -- and a Cash Receipts Journal-- in which all payments incoming from those customers are

recorded.

Sales Journal

The typical transaction in the Sales Journal is , where


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reduce to the cash/revenue transaction we showed in the first paragraph.

If you're doing paper accounting, the Sales Journal is important because it's your only sequential listingof customer invoice numbers -- making it immediately obvious if any are being used for purposes youhad not intended. (The Cash Receipts Journal is equally important -- in an incoming cash control sense

-- but we'll get into that later underReceivables Processing.)

If you're doing computer accounting, invoice-number tracking is not as important because the computercan detect missing numbers. (But make sure you have, get, or write software that can.)

With paper accounting, the transactions in these Journals are periodically (weekly or monthly)summarized into a Receivables Ledger, by customer(see earlier article, Paper Accounting). This letsyou easily see how much each customer owes you, and whether (and how much) they're falling behindin payments. It also facilitates compiling a Receivables Schedule for your bank (as your receivables arelikely one of the important assets they're loaning you money against).

Computer

With computer accounting, it's not necessary to keep Sales and Cash Receipts transactions in separatefiles since recording them directly in what, in a paper system, would be considered a ReceivablesLedger is much more convenient.

Essential data is . In theLedger, Sales transactions, receivable/amt+ revenue/amt- ..., can be distinguished from Cash Receipttransactions, cash/amt+ receivable/amt- ..., by the lead account-number of the transaction. Thecomputer can compile a hard-copy Sales Journal by looking for transactions that lead with thereceivable account-number, and a hard-copy Cash Receipts Journal by looking for transactions that lead

with the cash account-number. And by netting the receivable and cash amounts for each customer,compile the Receivables Schedule for your bank. Or by also looking at date, compile a ReceivablesAging Statement for both you and the bank.

Note the addition of to the data. Since we have no control over customers making partialpayments on our invoices, we have to provide for that eventuality. We do so by adding a "keying"system. Although there are many methods for "keying off" transactions, I'll describe one I've used.

One field in the Ledger file is reserved for a "key". When an invoice (sales transaction) is first recorded,the key is left blank. When payment of that invoice is received, a letter or number (sequential bycustomer) is entered into the key in both the sales and cash receipts transactions. However, if only a

partial payment was received, the key is left blank (on both transactions). The key is not filled in untilthe invoice has been paid in full -- and then the sales and all the cash receipts transactions that went intopaying it off are "keyed off".

Shipping & Sales Tax

We showed the Sales transaction above as, receivable/amt+ revenue/amt-. However if you're shippinggoods, you're probably billing the customer the shipping cost. (Actually, you're billing them to
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reimburse you for the shipping cost your shipper billed you. You have, or will have, in your PurchaseJournal, a bill from the shipper,payable/amt- freight-out/amt+.) The shipping cost you're billing thecustomer wants to offset your freight-out expense. So the more typical Sales transaction -- if you'reshipping goods -- will be receivable/amt+ revenue/amt- freight-out/amt-.

Similarly, if you're collecting sales/use tax on the sale, that tax has to be reported and paid to the stateand, to simplify reporting and audit, should be accounted separately, e.g., into a Sales/Use Taxpayables-account. So the more typical Sales transaction -- if you're also collecting sales/use tax -- willbe receivable/amt+ revenue/amt- freight-out/amt- sales-use-tax-payable/amt-.

Note: The states have been complaining for years that it's unfair that companies only have to collectsales-use tax on sales in states in which they are "doing business", i.e., in which they have physicalpresence. But here you can see the companies' problem -- are we really going to require every smallbusiness to set up 50 Sales/Use Tax payable-accounts (one for each state) -- never mind the subsequenthassle of understanding each state's rules, of paper-reporting to each state -- and making time for eachstate's audits. The answer to that question is -- yes, we probably will -- the powers-that-be believe that,

with computers, it's not that big a hassle (sure it isn't!). See why "tax simplification" might be high onthe small business agenda?

Sales Allowance

What if the customer pays the invoice -- except for a small amount (e.g., a few cents) that isn't worthgoing after? Set up a Sales Allowance expense-account and record the transaction as, cash/amt+receivable/amt- sales-allowance/amt+. The receivable-amount matches what was owed (allowing theinvoice to be keyed off) and the difference (between what was invoiced and what was paid) is expensedto sales-allowance.

Reinvoiceable

What if the amount is worth going after (e.g., a few dollars)? Just leave the transactions un-keyed-offuntil you collect.

But what if the customer is a regular, keeps underpaying by a few dollars, and you start building up abunch of un-keyed-off invoices that start becoming a hassle to you in trying to understand (andcommunicate) what they owe?

That's where a Reinvoiceable receivables-account can come in handy. Simply transfer all those amountsfrom your normal Receivables account to a Reinvoiceable account with transactions of the form,

receivable/amt- reinvoiceable-receivable/amt+. That allows you to key-off all those invoices -- withoutlosing sight that they're still owed. (You just moved them into a different receivables account.)

And if you want to re-invoice the customer for these unpaid amounts, go ahead. If they're that much outof control or into playing those kind of games, they deserve the opportunity to double-pay. (Justremember, when/if they pay to credit the payment to the right receivables account.)


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Bad Debt

What if the customer doesn't pay? All your dunning efforts have been unsuccessful -- and so has puttingthem into collection. Then you write-off the invoice (or unpaid balance) into a Bad Debt expense-account with the transaction, receivable/amt- bad-debt/amt+, keying off the invoice.

Note: And as we mentioned in the Payables Processing column, this is not a bad place to recordoverpayments, cash/amt+ receivable/amt- bad-debt/amt-, where receivable is the amount owed, cashthe amount paid and bad-debt the overpayment. Of course, if you subsequently have to return theoverpayment, you'll have a Payables transaction,payable/amt- bad-debt/amt+.

Credits

What if the customer returns the goods and you want to credit out their invoice? Do a negative invoice(a.k.a., Credit Memo), with a transaction, receivable/amt- revenue/amt+, that keys-off the invoice.

What if you want to charge them a restocking charge? If you infrequently bill restocking charges,simply credit out only part of the invoice (i.e., less the charge), and leave the invoice open (i.e., don'tkey it off). until the restocking charge is received.

However, if you regularly bill restocking charges, you may wish to set up a Restocking receivables-account, receivable/amt- restocking-receivable/amt+, to track them separately -- or a Restockingrevenue-account, in which you credit out the entire invoice, receivable/amt- revenue/amt+, and re-invoice the restocking charge, receivable/amt+ restocking-revenue/amt-.

If you choose the latter, be sure you have a system in place thatguarantees that the restocking invoicegets written. Be very, very careful with Sales transactions that give credit (i.e., any transactions that lead

with receivable/amt-) -- whether they're giving credit or making corrections. Every one of them is anopportunity for your money to walk out the door.

Receivables Processing

There are two parts to receivables processing -- Sales processing and Cash Receipts processing.

Sales Processing

A "sale" starts when you receive a Purchase Order from a customer. That PO may kick off a Shipping

Order (an in-house record to ship against) or a Job Order (an in-house record to build and ship against).If you need to send the customer written confirmation of scheduled delivery -- or your product'ssomewhat custom and you want to confirm with the customer (in your terms) what they've ordered --you might consider a Sales Order (a restatement of their PO).

These papers are "operations" records -- not "financial" records (although they can be, which we'll getinto in later columns when we talk about Inventory accounting). For now, they (or a copy of them) can
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be simply held in an Customer Open Orders folder until the order is invoiced.

A Customer Invoice is kicked off by some record (which may be one of the above "Orders" from theshipping area) recording when and what was shipped. A customer invoice is prepared and mailed, aSales Journal source document is prepared, and the sale (i.e., the customer invoice) is recorded in the

Sales Journal.

The source document consists of a copy of the customer invoice and whatever "source data" you want toattach to it, e.g., the customer's Purchase Order, your Sales Order, whatever shipment record you'veused, etc. If you've shipped only part of the order, you might annotate the line items of the PO/SO in theCustomer Open Orders folder with date shipped, attach a copy of them to the invoice (maybe yellow-highlighting the parts shipped), and leave the original PO/SO in the Customer Open Orders folder untilit ships completely.

The Sales Journal source document is filed in a Sales Journal Source Document folder, by Invoice-number, for ready reference when payments against that invoice are received.

Cash Receipts Processing

The major problem faced in cash receipts processing is making sure that all the monies coming in fromcustomers really ends up in your bank account

If you (the sole owner) receives and opens the mail, records the cash receipts, prepares and makes thebank deposits, no special procedures are likely required. However, if any employee (or another owner)is involved in any of these steps, procedures similar to those outlined below are recommended.

Receiving andopening the mail (at least that addressed to the company) should be vested in one person

(and not the one doing the subsequent receivables processing). Have that person keep a daily log of cashreceipts -- a simple listing of payer, amount and total -- stamp each check with the company's bankdeposit stamp, and forward to the person who will be doing the processing.

That person prepares a source document for each cash receipt, in this case just a copy of the checkannotated with week received, your invoice-number and anything else you might find useful. They thendetermine how the transaction should be recorded, record it, file the source documents in a CashReceipts Source Document folder and put the checks in a safe place (e.g., in a bank bag stuck in the rearof an unrelated file cabinet drawer).

The reason for annotating the Cash Receipts source document with invoice-number is to provide ready

reference back to the Sales source document where most of the "source data" for the sale is filed. Notethat we could have set up the files so that allsource data for the sale ended up in the Cash ReceiptSource Document folder -- as we set it up in Payables so that all source data for the purchase ended upin the Purchase Disbursements Source Document folder. In Payables, we chose to do it that waybecause we have control over how and when we make our payments (assuming we have adequate cashto pay our bills).

But in Receivables, we have no control over how our customers choose to pay. Each time our customers


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paid only part of our invoice, we'd have to attach and annotate a copy of the source data to the CashReceipts source document and leave the original source data in an Open folder until the invoice wastotally paid. That could amount to a lot of superfluous copying. However, if our customers always payour invoices fully, attaching the source data to the Cash Receipts source document (and avoiding SalesSource Document folders altogether) could make sense.

The point is there is no right or wrong to these decisions -- so long as you understand what you're doingand it meets your needs and the needs of others (internal and external) who may reference the data.

It can be argued that the checks should be deposited every day. However, that's a hassle and the risksare minimal. Each check is stamped with a "For deposit only" to your bank account number, so even ifthey're stolen, the thief is going to have trouble doing anything with them. And you have a good recordof them (in both your Cash Receipts Journal and Source Document folder) so you can notify yourcustomers to stop payment on them and issue new checks.

Periodically, e.g., at the end of each week, the Cash Receipts Journal is printed and filed, the checks are

pulled, a bank deposit slip prepared, the checks deposited, and the bank's deposit receipt rubber-cemented to the top sheet in the Cash Receipts Source Document folder. If you're computer accounting,the computer can print out the bank deposit data (same program that prints out the Cash ReceiptsJournal -- just different format).

As owner, you should check that the checks-in log, the Cash Receipts Journal and the bank's depositreceipt all match, i.e., all the monies that came in were in fact deposited.

About the only place this system can be "gamed" is at the mail-opening point. The person opening themail may not stamp some checks and try to cash them himself. That's why you don't want this personinvolved with the receivables processing (sending out statements, talking to customers about overdue

accounts, etc.). It's only a matter of time before this second person catches on to what's happening.

What if the two of them conspire? About all you can do is keep a close eye on your Receivables AgingStatement -- and don't be afraid to call on an overdue account yourself!

Payroll Accounting

Payroll deals with paying your employees (including seeing that the government gets the monies theyrequire you to withhold from the employees and the payroll taxes they require you to pay).

If you have occasional employees, or even one or two full- or part-time, you can get by recording thepayroll transactions in the General Journal. The typical transaction is , where include who you paid and the hours they worked. Labor-expense, withholding, accrued-taxes, and tax-expense include multiple accounts as we'll get into below.

If you have more than a couple of employees it definitely pays to set up a Payroll system.


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A Payroll system involves aPayroll Journal-- in which payroll is accrued, i.e., held in an "owed" state(like an open vendor invoice) until paid, and aPayroll Disbursements Journal-- in which the actualpayments to the employees are recorded.

Payroll Journal

The typical transaction in the Payroll Journal is , where accrued-wage is the employee's gross pay and include employee(name or number) and any other data you may wish to record, like hours-worked.

Note: Keep in mind that if you use employee numbers you will need a "key" -- paper listing or computerfile -- associating the employee numbers with employee names, and perhaps other employee data, e.g.,their pay rate, federal and state tax exemptions, address, phone, social-security number, birthdate andany other data you need or the government requires you to maintain.

The labor-expense in the above transaction might be to a single Labor account, or to many Labor

accounts as shown in our earlierChart of Accountscolumn, e.g., Administrative labor, Selling labor,Engineering labor, Manufacturing labor (and that could be further sub-divided into Area1 labor, Area2labor, etc., depending on how finely we wish to track our labor costs).

Payroll Disbursements Journal

The typical transaction in the Payroll Disbursements Journal is , where include employee (name or number) and any other data you may wish to record. Note thatthe transactions in these two Journals -- netted together -- reduce to the cash/labor-expense/withholding/accrued-tax/tax-expense transaction we showed in the second paragraph.

If you're doing paper accounting, it's recommended you set up a separate checking account used only forPayroll. The reason for this is that your Payroll Disbursements Journal then becomes a sequential listingof your check numbers -- making it immediately obvious if any have been lost or stolen.

If you're doing computer accounting, that's not as important because the computer can detect missingcheck numbers. (But make sure you have, get, or write software that can.)

With paper accounting, the transactions in these Journals are periodically (weekly or monthly)summarized into a Payroll Ledger, by employee (see earlier article,Paper Accounting). This lets youand others (e.g., a Labor Department or EEOC auditor) easily review the pay record and status of each

employee.

Payroll Withholdings & Taxes

Now we have to get into withholdings and accrued taxes. Bear with me. This involves a lot of detail(don't blame me -- blame your user-friendly government) -- but there's really nothing horriblycomplicated about it.
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The withholdingportion of the Payroll Disbursements transaction are the monies required (bygovernment dictum) to be withheld from each employee's gross pay. They includeWithheld Federal Income Tax (WH-FIT),Withheld Social Security (WH-FICA),Withheld Medicare (WH-FICM), and

Withheld State Income Tax (WH-SIT).

The withholdingportion of that transaction should really have been written as WH-FIT/amt- WH-FICA/amt- WH-FICM/amt- WH-SIT/amt- .... The "..." indicates there may be more, e.g., if you haveemployees in other states, you'll need a separate WH-SIT account for each state... if you offer youremployees "direct deposit" to their bank account, you'll have one or more WH-Bank accounts.

The accrued-tax portion of the Payroll Disbursements transaction are monies you are required to pay forthe "privilege" of having employees. They includeAT-FICA (an amount related to WH-FICA, usually equal),AT-FICM (an amount related to WH-FICM, usually equal),

AT-FUT (Federal Unemployment Tax), andAT-SUT (State Unemployment Tax),

The accrued-tax portion of that transaction should really have been written asAT-FICA/amt- AT-FICM/amt- AT-FUT/amt- AT-SUT/amt- ....

And the tax-expense portion of the Payroll Disbursements transaction are the expense part of theaccrued-tax transaction, i.e.,FICA-expense = AT-FICA,FICM-expense = AT-FICM,FUT-expense = AT-FUT, and

SUT-expense = AT-SUT.

The tax-expense portion of that transaction should really have been written asFICA-expense/amt+FICM-expense/amt+ FUT-expense/amt+ SUT-expense/amt+ ....

Most of what you need to know to calculate these payroll withholdings and taxes are spelled out inCircular E(available from the Federal government and updated annually) and an equivalent booklet(s)available from the State government(s). The calculations are generally straight-forward -- simple linearequations, with tables included for those processing manually.

Now, I've implied above that the accrued-tax and tax-expense amounts have to be calculated for each

employee. They don't -- they can be calculated on total payroll. If you're processing payroll manually,you'd typically drop these from the Payroll Disbursements transaction and record separate transactionsof the form, accrued-tax/amt- tax-expense/amt+, directly into your Purchase Journal.

However, with computer processing it's easier to calculate them by employee because they all comewith upper limits -- each applies only to the first $x of an employee's gross pay. (With manualprocessing, the person doing the processing sorta has to watch for these limits with side calculations.)


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So how do all these payroll withholdings and taxes get paid to the government. The same Federal andstate booklets we referred to earlier specify how and when they must be reported and paid and theForms or deposit records to be used for reporting. A copy of these Forms or records becomes the sourcedocument for a Purchase Disbursement Journal entry recording the actual payment.

WARNING: Make these payments -- and on time -- even if you don't have the cash to pay anyone else.The penalties for late payments are draconian -- and the government entities have Gestapo-like powersto collect far exceeding those of other debtors and penetrating into normal bankruptcy protections.Always -- pay your friendly government -- first!

Computer

With computer accounting, it's not necessary to keep Payroll and Payroll Disbursements transactions inseparate files since recording them directly in what, in a paper system, would be considered a PayrollLedger is more convenient.

Essential data is , where consists ofcash/amt- accrued-wage/amt+ and all the withholdings, accrued-taxes, tax-expenses and labor-expenses we talked about earlier.

From this data, the computer can look at to compile a hard-copy Payroll Journal and at to compile a hard-copy Payroll Disbursements Journal... or to print the payroll checks... orto printout the myriad payroll reporting forms... or to printout an Employee Pay Record for the year.

If you intend to set this up yourself, i.e., put this data into a file to be processed by your own scripts,programs, tools, etc., a suggestion. In addition to the "essential data" we showed above, consider addinganother type of record (an employee-record) that contains

, data that you would otherwise keep in an Employee Key.

This buys you two things. First, a time-record of employee pay-rate and exemption changes. Second, itallows you to record labor-expenses in "hours" instead of "dollars" -- which you need to maintain forother purposes anyway. All payroll disbursements made on or after are processedusing the new and . And in fact doing it this way allows you to write a script,program, macro, etc., that calculates your payroll (and writes the data into the file) automatically -- youprovide only employee and labor-hours (which you get from their Time Sheets or equivalent).

I use a simple 50ish-line awkscript that can calculate payroll (including all the withholdings and taxes)for several hundred employees in seconds -- and print out the checks and hard-copy Journals. And the

only time I have to fiddle with the script is when the government's rules change (which is typically oncea year).

Source Documents

The Payroll source documents are the employee Time Sheets (or equivalent) that record when theemployee worked and generally what they did. These records are subject to audit by the LaborDepartment, EEOC and probably others that I haven't encountered. These should be bound into a


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Payroll week-paidSource Document folder.

However, there are other employee documents that need to be retained, e.g., their original employmentapplication, employee reviews (if you do them), Federal and state W-4s (that record their federal/statetax exemption choices), employer's copy of their W-2 (reporting their annual wages and withholdings),

etc.

These can be filed in separate Employee files (by employee name or number) -- or simply integratedinto the Payroll Source Document folders (in the week in which they occur). I very much favor the latter-- especially if you're doing computer accounting -- in keeping with my "always file chronological"bias.

Miscellaneous Accounts

We've talked about Payables, Receivables and Payroll. We still need to talk about Property and

Inventory. But before getting into those, there are a few miscellaneous accounts we should touch on.

Overtime

If you ask your hourly employees to work more than 40 hours in a week, or ask them to work onholidays, the government requires you to pay them overtime -- time-and-a-half or double-time.

You should account the overtime premium into a separate overtime-expense account -- for governmentaudit, but also to watch what that practice (i.e., asking employees to work overtime) is costing you. Inyour Payroll Journal, account theiractualhours worked to the labor-expense account -- but account theovertimepremium (i.e., the extra half- or full-hour you're paying them) to an overtime-expense account,

e.g., accrued-wage/amt- labor-expense/amt+ overtime-expense/amt+.

Employee Vacation

If you accrue vacation for your employees, you need to account it. That's money you owe -- and if itdoesn't show up on your Balance Sheet, you're just digging yourself another hole of unforeseen expense.We need to add an accrued-vacation account and a vacation-expense account.

When you accrue vacation for your employees, e.g., at end of month, you have a General Journaltransaction, accrued-vacation/amt- vacation-expense/amt+. When they take vacation, it's a normalpayroll transaction -- their vacation time is simply charged to the accrued-vacation account number.

If you have many employees, you should consider setting up an Employee Vacation journal, to recordthe individual accruals, and an Employee Vacation subsidiary ledger (sheet per employee) to track theirbalances.

The interesting aspect of employee vacation accounting is that the accounting is typically in hours -- notdollars. Your employees are concerned with how many "hours" of vacation they have coming -- notwith how many "dollars". But your financial records need to be in dollars. If an $8/hour employee has


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40 hours of vacation accrued, your liability to that employee is $320 -- and should show as such on yourBalance Sheet.

But what if between accruals, you raise that employee's pay to $9/hour. Your liability to that employeejust went from $320 to $360. You need another General Journal (or Vacation Journal) transaction,

accrued-vacation/amt- vacation-expense/amt+, to record this added liability. These accruals can beexpensed to vacation-expense, as shown -- however, I prefer to expense them to a separate account,vacation-rate-change-expense, simply to track what they're costing separate from the normal accruals.

If you offer your employees sick time -- in addition to vacation -- recognize you'll have a parallel set ofbooks and transactions recording that time. Just replace "vacation" in everything above with "sick time".

Travel & Entertainment

Keep in mind that an employee can also be a vendor. For example, an employee travels to a trade showor entertains a customer for your company. He turns in an Expense Report and you reimburse him. This

is a Payables transaction (cash/amt- T&E/amt+) -- NOT Payroll.

It is important to account employee travel & entertainment expenses into a separate Travel &Entertainment (T&E) account because the government has its own peculiar ideas about what T&Eexpenses are "valid" -- hey, the employee had to eat anyway -- and this is one of the first areas an IRSauditor will dig into.

Note: If you have T&E expenses, make special effort to stay current with the rules -- and adhere to themstrictly! By the time an audit rolls around -- and you argue and appeal a bit -- you will find that penaltiesand interest can more than double the amounts disallowed.

What if you advance the employee cash for a trip? That's a payables transaction, cash/amt- employee-advance/amt+. When the employee turns in his Expense Report, another payables transaction,cash/amt- employee-advance/amt- T&E/amt+ -- if the advance didn't cover the trip... Or a generaljournal transaction, employee-advance/amt- T&E/amt+ -- if it did but he hasn't yet returned theoverage... Or a cash receipts transaction, cash/amt+ employee-advance/amt- T&E/amt+ -- if he didreturn the overage.

This latter is a good illustration of the importance of good accounting. It's so easy to advance someone,say $500, for a trip you want them to take for you. And they come back with an expense report for, say$450. You know they owe you $50 -- but that's very easy to forget. But if you account the transactionproperly, there sits $50 in an Employee Advance account that stares back at you every time you look at

your Balance Sheet. Now forgetting that $50 isn't likely to put you under -- but it doesn't take that manyto do so.

Petty Cash

When you or your employees frequently make small (reimbursable) cash purchases from localbusinesses, it's convenient to set up a Petty Cash box. You initially load it with cash, say $100.


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Whenever someone needs to be reimbursed for a small cash purchase, they simply turn in the receipt (orfill out a petty-cash slip) and the keeper of the box gives them cash. Eventually the box will containmore receipts and slips than cash -- whereupon we reimburse (replenish) the box by writing a Payablescheck to vendor "Petty Cash".

The transaction to initially set up the box is cash/100- petty-cash/100+. Since petty-cash is an assetaccount, this has no effect on your expenses. When you go to replenish the box, you'll find that thereceipts and slips will need to be accounted to many different expense accounts. The transaction ispayable/amt- expense/amt+ .... Note that the petty-cash account balance doesn't change -- it continues toshow on your Balance Sheet as a asset of $100. However, this transaction -- in terms of number ofexpense/amt+ entries -- can be one of the longest you'll encounter. Make sure you have, get or writesoftware that can handle long transactions.

Commissions Payable

Let's say you do your selling through sales reps and they get, say a 5% commission on sales. You need

some way of accruing these commissions so you can pay them out as agreed, e.g., monthly. You'regoing to need a commissions-payable account and a commissions-expense account.

First question -- is the commission accrued on order or on invoice? If on order, you're going to have tobuild into your Customer Order Processing system a step that enters a Payable -- commissions-payable/amt- commissions-expense/amt+. If on invoice, however, you can simply add that transactiononto the end of your normal sales transaction -- see earlierReceivables Accountingcolumn. Reps preferthe former. I very much prefer the latter -- less transactions and easier to audit.

If you have many reps, you may wish to set up a separate Commissions Payable subsidiary ledger (sheetper rep) so you can more easily track how each is doing and how much each is owed.

At end of month, another Payable transaction(s), cash/amt- commissions-payable/amt+, to pay eachwhat you owe.

Bank Loan

The bank loans you some money. You now have cash -- but you also have a debt. Transaction iscash/amt+ bank-loan/amt-. The added cash shows as an asset on your Balance Sheet -- but the bankloan shows as an offsetting liability.

The bank will expect you to make regular interest payments on that loan. If the payments are interest

only, the payable transaction is cash/amt- interest-expense/amt+. If it's a self-amortizing loan (i.e., yourpayments include principal), the payable transaction is cash/amt- bank-loan/amt+ interest-expense/amt+.

Property Accounting

When you invest in property (building, machinery, furniture, vehicle, etc.), the government doesn't let


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you "expense" it. Rather you have to put it into an asset account, cash/amt- property/amt+, anddepreciate it over it's "economic life" (which the government -- not you -- defines, and which theylengthen whenever they need a little more tax revenue -- which is often).

Depreciation is a curse on small business -- one that every small business suffers with. Government acts

like your partner -- after all, they are taking 50% of your profits (in taxes -- city, state, federal). And forall the things they let you expense, they're picking up half the costs. But for things you have todepreciate, they shift the cost burden onto you. In the year you buy, say a building (30-year economiclife), you pick up the full cost of that building -- and they pick up 1/30!

And they'll argue that's "fair". They don't see themselves as your "partner". (Too bad, because if theydid, we'd have a much more booming small business economy.) Instead, they look at your businesssimply as an economic entity. If they let you expense that building, it wouldn't show up on your BalanceSheet. The "book" value of your entity would drop by the price of the building, whereas the "real" valueof the entity didn't drop at all -- all you did was shift the money from your cash account into a buildingaccount -- both asset accounts.

The answer, of course, is for the government to let you keep your books according to "acceptedaccounting standards" -- but tax your property purchases on a cash basis. But, of course, that's toocomplicated -- but the myriad, ever-changing depreciation schedules aren't?!

Anyway... One thing we've been able to count on (at least so far) is that they don't change depreciationschedules in mid-stream. Your depreciation schedule (i.e., the portion of your property purchases thatyou can expense each year) is established (and fixed) in the year of purchase. We know for our building,for example, that we can expense 1/30 of its purchase price each year for the next 30 years.

So we set up accounts for categories of properties that will be depreciated alike (at least this year) --

buildings, building equipment, machinery & equipment, furniture & fixtures, vehicles, etc. At end ofyear, we compute a depreciation schedule for each category and expense what we're allowed, building-depreciation/amt- depreciation-expense/amt+, building-equipment-depreciation/amt- depreciation-expense/amt+, etc. And we hold onto those schedules -- in a Depreciation folder -- so we know what toexpense in subsequent years.

A problem comes about when we sell one of those properties. Let's say 5 years downstream, we sell thatbuilding. And let's say we sold it at the price we paid for it. But we've been depreciating it for 5 years --its present value on our books is only 25/30 of its purchase price. So we have a gain-on-sale of 5/30 ofit's purchase price. That's revenue, cash/amt+ building/amt- building-depreciation/amt+ other-revenue/amt-.

And we can't take any more depreciation on it so we have to back it out of our depreciation schedule.Now that's do-able if we set up our categorized depreciation schedules well. But there's still lots of roomfor error and confusion -- especially as you accumulate more property. Remember, "property" includesdesks, chairs, benches, file cabinets, computer equipment, etc.

I recommend just biting the bullet and setting up a separate depreciation schedule for each individualproperty. And also annotating the schedule sheet with a (sequential) property number -- and marking the


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actual property with that number. Store these sheets in folders, one folder per category. Then when youdispose of a piece of property, you only have to annotate that one schedule (and move the sheet to an"inactive" section of the folder). To compute depreciation for the year, you just go through the "active"section of the folder and total up all the amounts listed for the current year.

One possible format for these schedules is, , followed by the schedule, , , etc. is just ashorthand description of the method used to compute the depreciation-expense numbers that follow,e.g., 30-year straight line (30sl), 5-year declining balance (5db), 7-year declining balance (7db), etc.

When you sell or dispose of a property, annotate the depreciation-expense line in the year of sale withthe selling price (zero if scrapped) and cross-out all following depreciation-expense lines. This givesyou all the data you need to compile a source document for your depreciation transactions -- propertyschedule with prior and current year's depreciation, property added during the year, property disposed ofduring the year and gain-on-sale of disposed properties.

If you keep these schedules in a computer file, scripts or programs can calculate the depreciation-expense numbers (filling in that portion of the file), compile and print out your depreciation sourcedocument, compile a property schedule by physical location (e.g., for personal property tax backup),etc.

One final note -- do you really have to depreciate allproperty? Even an old desk you bought for, say$25? No. The government lets you just expense property whose cost isn't "significant" -- of course theydon't define "significant" -- hey, they gotta have some things to catch on audit. I used to use $300 --property costing less than $300, I'd expense -- more than $300, I'd depreciate -- and never had IRS auditproblems with it. (Of course, I may have just been lucky.) Ask your tax preparer what number they'd

feel comfortable defending.

Inventory Accounting

As we said back in ourPayables Accountingcolumn -- "Inventory (products bought for resale, materialsbought to manufacture products to be sold, etc., can't be expensed until sold --- and in the meantime areaccounted in an inventory asset-account, e.g.,payable/amt- inventory/amt+". So we got materials intothe inventory account through payables. How do we get them out? That's the job of inventoryaccounting.

If you're doing just custom jobs, where you're buying materials strictly for that job -- like a residentialcustom builder -- you could use a "percent completion" method. You buy the materials to a job-numberand account your labor to the job-number -- accumulating them in an inventory account -- and thenperiodically expense them according to the percent the job is complete, inventory/amt- cost-of-sales/amt+. When the job is 100% complete, all of your costs for that job have been expensed, and nomore sits in inventory.

However, if you're manufacturing a product line, with subassemblies common to multiple products,


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things aren't quite as simple. If you walk through the plant, you'll find stocks of purchased parts andmaterials, stocks of subassemblies, and batches of end products being assembled and tested forscheduled shipping.

Each of these is different. Purchased materials have no labor content -- but subassemblies do have labor

content. And the end products have both labor and subassembly content.

How do you know what dollars you have invested in all these stocks and batches? And how do youknow how many dollars to expense to cost-of-sales when you ship a product?

Inventory Processing

I'll lead you through a system I used back in the '70s. It's not the only system -- nor necessarily the best.It's just one that worked well for me.

First, you'll need inventory accounts to reflect the inventories you have -- a purchased-materials

account to account your purchased parts and materials... asubassembly-inventory account to accountyour subassemblies... and aproduct-inventory account to account your end products.

Parts and materials get into your purchased-materials account through payables,payable/amt-purchased-materials/amt+. The purchased-materials account balance contains the cost of all thosestocks of parts and materials on the plant floor.

Now you purchased those materials to build things -- subassemblies and products. Let's say we want tobuild 50 of some subassembly. So we compose a Job Order to tell the assembly people what we want tobuild. And we give this Job Order a number, say S001 -- "S" for subassembly. The assembly people pullthe materials, build the subassemblies and return the Job Order showing they've completed the

subassemblies.

We now have that many fewer parts in stock -- and that many more subassemblies. So we take the costsof those parts out of our purchased-materials account and add them into our subassembly-inventoryaccount,purchased-materials/amt- subassembly-inventory/amt+. The subassembly-inventory accountbalance now shows the material cost of those 50 subassemblies.

But those subassemblies should also contain the cost of the labor expended in building them. So wehave the assemblers charge their time to the S-job number they're building. In our Payroll processing,we recognize that any S-job labor-expense should be accounted to our subassembly-inventory account,accrued-wages/amt- subassembly-inventory/amt+. Our subassembly-inventory account balance now

includes the labor cost of those subassemblies.

Now let's say we want to build 25 of a product, and that product contains 2 of the subassemblies we justbuilt plus some purchased materials. So we compose a Job Order to tell the product assembly peoplewhat we want to build. And we give this Job Order a number, say P001 -- "P" for product. Theassembly people pull the parts and subassemblies, build the products and return the Job Order showingthey've completed the products.


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We now have that many fewer parts and subassemblies in stock -- and that many more products. So wetake the costs of those parts out of our purchased-materials account, and the costs of thosesubassemblies out of our subassembly-inventory account, and add them into our product-inventoryaccount,purchased-materials/amt- subassembly-inventory/amt- product-inventory/amt+. The product-inventory account balance now shows the materials cost of those 25 products.

But those products should also contain the cost of the labor expended in building them. So we have theassemblers charge their time to the P-job number they're building. And in our Payroll processing, werecognize that any P-job labor-expense should be accounted to the product-inventory account, accrued-wages/amt- product-inventory/amt+. Our product-inventory account balance now includes the laborcost of those products.

We now know what each of those products cost us to build -- 1/25 of the product-inventory accountbalance. When we ship one, we can account its cost-of-sales in our Sales Journal transaction,receivable/amt+ revenue/amt- product-inventory/amt- cost-of-sales/amt+.

Now let's take a look at what these Job Orders look like. They obviously have to contain a list ofmaterials so the assemblers know what parts and materials to pull. And somewhere there have to besome instructions on what to do with those parts and materials. So why not combine them, e.g., like arecipe -- "pull these parts, do this with them, then pull these parts, do this with them, etc, etc."

This "recipe", for building one (subassembly or product), can be your engineering documentation -- itcarries a subassembly or product (part) number that you assign when you design it. If the assemblersneed a drawing to refer to, the recipe can simply say, "refer to drawing so-and-so". (I prefer to use amodel -- built by an assembler under engineering auspices.)

Now the Job Order becomes simply a copy of that "recipe" with the quantity changed to the number you

want to build.

Inventory Ledgers

In practice, you'll have many parts and materials flowing through this process -- into subassemblies andproducts into shipping -- in various stages of completion. How do you keep track of all this stuff? You'llneed a subsidiary ledger for each of your inventory accounts -- a Purchased-Materials ledger (one sheetper part number), a Subassembly ledger (one sheet per subassembly part number), and a Product ledger(one sheet per product part number).

When you purchase parts, you not only post the cost to the Payables ledger -- but you also post the

quantity and cost to the Purchased-Materials ledger.

When you get an S-job back from the floor, you post the quantity and cost of the parts used to thePurchased-Materials ledger (referencing the S-job number). The totaled cost of the parts posted is thematerial cost of the subassemblies -- which you then post to the Subassembly ledger. When payroll isrun, you post the S-job labor not only to the Payroll ledger -- but also to the Subassembly ledger (to thesheets corresponding to the subassembly part numbers built).


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When you get an P-job back from the floor, you post the quantity and cost of the parts used to thePurchased-Materials ledger (referencing the P-job number), and you post the quantity and cost of thesubassemblies used to the Subassembly ledger (referencing the P-job number). The totaled cost of theparts and subassemblies posted is the cost of the products -- which you then post to the Product ledger.When payroll is run, you post the P-job labor not only to the Payroll ledger -- but also to the Product

ledger (to the sheets corresponding to the product part numbers built).

And when you get shipping papers back from the floor telling you products have shipped, you post thequantity and cost of the products shipped to the Product ledger (referencing the Sales (or Shipping)Order) -- which cost is the cost-of-sales amount posted to the Sales Journal when you prepare andaccount the Customer Invoice.

As parts are purchased and used, subassemblies built and used, products built and shipped, the sheets inyour ledgers tell you the current quantity and cost balance of each of your parts, subassemblies andproducts. The individual cost balances in your Purchased-Materials ledger should total to the balance inyour purchased-materials account. Similarly, the individual cost balances in your Subassembly ledger

should total to the balance in your subassembly-inventory account, and the individual cost balances inyour Product ledger should total to the balance in your product-inventory account,

Now this is a lot of work manually. But it's not a big deal on computer. If your "recipes" are oncomputer, you just print them out for a new Job Order -- and if your payables and payroll are already oncomputer -- all the data's there for your computer to construct and maintain these ledgers.

Standard Cost

One alternative to the above system should be mentioned -- a standard cost system. Rather than tracking"actual" costs through the manufacturing process, we track "estimated" (or standard) costs and

periodically correct our inventory accounts to reality, e.g., through inventory counts.

This avoids the inventory ledgers and multiple accounts. Rather we estimate the material and labor costof each subassembly and product and assign it that (standard) cost. When we ship a product, we moveits standard materials cost from our purchased-materials account -- and its standard labor cost from ourmanufacturing-labor-expense account -- into our cost-of-sales account, receivable/amt+ revenue/amt-purchased-materials/amt- manufacturing-labor/amt- cost-of-sales/amt+

This system buys you simplicity -- at the cost (loss) of considerable visibility and control. Of course, ifyou're not going to use that visibility to better control your manufacturing process anyway, then youmight as well go the route of simplicity.

Retail Recordkeeping

The preceding columns have provided an overview of recordkeeping for thesmall manufacturer. Muchapplies to allbusinesses -- and some doesn't.


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We'll wrap up this series with a look at financial recordkeeping forsmall retail. Our purpose is simplyto illustrate how a financial recordkeeping system can be designed or adapted to fulfill the needs of yourparticular business situation. Remember that the purpose of financial recordkeeping is to give bettervisibility into where the monies in your business are going -- so that you can better control how muchends up in your pocket.

Much of the recordkeeping for small retail is the same as that already described for smallmanufacturing. Payables and Payroll are handled the same, as are Overtime, Employee Vacations,Travel & Entertainment, Bank Loans, Petty Cash, Property Depreciation, etc. The major differences arein Receivables and Inventory processing.

In manufacturing, your Receivables processing is concerned with issuing invoices to customers andtracking their payments on those invoices. In retail, you don't have "receivables" per se -- but cashreceipts from your points of sale.

And in manufacturing, your Inventory processing is concerned with tracking your purchased materials

through increasingly higher levels of integration until they end up in the manufactured products yousell. In retail, your Inventory processing is concerned with making sure you have the correct (andsufficient) products on the display floor at the right time.

I'm going to describe these systems in the context of a computer doing the processing -- primarilybecause I doubt they'd be practical otherwise, given normal retail profit margins.

Inventory Processing

The first difference we encounter in retail is in parts identification. In manufacturing, if an engineerdesigns in a 15-ohm carbon-comp resistor -- which we can and probably will buy from many sources --

we need to assign it an internal part number to use in tracking it.

That part number describes a "specification" -- not necessarily a specific physical part from a givensource. In retail, however, we're not (generally) buying "specs" -- we're buying a physical product toresell. If we buy antiques... or one-of-a-kinds from a craftsperson... or Fall '98 womenswear..., we'llnever be able to buy those products again anyway. Trying to assign them manufacturing-like "partnumbers" would create unnecessary work and confusion.

But we still need some way of identifying the products so that when they sell, we can figure out whatwe made on them. So we need a different kind of "part number" -- something related to a particularpurchase, not to a particular specification. I'll call this an "item-number" to distinguish it from a

manufacturing "part number".

The format I chose for item-numbers was . And I further choseto format my purchase order numbers . For example, PO-number726a, identifies the first PO issued in week 726 (i.e., the 26th week of 1997 -- see earlierGeneralJournal column). PO-number 726z identifies the last PO issued in week 726. Item-number 726aaidentifies the product(s) bought on line-item "a" of PO 726a. Item-number 726az identifies the
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product(s) (if any) bought on line-item "z" of PO 726a.

Now this particular format limits us to 26 POs per week and 26 line-items per PO. But even with adozen stores, that never proved a problem. If we needed to order more than 26 line items from a vendor,we'd simply continue with the next PO number. And if we needed to issue more than 26 POs in a week

(e.g., Christmas buying), we'd simply continue with the next week. (Obviously, other part-numberformats could be used, e.g., 726-nn-nn, allowing 100 POs a week and 100 line-items per PO if the letterusage proved restricting.)

OK, so we have a shorthand way of identifying the items we're buying to resell. But we have to trackthem through to the sale. So when the items we order come in, we sticker them with our item-numberand our retail price. (That's another reason to keep our item-numbers short -- to fit on a small sticker.)

Let's assume for the moment that the sales clerk writes up sales slips manually. When a customer bringsseveral items to the counter to purchase, the clerk pulls the stickers and writes up the sale as a list --quantity, description, price -- (where description includes the item-number), adds up the prices,

calculates and adds the sales tax, and the customer pays.

One copy of the sales slip goes to the customer as their receipt -- the other goes in the cash drawer as thestore copy. (The stickers removed from the items are re-attached to the sales slip for error correction incase the clerk mis-writes an item-number.)

Inventory Ledger

So... now we have POs that identify items we've bought -- and sales slips that identify items we've sold.How can we organize this data into a usable ledger? One way is to put the data into a (computer) textfile. Essential data for the purchase lines are

. Essential data for the sales lines are .

From this data, a person looking at the file can easily determine how many of a given item remain instock, what the cost of those items is, how much we've made (gross profit) on those we've sold, etc.More importantly, with relatively simple scripts or programs, so can the computer -- and faster andmore accurately.

This file needs to be purged periodically to remove the records of items we've sold out of -- otherwise itwould grow without bounds. But we'd kinda like to keep this data for historical record. We'd like thecomputer to be able to compare, e.g., our sales this Monday with sales the equivalent Monday a year

ago, with two years ago, etc.

So we put the file in a directory called, sayInventory, name the file, say Open, and have the computergo through, say once a quarter, and move the data for all closed-out items into a history file named, e.g.,199713, or 199726, etc. We now have only open inventory in our Open file -- and our historical data ispreserved in files related to the quarter they were closed out in.

But how do we compare, e.g., this Monday's sales with other Mondays? One way is to encode day-of-


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week into the sales-slip numbers. The format of my sales-slip numbers was . For example, sales-slip number A215 lists the items sold in the 15th saleof the 2nd day of the week from store "A".

If we want to compare sales on week 726 day 2, with week 626 day 2, with 526 day 2, etc. --- the

computer has the data needed to give it to us. Or for any periods we choose -- total sales ...or bystore ...or by vendor. (We could have added time-of-day to the field to allow even time-of-daycomparisons -- but that didn't appear useful at the scale I was operating.)

What do such comparisons buy us? They allow us to "measure" how (and where) we're improving -- insales and gross margin. Once again --you can't manage what you can't measure!

Since we have the open-inventory file, there's no sense typing up a PO and then entering the purchasedata into the file. Rather we just enter it into the file to begin with -- and then have the computer printout the PO. The payables key (another computer file) contains the vendor name, address to order from,any special terms, etc., under the vendor-number (which is one of the fields in the purchase line). The

computer just looks in the key to pull that information. (We'll show later a method