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tracks all company profits that have been reinvested in the company rather than paid out to the company’s owners. Small, unincorporated businesses track money paid out to owners in a Drawing account, whereas incorporated businesses dole out money to owners by paying dividends (a portion of the company’s profits paid by share of common stock for the quarter or year).
Here are a few terms related to the income statement that you’ll want to know:
✔ Income statement: The financial statement that presents a summary of the company’s financial activity over a certain period of time, such as a month, quarter, or year. The statement starts with Revenue earned, subtracts out the Costs of Goods Sold and the Expenses, and ends with the bottom line – Net Profit or Loss.
✔ Revenue: All money collected in the process of selling the company’s goods and services. Some companies also collect revenue through other means, such as selling assets the business no longer needs or earning interest by offering short-term loans to employees or other businesses.
✔ Costs of goods sold: All money spent to purchase or make the products or services a company plans to sell to its customers.
✔ Expenses: All money spent to operate the company that’s not directly related to the sale of individual goods or services.
Some other common terms include the following:
✔ Accounting period: The time for which financial information is being tracked. Most businesses track their financial results on a monthly basis, so each accounting period equals one month. Some businesses choose to do financial reports on a quarterly basis, so the accounting periods are three months. Other businesses only look at their results on a yearly basis, so their accounting periods are 12 months. Businesses that track their financial activities monthly usually also create quarterly and annual reports (a year-end summary of the company’s activities and financial results) based on the information they gather.
✔ Accounts Receivable: The account used to track all customer sales that are made by store credit. Store credit refers not to credit-card sales but rather to sales for which the customer is given credit directly by the store and the store needs to collect payment from the customer at a later date.
✔ Accounts Payable: The account used to track all outstanding bills from vendors, contractors, consultants, and any other companies or individuals from whom the company buys goods or services
✔ Depreciation: An accounting method used to track the aging and use of assets. For example, if you own a car, you know that each year you use the car its value is reduced (unless you own one of those classic cars that goes up in value). Every major asset a business owns ages and eventually needs replacement, including buildings, factories, equipment, and other key assets.
✔ General Ledger: Where all the company’s accounts are summarized. The General Ledger is the granddaddy of the bookkeeping system.
✔ Interest: The money a company needs to pay if it borrows money from a bank or other company. For example, when you buy a car using a car loan, you must pay not only the amount you borrowed but also additional money, or interest, based on a percentage of the amount you borrowed.
✔ Inventory: The account that tracks all products that will be sold to customers.
✔ Journals: Where bookkeepers keep records (in chronological order) of daily company transactions. Each of the most active accounts, including cash, Accounts Payable, Accounts Receivable, has its own journal.
✔ Payroll: The way a company pays its employees. Managing payroll is a key function of the bookkeeper and involves reporting many aspects of payroll to the government, including taxes to be paid on behalf of the employee, unemployment taxes, and workers’ compensation.
✔ Trial balance: How you test to be sure the books are in balance before pulling together information for the financial reports and closing the books for the accounting period.
Pedaling through the Accounting Cycle
As a bookkeeper, you complete your work by completing the tasks of the accounting cycle. It’s called a cycle because the workflow is circular: entering transactions, controlling the transactions through the accounting cycle, closing the books at the end of the accounting period, and then starting the entire cycle again for the next accounting period.
The accounting cycle has eight basic steps, which you can see in Figure 1-1.
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Figure 1-1: The accounting cycle.
1. Transactions: Financial transactions start the process. Transactions can include the sale or return of a product, the purchase of supplies for business activities, or any other financial activity that involves the exchange of the company’s assets, the establishment or payoff of a debt, or the deposit from or payout of money to the company’s owners. All sales and expenses are transactions that must be recorded. The basics of documenting business activities involve recording sales, purchases, and assets, taking on new debt, or paying off debt.
2. Journal entries: The transaction is listed in the appropriate journal, maintaining the journal’s chronological order of transactions. (The journal is also known as the “book of original entry” and is the first place a transaction is listed.)
3. Posting: The transactions are posted to the account that it impacts. These accounts are part of the General Ledger, where you can find a summary of all the business’s accounts.
4. Trial balance: At the end of the accounting period (which may be a month, quarter, or year depending on your business’s practices), you calculate a trial balance.
5. Worksheet: Unfortunately, many times your first calculation of the trial balance shows that the books aren’t in balance. If that’s the case, you look for errors and make corrections called adjustments, which are tracked on a worksheet. Adjustments are also made to account for the depreciation of assets and to adjust for one-time payments (such as insurance) that should be allocated on a monthly basis to more accurately match monthly expenses with monthly revenues. After you make and record adjustments, you take another trial balance to be sure the accounts are in balance.
6. Adjusting journal entries: Post any necessary corrections after the adjustments are made to the accounts. You don’t need to make adjusting entries until the trial balance process is completed and all needed corrections and adjustments have been identified.
7. Financial statements: You prepare the balance sheet and income statement using the corrected account balances.
8. Closing: You close the books for the revenue and expense accounts and begin the entire cycle again with zero balances in those accounts.
Tackling the Big Decision: Cash-basis or Accrual Accounting
Before starting to record transactions, you must decide whether to use cash-basis or accrual accounting. The crucial difference between these two processes is in how you record