Chapter 12 for more info about depreciation.)
Chapter 3
Running the Numbers for Success
IN THIS CHAPTER
Students approach me every session I teach financial accounting to pick my brains about accounting for a small business. I’ve come to find out that a lot of people have a small gig running on the side to make extra money. Sometimes it’s because they want to completely transition from working for “the man” to self-employment. Other reasons include increasing savings, paying off student debt or planning for a big purchase like a house.
To address this occurrence, in this chapter, you learn the difference between the two most common types of business entities selected by small business owners: sole proprietorships and S corporations. Hint: It’s because both are easy to set up and operate! I also discuss the difference in recording revenue and expenses between the two. To round it all out, I offer a brief introduction to the tax applications of both, which is expanded on in Chapter 18.
There’s more! This chapter provides an overview of how to prepare and analyze financial statement data. You discover the difference between costs and expenses and why the distinction is important. The chapter also provides a walk-through on managing cash and preparing a bank reconciliation, a topic you’ll definitely be tested on in your financial accounting course!
Even if you aren’t interesting in accounting for your own business, this chapter is loaded with information relevant to financial accounting homework and test questions. And since every financial accounting course includes at least one chapter about cost accounting, I also go through the necessary lingo to ace that part of your financial accounting class!
Identifying Accounting Issues and Solutions
Your financial accounting course goes into great detail about classification, interpretation and decision-making. Classification deals with how to properly enter an accounting transaction. Interpretation addresses the assumptions that can be made by viewing that accounting transaction. Decision-making flows from the classification and interpretation.
This chapter discusses how this information is relevant to the internal user of the financial statements, particularly management and owners. It supports the decision to change vendors, add product lines, increase advertising and a myriad number of other forward and backwards actions. The object is usually to increase or maintain steady profits.
Selecting a Business Entity
In this chapter, I discuss the sole proprietorship and S Corporation, which are the two most popular small business entities. As an owner of the business, how you choose to operate your business directly affects how you classify transactions.
But what about partnerships and regular corporations, as both entities are discussed in your financial accounting course? Chapter 9 gives you the scoop on both.
Advantages of the sole proprietorship
A favorite with many of my small business clients, the sole proprietorship is the easiest type of business entity to start and maintain. It also requires the least amount of initial cash outlay. Permitting and licensing issues aside, you are the proud owner of the sole proprietorship the second you make a business purchase or sale.
Sole proprietorships aren’t required to keep a balance sheet for tax purposes (see Chapter 2), so keeping your accounting books is a snap. This is a plus if you plan to use a spreadsheet program such as Excel to keep track of your sales and costs. Don’t laugh; I still have clients who give me a flash drive with spreadsheet data at year-end for tax return preparation.
Plus, you don’t incur the additional expense to file a separate tax return to report all that income you’re going to be bringing in! Sole proprietorships report their income or loss on the owner’s Form 1040.
And tah-dah! If you don’t have any employees, you don’t need to bother with those pesky employment tax forms. The owner of a sole proprietorship does not get paid like an employee; she receives a draw, which is part of owners’ capital.
Owners’ capital
Most sole proprietors initially fund their business from personal sources, which can be either cash or noncash. An example of the first is depositing cash that you’ve saved up into the business bank account. I do a step-by-step on process in Chapter 5.
After that initial cash infusion, many sole proprietorships have an on-and-off need over the years for an additional owner influx of cash. It’s a simple fact of doing business that sometimes you have to pay for business expenses before you collect the money from your customers.
When you started your sole proprietorship, you may already have personally owned inventory (see Chapter 13) or computer equipment that you convert to business use. If you decide to make these assets the property of the business, you increase your owner's capital by the amount of the fair market value of the assets, which is what an unrelated third party would pay in an open marketplace.
For example,
