Glossary of Commonly Used Accounting Terms

Whether completing undergraduate work or preparing for the CPA exam, accounting students have told us that a glossary of terms is never far from their side. But a simple definition rarely seems to be enough for a real understanding of complex concepts and processes.

Here we provide a list of the most frequently searched accounting terms, along with the supporting examples and contextual definitions necessary to not only understand the concepts, but to apply the processes behind them.


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Accounting Concepts

Financial accounting concepts are the basic principles used in the preparation of financial statements.

Financial Statements

The concept of the accounting period is an important one for financial statements. An accounting period is the interval of time during which accounting activities are measured. Common accounting periods include monthly, quarterly, and annually.
The four most important financial statements in accounting are:

  • Income statement: Summarizes financial results for an accounting period. Revenues – Expenses = Income.
  • Balance sheet: Lists the assets and liabilities at the end of an accounting period. Assets = Liabilities + Equity.
  • Cash flow statement: Shows the actual flow of cash into and out of an organization during the accounting period.
  • Statement of retained earnings: Shows the dividends paid from earnings to shareholders and the earnings kept (retained) by the company.

Financial Accounting Concepts

Accounting concepts for preparing financial statements include:

  • Conservatism (also called prudence): If a financial result can be reported in two ways, the least beneficial way is used.
  • Consistency: An organization should use the same accounting method over time, and not change accounting methods between accounting periods.
  • Cost principle: Accounts and financial statements show the actual cost of an asset, rather than the current value.
  • Dual aspect: Every transaction involves at least two accounts.
  • Going concern: The assumption is that an organization will continue into at least the near future.
  • Matching: When a transaction affects both revenues and expenses, the effect on financial statements should occur in the same accounting period.
  • Materiality: While an organization needs to disclose all relevant information on financial statements, insignificant events need not be disclosed.
  • Money (or monetary) measurement: Only transactions that can be quantified in actual amounts of money are included on the financial statements.
  • Realization: An organization recognizes revenue when shipping goods or rendering services, not when payment is received.
  • Separate Entity: A clearly defined business unit is used for financial reporting purposes.

Other important concepts concerning accounting information include the need for the information to be understandable, timely, relevant, reliable, and complete so as to serve as an objective representation of an organization’s financial status.

Sometimes, these concepts may come into conflict; in which case, it’s the accountant’s job to decide which concept to follow, based on the needs of the users of the financial information, whether this be financial regulators or internal managers.

As of November 2012, the Financial Standards Accounting Board (FASB) publishes five Concepts Statements that set objectives, qualitative characteristics, and other concepts accountants can use as a guide when preparing financial statements.

Accounting Cycle

During each accounting period, businesses must perform a number of steps to account for business activities. These steps are called the accounting cycle. Although different sources identify the steps in the cycle slightly differently, the following ten-step accounting cycle covers the entire process comprehensively.

The first three steps take place throughout the accounting period, while the last seven steps happen only at the end of each accounting period.

Step One: Identify and Analyze Transactions
Identifying and analyzing transactions involves looking at the source documents, such as bank statements, checks, and purchase orders, that describe the transactions and their purpose, including the transaction amount. It is then decided which accounts are affected by the transaction, and how exactly those accounts were affected.

Step Two: Journalize
Journalizing refers to using double-entry accounting to record the appropriate debits and credits for a transaction into a journal.

Step Three: Post
Posting is the transfer of the debits and credits from the journal to the ledger. While a journal is simply a list of transactions, a ledger is a collection of all of the company’s accounts (Cash, Accounts Receivable, Accumulated Depreciation, Accounts Payable, etc.).

Step Four: Make an Unadjusted Trial Balance
A list of all accounts and their balances at a point in time is called a trial balance. The purpose of a trial balance is to make sure that the debits equal the credits.

Step Five: Make Adjusting Entries
Accrued and deferred items require the use of adjusting entries, which assign income and expenses to a different accounting period. Adjusting entries are recorded in the general journal and then posted to the ledger.

Step Six: Make an Adjusted Trial Balance
Another trial balance is prepared to verify that debits still equal credits. This information is also used to prepare the financial statements.

Step Seven: Prepare Financial Statements
The financial statements must be prepared in a specific order:

  • Income statement
  • Retained earnings statement
  • Balance sheet
  • Cash flow statement

This order must be followed simply because the retained earnings statement uses information from the income statement and the balance sheet uses information from the retained earnings statement.

Step Eight: Close
Closing entries move the balances of temporary accounts to owner’s equity and get the accounts ready for recording transactions in the next period.

Step Nine: Make a Post-Closing Trial Balance
A post-closing trial balance contains only the balance of debits and credits for permanent accounts. Again, the purpose is to make sure that debits equal credits and that all temporary accounts have a zero balance.

Step Ten: Make Reversing Entries
This step is optional. A reversing entry reverses previous adjusting entries. Companies may use reversing entries to make it easier to record later transactions by getting rid of the need for compound entries.

Accounting Ratios

Accounting ratios, also called financial ratios, are used in analyzing financial statements. A ratio shows the relationship between two amounts. However, a ratio by itself may have no meaning until it is compared to ratios from previous years (called time series analysis) or ratios of other firms in the same industry (called cross-sectional analysis).

Advantages and Limitations of Using Accounting Ratios

The use of accounting ratios is useful because it provides a quick summary of financial statements. This helps with trend analysis of a company, and also provides a way to compare companies of different sizes.
The limitations of ratio analysis include the inability for comparisons to be made across industries due to the fact that acceptable ratios vary by industry. Even within an industry, comparisons may not be accurate because different companies may make different assumptions in preparing financial statements. Plus, ratio analysis focuses on the past, rather than the present or future.

Types of Accounting Ratios

A number of possible ratios can be used to analyze financial statements, including the following most commonly used accounting ratios:

Liquidity ratios show how liquid the organization is. An organization is liquid if it can pay its bills on time. Four liquidity ratios are:

  • Current Ratio is one of the most commonly used ratios. It is equal to Current Assets divided by Current Liabilities.
  • Quick Ratio = Quick Assets / Current Liabilities
  • Quick Assets = Cash + Short Term Securities + Accounts Receivable
  • Net Working Capital Ratio = (Current Assets – Current Liabilities) / Total Assets

Profitability ratios show an organization’s returns on investments. Profitability ratios include:

  • Profit Margin = Net Income / Revenue
  • Return on Assets = Net Income / Average Total Assets
  • Average Total Assets equals ending plus beginning Total Assets divided by two
  • Return on Equity = Net Income / Average Stockholders’ Equity
  • Average Stockholders’ Equity equals beginning plus ending stockholders’ equity divided by two. Return on Common Equity is a similar ratio but uses average common stockholders’ equity.

Capital structure ratios show how an organization has financed the purchase of assets and include:

  • Debt to Equity Ratio = Total Liabilities / Total Stockholders’ Equity
  • Interest Coverage Ratio = Income Before Income Taxes and Interest Expense)
  • Debt to Asset Ratio = Total Liabilities / Total Assets

Market value ratios show the value created for shareholders and include:

  • Price Earnings (P/E) ratio = Price per share of common stock / Earnings per share
  • Dividend yield = Per share dividend / Per share price
  • Dividend payout ratio = Common Stock Cash Dividends / Net Income
  • Market to Book Ratio = Common share market value / Common share book value

Activity analysis ratios show how efficient the organization has been in using its assets to generate sales and include:

  • Inventory Turnover Ratio = Cost of Goods Sold / Average Inventories
  • Accounts Receivable Turnover Ratio = Sales / Average Accounts Receivable
  • Assets Turnover Ratio = Sales / Average Total Assets

Accounting Records

Accounting records are all of the documentation concerning the financial life of a business or individual. Records include the accounting system used to record and track financial transactions, prepared financial statements, and supporting documents, such as checks and invoices.

Records can be kept on paper, using a spreadsheet program, or using specialized accounting software. Record keeping for an individual or small-to-medium sized business may be relatively simple and straightforward, while a large corporation, as would be expected, has complex and involved records.

Basic Record Keeping in Accounting

A basic record keeping system for a business generally consists of:

  • A basic journal for recording transactions, such as revenues and expenses
  • Accounts receivable and accounts payable records
  • Inventory records
  • Payroll records
  • Petty cash records
  • Records also include tracking of assets and liabilities.

Records and the Accounting Process

Although an individual or small-to-medium sized business might operate on a cash basis, simply recording cash transactions, most businesses use double entry accounting. Transactions are first recorded in a general journal by date of transaction. Every transaction affects at least two accounts, one with a credit and the other with a debit.

Debits and credits to each account in the general journal are then posted (transferred) to the chart of accounts in the general ledger. A general journal is just a list of transactions by date, while the general ledger is a collection of all of the company’s accounts.

Journalizing and posting are done throughout the accounting period. At the end of the accounting period, these records are then used to prepare financial reports and statements.

The Importance of Good Accounting Records

Well-organized and thorough records provide quick and easy access to important information, such as cash flow, expenses, money owed, accounts receivable, inventory turnover, and profit.

The survival of a business can depend on accurate and timely accounting records. For a publicly traded company, good records are needed to produce the financial statements required by law. For every business, good records provide essential information needed by management or owners to increase profits and grow the business.

Then there are taxes; lack of good tax records can bring down the wrath of the Internal Revenue Service. This is the prime reason most individuals and small organizations make every effort to maintain sound accounting records.

Accounting Technology

Accounting has evolved from a pencil and paper ledger profession to one that uses the full extent of computer technology. In fact, there are in excess of 3,300 accounting software options available.
Most of these fall within the following general classification types:

  • Work Order Management
  • Warehouse Management
  • Time and Billing
  • Tax Preparation
  • Purchase Order
  • Project Management
  • Point Of Sale
  • Payroll
  • Order Entry
  • Material Resource Planning
  • Job Cost
  • Inventory Control
  • General Ledger
  • Fund Accounting
  • Foreign Currency Conversion
  • Fixed Asset Management
  • Customer Relationship Management
  • Cash Management
  • Budgeting, Planning & Forecasting
  • Bill of Materials
  • Auditing
  • Accounts Receivable
  • Accounts Payable

Accounting in the Cloud

While traditional accounting software is computer based, cloud accounting operates exclusively within the cloud.

Two benefits of using cloud-based accounting applications:

  • Multiple people can access and work with the information at any given time
  • Data is safe from onsite physical hazards such as fire or computer theft

Business Management Systems

A business management system, or enterprise resource planning (ERP) system, is a collection of high-level tools that companies use for planning and implementing business decisions. Accounting software and tools are typically an important part of a business management system.

Client Portals

Client portals are secure, password-protected online storage areas that let accountants and their clients exchange files and information. A portal provides a way to securely exchange confidential information that shouldn’t be sent through non-secure e-mail, while also allowing both accountants and clients real-time access.
A number of companies offer client portal websites used by accountants, while larger accounting firms have client portals built into their own websites.

Some portals are simple, basically just allowing for the exchange of files, such as completed tax returns or accounting software files. Other portals have more functionality, such as invoicing capabilities, tax organizing, and payroll organizing.

Emerging Trends in Accounting Technology

According to an October 18, 2012, article in Accounting Today, retail tax businesses need to consider developing mobile components for their client portals, as a study by OnDevice Research showed that Americans spend more time on mobile devices than on any other platform. The article also noted that the South African Revenue Service has pioneered the use of mobile portals and now has a mobile site and application for e-filing individual income tax returns from smartphones and tablets. It is expected that in just a few years the Internal Revenue offices of many more industrialized countries will offer the same services.

More information on emerging accounting technology can be found in the Journal of Emerging Technologies in Accounting (JETA) from the American Accounting Association.

The Issue of Security and Integration in the use of Accounting Technology

The foremost issue concerning the use of accounting technology is, of course, security, according to a 2012 survey by the American Institute of Certified Public Accountants (AICPA). Security concerns include:

  • Securing the IT environment
  • Managing risk
  • Ensuring privacy
  • Preventing fraud

The survey also revealed that AICPA members found the following issues related to the use of accounting technology to be the highest priority:

  • Leveraging emerging technologies
  • Managing implementation of systems
  • Setting up decision support and managing performance
  • Managing vendors and service providers

Accounting Worksheet

Accountants use an accounting worksheet to compile, organize, and structure data from the ledger accounts onto one page. In the past, worksheets were constructed on basic ruled paper, but today worksheets are prepared mostly using spreadsheet software.
Worksheets aren’t formal documents and are an optional intermediary step for preparing financial statements. Accountants generally prepare worksheets at the end of an accounting period to make sure the books are balanced and to pull together information for the financial statements.

Structure of an Accounting Worksheet

Although the structure of a worksheet can vary, depending on the purpose for which the accountant is preparing the sheet, the traditional accounting worksheet usually has a far left column that contains a list of all the open accounts, plus five pairs of debit and credit columns. One pair at a time would be completed, from left to right.

  • The first pair of columns contains the debit or credit balance for the accounts listed in the far left column. This pair of columns is the unadjusted trial balance
  • The second pair of columns contains adjusting entries for the accounts
  • The third pair of columns is for the adjusted trial balance (Some worksheets skip using these columns)
  • The fourth pair of columns is for income statement data (revenue and expense account balances)
  • The fifth pair of columns is for balance sheet data (assets, liabilities, owner’s capital, and owner’s draw)

If the worksheet contains the third, adjusted trial balance column, the accountant can take the numbers from that third column and enter them in the appropriate place in either the fourth or fifth column.

Determining Net Income or Loss

After completing the fourth and fifth columns, the accountant finds the sum totals of the columns. In the income statement columns, if total credits are more than total debits, there’s net income. The accountant then adds the net income number to the debit column for the income statement and to the credit column (representing an increase in owner’s equity) for the balance sheet.

If the income statement column shows total debits more than total credits, there’s a net loss. The accountant then adds the net loss number to the income statement’s credit column and to the balance sheet’s debit column.

The worksheet is now complete and can be used to prepare financial statements.

Double Entry Accounting

The simplest type of accounting system involves simply making a list of income and expenses recorded when a cash transaction occurs–that’s called single entry (or cash) accounting.

In contrast, a double entry accounting system consists of a chart of accounts where every financial transaction is recorded into at least two of the accounts, once as a debit and once as a credit. This is done to add an additional layer of verification to further ensure the accuracy of the accounting.

Single vs. Double Entry Accounting

The advantages of single entry (cash) accounting is that it’s simple and provides information needed for income tax purposes. However, single entry accounting offers a limited ability to track financial performance and do financial analysis.

Although double entry accounting is more complex, it also has a number of advantages, including an automatic way to catch arithmetic mistakes. Also, accrual adjustments are automatic, whereas in single entry accounting, they have to be made manually. Double entry accounting provides detailed financial information for tracking financial performance and producing the income statement and net worth statement.

Chart of Accounts

Setting up a double entry accounting system consists of setting up a chart of accounts in a general ledger. There are five basic types of accounts made up of three balance sheet accounts (assets, liabilities, and equities) and two income statement accounts (revenue and expenses).

  • Examples of asset accounts: Cash and Accounts Receivable.
  • Examples of liability accounts: Accounts Payable and Wages Payable.
  • Examples of equity accounts: Retained Earnings and Common Stock.
  • Examples of revenue accounts: Merchandise Sold and Service Revenues.
  • Examples of expense accounts: Wages Paid, Rent, and Office Supplies.

When a financial transaction occurs, entries are made in at least two of the accounts on the chart of accounts. In a general ledger chart of accounts, debits are recorded on the left side and credits are recorded on the right side.

The left side must always equal the right side.

The Basic Accounting Equation and Examples of Double Entry Accounting

The basis of double entry accounting is the equation:
Assets + Expenses = Liabilities + Equities + Revenues.

Increases in assets and expenses are left side entries (debits) in the chart of accounts, and increases in liabilities, equities, and revenues are right side entries (credits). Here are three example entries:

Example #1

Account Name Debit Credit
Cash $10,000
Common Stock $10,000

(This entry represents an increase in assets (cash) and an increase in owner’s equity.

Example #2

Merchandise Purchase $3,000
Accounts Payable $3,000

(This entry represents an increase in assets (merchandise) and an increase in liabilities (accounts payable)).

Example #3

Office Supplies $50
Cash $50

(This entry represents an increase in expenses (office supplies) and a decrease in assets (cash)).

Here’s a slightly more complex example: A business sells $5,000 in merchandise (that cost the company $2,500), and the customer pays $3,000 at the time of the sale.

Example #4

Account Name Debit Credit
Cash $3,000
Accounts Receivable $2,000
Merchandise Revenue $5,000
Cost of Merchandise Sold $2,500
Merchandise Purchase $2,500

GAAP (Generally Accepted Accounting Principles)

Generally accepted accounting principles (GAAP) are the guidelines and standards used in financial accounting and reporting all non-government organizations. They are the universal standard by which all financial accounting and reporting must conform. Having a single accounting standard that all companies are required to adhere to – regardless of industry, ownership structure or the regulatory body they are beholden to – is the very thing that allows the performance and value of one company, including all assets and holdings, to be compared accurately to the value of another company.

Financial accounting and reporting refers to tracking financial information and preparing financial statements that a company presents to the public. In using the generally accepted accounting principles as the common platform for assessment and reporting of value and performance, the investing public is assured of like to like comparisons between companies so as to be protected against inconsistencies that would arise from multiple valuation and reporting systems.

The Financial Accounting Standards Board (FASB) originally established GAAP and continues to oversee the amendments that need to be made from time to time. In The Wall Street MBA, author Reuben Advani compares the FASB to the Supreme Court; just as the Supreme Court is the final decider of legal questions, the FASB is the final decider of generally accepted accounting principles for the private sector. However, the FASB must still follow any legal requirements the Securities and Exchange Commission hands down.
The body that set the accounting standards used by state and local government is the Governmental Accounting Standards Board (GASB), while the Federal Accounting Standards Advisory Board (FASAB) sets standards for federal entities.

The generally accepted accounting principles are based on the basic tenets of accounting:

  • Four basic assumptions
  • Four principles
  • Four constraints

The Four Basic Assumptions of Accounting

  • Economic or Separate Entity: The company is treated as a separate economic entity for accounting purposes, even if it isn’t a separate legal entity.
  • Monetary Unit: The only business transactions recorded are those in financial terms (dollars and cents in the U.S.).
  • Time Period: Financial reports cover a specific period of time.
  • Going concern: Financial reporting assumes, unless otherwise known, that the business will continue operating indefinitely.

The Four Principles of Accounting

  • Historical Cost: Initial recording of financial transactions must be at their original cash equivalent cost.
  • Full Disclosure: Financial statements contain enough information that they are not misleading.
  • Revenue Recognition: A company records revenue in the accounting period when services are completed or goods are delivered to the customer, not when the customer makes payment.
  • Matching: A company records expenses in the accounting period in which it helped create revenue, not when payment was made for the expenses.

The Four Constraints of Accounting

  • Materiality: Should purchases of assets be expensed or depreciated? Theoretically, an asset expected to last four years would be depreciated over four years. However, if the asset cost is immaterial, for example $30, expensing the $30 may be acceptable.
  • Conservatism: If a company could equally use more than one accounting method, the company should use the one that affects the financial statements in the least favorable immediate way.
  • Cost-Benefit: Cost-benefit analysis compares the outflows of resources needed to create additional inflows of resources. The benefits should outweigh the costs.
  • Industry Practice: Some industries have unique requirements, and companies in those industries can follow standard industry practices.

GAAP and International Accounting Standards

GAAP are U.S.-based accounting standards. Each country has its own accounting standards, creating challenges for companies that do business across borders. These differences affect everything from how depreciation and amortization are treated to how financial statements are structured.

Although the differences between GAAP and the standards used in some countries, such as the UK, are minor, significant differences exist with the standards used by many other countries, in particular Asian countries that are among the top U.S. trade partners.

The International Accounting Standards Board (IASB) works to develop internationally accepted financial reporting standards. A movement is underway to align the standards of the FASB and IASB to make accounting across borders consistent.

Accounting for Stocks & Bonds on the Balance Sheet

A company’s excess revenue is often reinvested to earn even more income. At the very least, it may sit in a savings account. However, many companies choose to reinvest their profits in stocks and bonds.

Stocks and bond assets are reported similarly to other assets. There are various methods for reporting the value of an investment in the balance sheet. How an investment is classified depends on its marketability, management’s intent and the investment’s type.

Three Reporting Methods:

  1. Market
  2. Present Value
  3. Equity Method

Five Classifications of Management’s Intent

Typically all securities traded on an exchange or in over-the-counter markets are considered marketable.

  1. Trading Securities-These are stocks and bonds purchased with the intent to resell. These short-term investments are considered current assets. They are recorded on the balance sheet at market value.
  2. Securities Available for Sale– These are stocks and bonds management intend to hold indefinitely. If management thinks they may sell them within a year, they are classified as current assets. If not, they are recorded on the balance sheet as long-term investments and reported at market value.
  3. Securities Held-to-Maturity-These are bonds management has in mind to hold until the issuer redeems them. They are classified on the balance sheet as long-term investments at present value.
  4. Securities Held to Obtain Significant Influence- For this type of securities, the equity method of accounting is applied. These are considered a long-term investment. Once a company owns more than 20% of another company’s stock, the accountant can assume significant influence exists.
  5. Securities Held to Collect Controlling Interest- An investor obtains controlling interest of a company when he holds more than 50% of the company’s common shares. The reason being he has the ability to elect the majority of the directors. This is defined as a parent-subsidiary relationship and a consolidated financial statement presentation is required by the accounting rules.

Accounting for Bad Debts

Accounting for bad debts is necessary yet not always straight forward. Both the income statements and the balance sheet are affected. To shareholders reviewing a company’s annual report, it is crucial to investigate the company’s bad debt standing.

On the income statement: The estimate of bad debts appears.

On the balance sheet: The estimate of uncollectible accounts appears as a subtraction from accounts receivable in the current assets section.

Two Aims in Accounting for Bad Debt

  1. To match the cost of bad debts to the sales revenue incurred for that time period. Some credit sales will result in being uncollectible along with other uncollected sales. An estimation is necessary because not all accounts will be proved uncollectible even at the year ‘s end. Therefore, to ensure the annual report reflects this year’s sales as accurately as possible an estimate of the uncollectible amount must be made if the company is to charge this year’s profits with bad-debts expense as accurately as possible.
  2. To place the correct value on the amount of accounts receivable recorded in the current assets section of the balance sheet. This is also just an estimation. The accounts remain listed in accounts receivable. Therefore, the company has not yet finalized them as bad debt.

These estimates can result in some conflicts between the income statement and the balance sheet. The estimates may be too high or too low, especially on quarterly reports. The annual report tends to be more accurate in its estimations and is therefore, more reliable overall.

Accounting for Discontinued Operations

In financial statements, discontinued operations must be disclosed on the income statement in the period in which it occurs. Although a discontinued operation is considered a contingency, the guidelines for revealing this information is not the same as for other “likely” contingencies. It is only the amount of gain or loss that is “contingent”

A contingency is an amount dependent on another transaction or event. When management makes the executive decision to sell a portion of the business, often they don’t even know whether the sale will result in a gain or a loss. The exact amount isn’t usually known until the transaction is final.

As a result of the unknown, a contingency has been created by the existence of the discontinued operation. On the income statement, gains or losses on discontinued operations are reported in the section that follows income from continuing operations and precedes extraordinary items.

When the company sells or discontinues a portion of the business, there are tax consequences. When the company experiences a gain, typically, there are additional taxes to be paid. When the company experiences a loss, there are often tax savings to be had. Regardless, these tax consequences must be disclosed.

For potential and current investors, when a discontinued operation is disclosed, it is key to not only pay attention to the net income. The reason for this is that clearly a section of the business is no longer contributing to the company’s earnings. Therefore, the income from continuing operations becomes the supreme figure of importance when trying to predict the future earning capacity of the company.

Accounting vs. Finance Functions

The board of directors of a nonprofit ultimately carries the responsibility for the financial performance of the organization. The chief executive, along with the help of senior management, provide board members with the necessary financial information to perform their job responsibilities.

Part of the board’s function is to approve a long-term (five to ten year) financial plan and a short-term (one-year) capital and operating budget. Board members must remain informed about the organization’s financial status. Each board member plays a different role when it comes to accounting functions and finance functions.

Accounting Functions for a Nonprofit

  • Identify and record all valid transactions
  • Classify financial transactions on a timely basis
  • Identify the time period in which these transactions occurred (accural accounting)
  • Value these financial transactions in an appropriate manner
  • Disclose these transactions in an adequate manner

Using the GAAP, the accounting functions are then presented for financial analysis in an understandable, standardized form.

Finance Functions for a Nonprofit

The purpose of finance functions is to analyze the numbers presented from the accounting functions. The key is to recognize financial trends that will assist the organization in the future. Ratios may be developed to assist in this process of analysis.

  • Collect
  • Analyze
  • Communicate accounting and statistics

From this analysis, the board will then set goals based on financial-ratio benchmarking. It will be the management’s job to achieve these predetermined goals. The board must thoroughly understand the information behind each ratio in order to set realistic and authentic goals for the organization. The board must monitor the accuracy of the numbers reported according to GAAP.

Accounting for Extraordinary Items

In order for an item to be considered extraordinary, it must meet the following criteria. The gain or loss experienced by the company from the transaction or event must be-

  1. Unusual. This means it is unrelated to the business’ normal enterprises.
  2. Nonrecurring. This means this type of transaction or event is not expected by management to transpire again.

To accurately meet this criteria is company specific. In order to classify a transaction or event as unusual and nonrecurring, a company’s sphere of business and geographical location must be taken into consideration. Where the loss from a natural disaster in one area would be considered an extraordinary item in another location it may be considered a regular occurrence.

Recording Extraordinary Items

Extraordinary items are presented on the income statement between discontinued operations and the cumulative effect of a change in accounting principle. An accountant must record an extraordinary item net of its tax consequences. A net extraordinary gain (gain less additional income taxes) will increase income whereas a net extraordinary loss (loss which is reduced by income tax savings) will decrease income.

When comparing fiscal years, it is important to contrast income before extraordinary items with the net income from previous years where there were not extraordinary gains or losses. This is possible because management does not predict for the extraordinary item to happen again.

Excluded Gains or Losses

The following gains or losses cannot be treated as extraordinary items according to the accounting principles.

  • Gains or losses related to foreign currency exchanges
  • Losses from the write-down or write-off of receivables, inventories, equipment, or intangible assets
  • Gains or losses from the sale of a portion of the business
  • Losses from strikes by employees
  • Gains or losses from the sale or desertion of property, plant or equipment

Accounting for Bonds

Part of an accountant’s job may be to advise management when there is excess profit. One way to invest extra cash is in bonds. A bond is a loan given to another company that bears interest.

Bonds are a short-term investment strategy because they can easily be converted to cash when needed. Bonds can be sold at discount or premium. Here are three possible variations-

  1. Bonds sold at par: Bonds are sold at the face value stated on the bond certificate. The stated interest rate is the same as the market interest rate.
  2. Bonds sold at a discount: These bonds have a lower stated interest rate than the market interest rate. The bond will be sold at less than face value to compensate for offering a non-competitive interest rate.
  3. Bonds sold at a premium: These bonds have a higher stated interest rate than the market interest rate. This occurs because the seller of the bond will not sell when the stated amount of interest to be paid is greater than what is being paid in the market.

Types of Bonds

This is a list of bonds typically sold on the market.

  • Coupon Bonds: They come with detachable coupons that are cashed in at specific dates. They are not very common today.
  • Registered Bonds: These are registered in the name of the owner and require the presentation of the bond certificate at the time of maturity.
  • Serial Bonds: They are issued to mature at dates spread out over time.
  • Convertible Bonds: These bonds can be exchanged by the holder for a specified number of shares of corporate stock.
  • Callable Bonds: These bonds allow the company to buy back the bonds at a specified price before the bonds’ maturity date. The company will often exercise this option when the market interest drops significantly below the stated rate.

Accurately Tracking Inventory Prevents Profit Loss

Keeping track of your inventory is another way to track your current assets (things that you own that you can easily use or liquidate). In the inventory account, you keep track of the products you have purchased for sale. As you sell products, you deduct the cost of each item sold from the inventory account. This account allows you to easily track the products still available for sale.

Although periodic physical counts of inventory are time-consuming, it is necessary to compare your actual inventory with what is recorded on paper. If inventory isn’t accurately accounted for a business’ profits are negatively impacted. Inventory losses can be written off due to theft or damage but accurate documentation of those losses are needed.

Tracking Inventory

Companies may choose to track their inventory in one of two ways. Tracking inventory helps detect carelessness, lost items and theft.

Periodic Inventory Method:

Requires a physical count on a periodic basis. This could be daily, monthly or yearly depending on the type of business. The cost of goods is calculated using the items-sold number.

Perpetual Inventory Method:

Calculated based on actual transactions. A computerized inventory control system is required to use this method. Major retailers often link their cash register sales to their inventory control system.

Annual Report Notes on Commitments

Investors pay attention to the financial statements in a corporation’s annual report. In addition, they closely review the disclosures in the note section as well. The detailed information recorded reveals the underpinnings of a corporation’s financial state as well as indicators of its future standing.

The company is required to disclose all commitments on the balance sheet. Some commitments directly affect the balance sheet at the time of their occurrence. Others may not have any current affect but with the company’s intentions revealed, it could significantly affect the company in the future.

Types of Commitments Disclosed

The most common types of commitments noted in financial statements are-

  • the terms of outstanding loans
  • long-term purchase plans
  • arrangements to refinance existing debt
  • lines of credit
  • employee pension plan specifics
  • lease terms

These disclosures are particularly valuable because they are indicative of the company’s future debt structure and need for cash to satisfy its current obligations.

The details of lease terms and arrangements greatly affect the definition of a company’s assets. Some noncancelable long-term leasing arrangements can be equated as alternative purchase and mortgage arrangements. With some leases, the risk of ownership is transferred to the lessee. Due to the variation in lease agreements, it is difficult to compare the financial statements of companies that lease with companies who do not lease. Therefore, the notes explaining the lease’s specific terms will assist investors in making a more equivalent comparison.

Contingencies are also communicated in the notes on commitments. Contingencies are in play when the company risks a gain or lose because of a past transaction or event. It must be classified as likely to occur, having a remote chance of occurring, or as may possibly occur. If it is determined a contingency is likely to result in a loss, it must be accrued, using the smallest amount estimated. If it is determined a contingency is likely to result in a gain, it is disclosed but not calculated.

Asset Controls

A business must set up a variety of internal controls to minimize error and protect itself from fraud or theft. One form of internal controls is through establishing controls for the transaction process in the operations of a business. Another form of controls is asset controls.

Asset controls seeks to institute methods and procedures to control the assets of the business. Since there are a variety of assets a business may hold, a variety of controls are applied to each asset category.

Specific Asset Controls

  • Cash

It is advisable to have the standard established that all cash receipts be deposited daily in full. The employee who does the actual depositing should be different from the one who prepares the deposit. Checks should be pre-numbered and unused checks kept under lock and key by the treasury officer.

A check protector can be used to imprint the amounts on checks so they cannot be changed. Records should be constantly compared. Bank reconciliations should be made monthly by an employee who did not do any handling of the cash or the recording of its transactions.

  • Investments

The supervision, authority to buy and sell investments and the accounting records are all responsibilities of different employees. The employees who handle securities are bonded. It is a common practice in most companies that the approval of the board of directors is required for most investments.

  • Receivables

All adjustments to accounts receivables for bad debt write-offs, credits for sales returns and allowances must be approved by the credit manager. Credits for returns must be substantiated by receiving reports.

  • Inventories

Typically, inventories are kept under lock and key. At least once a year, inventories are counted, weighed or measured to verify their amounts with those on the reports. Any differences are thoroughly investigated.

  • Plant and Equipment

Big purchases or disposals of plant and equipment must be approved by the board of directors. Small items must be approved by the department managers. Detailed lists of plant assets are kept and maintained. An inventory of plant assets may be taken from time to time.

Audit Report Contents in the Annual Report

The content of a publicly traded company’s audit must be disclosed in the annual report. Each paragraph of the audit report has a specific purpose. The ultimate purpose of the audit report is to expand the awareness of the features as well as the limitations of the audit for the shareholders.

The Audit Report’s Content

  • Paragraph One

Paragraph one contains the admission that the management is primarily responsible for the financial statements. This is to clarify the auditors themselves are not responsible.

  • Paragraph Two

Paragraph two is a description of the audit. The auditor’s objective is to test the soundness of financial statements by carefully reviewing the accounting records and other supporting documents. The SEC’s Public Company Accounting Oversight Board designates the exact responsibilities of the auditor.

  • Paragraph Three

Paragraph three offers the auditor’s opinion. Their opinion can be described as either “clean,” “qualified,” or “adverse.” Another option is they may “disclaim” and offer absolutely no opinion.

Every company desires their financial statements be declared as “clean” with fair presentations of the company’s financial position and earnings. A “qualified” opinion is stated when there are particular areas that the auditors do not deem to be “fair presentation.”

An adverse opinion concludes the financial statements were not found to be “fairly presented.” A list of why they drew this conclusion typically follows.

  • Paragraph Four

Paragraph four lists any changes made during the fiscal year in accounting principles. They are described in the specific notes to the financial statements.

  • Paragraph Five

Paragraph five is the auditor’s assessment of the management’s system of internal controls over financial reporting.

In addition, a company seeks to be found in conformity with the generally accepted accounting principles (GAAP).

Books of Account

Before the era of electronic accounting, transactions were recorded in different books. Although these books are no longer manually recorded, their terminology still holds a place in the storage and process of accounting data.

The general ledger is the master book. It contains all the accounts and statements. There is an account for each category of asset, equity, expense, and revenue. Every debit and credit is summarized in these accounts. At the end of each accounting period, financial statements are prepared using the balance remaining in each account.

However, the general ledger often doesn’t go into enough detail to satisfy management. For more detailed data regarding each account, a subsidiary ledger is formed. In essence, the total of the individual balances in a subsidiary ledger will equal the overall total balance in the corresponding general ledger account.

A general journal is often kept as well. This is the initial point of entry for every transaction. It is also known as the book of original entry. The transaction is first recorded here and then transferred to the general ledger. The general journal serves as a complete record, the debit and credit, of every single transaction. Recording the transaction in two locations makes it easier to track a mistake if one needs correcting.

Most businesses have other books of original entry as well for this reason. They may keep a cash receipts journal, a sales journal, a payroll journal, a purchase journal and a cash payments or disbursements journal. Not all books will be necessary. It depends on the types of services offered, the nature of the enterprise and the other methods used for tracking data.

The Importance of Bank Reconciliation

This simple procedure of reconciling bank accounts is extremely important. However, for a variety of reasons, many people just don’t do it. This is a primary way to establish internal control over a company’s cash. The goal is to compute the true cash balance that will be reflected on the balance sheet as of a particular date.

However, sometimes this process is frustrating because the general ledger for the cash account rarely equals the bank’s balance. There are several potential reasons why the accounts don’t balance. Carefully consider these options when hunting down the possible culprits.

Reasons Why Accounts Might Not Balance

  • A missed service charge to the bank account: There are some fees that the bank charges consistently. However, some may come as a surprise. For example, there may be an overdraft fee on the account while you were unaware that the account was overdrawn.
  • A note receivable the bank collected for the company: When the collection is made, the bank is made aware of the collection before the company is.
  • Interest earned on the bank account
  • An error made by the bank: Catching this type of error can pay off for the account. Make sure you have records to prove the error as well.
  • A deposit in transit: You have recorded a deposit made but it has not yet been cleared by the bank.
  • Outstanding checks: Checks written to vendors may not be deposited by the vendor in a timely manner. The amount of all outstanding checks must be subtracted from the bank’s balance.
  • An error made in the company’s books

To reconcile the general ledger with the bank account statement, make any adjustments needed on the company’s balance sheet.

The Bookkeeping Cycle

With so many transactions happening day to day, a bookkeeper or accountant must be highly organized. There is a natural cycle transactions go through from start to finish. A transaction comes into the book of original entry and eventually ends up on a financial statement at the end of the month. But there are a few other stops in between.

Purchases, sales, payments and collections-these are the day to day transactions of most businesses. Typically, at the end of the month, the debits and credits recorded are totaled by account category. The amounts are then recorded in the accounts of the general ledger. This process is known as posting.

One must be aware that transactions are not always recorded in the period they occur. This is common with businesses which offer services occurring continuously over time but that are paid for at different intervals. To compensate for this, an adjusting entry must be made. Adjustments are also made for assets that depreciate, liabilities and interest on debt and taxes.

A complete bookkeeping cycle is most often one year. At that time, the recorded adjustments are recorded in the accounts by way of the general journal. Even though month end adjustments are made for the financial statements, they often are not recorded into the accounts themselves until the year end.

The bookkeeping cycle is finished by closing the books. The books are closed out at a zero balance. A general journal entry is made that returns all revenue and expense accounts to zero. Next, the net difference between the credit and debit amounts, the net income or loss, is transferred over as ownership equity. With the books at zero, the company is then ready to begin the next bookkeeping cycle.

Balanced Scorecards

In addition to trending and benchmarking, balanced scorecards are another way to evaluate an organization’s performance. With balanced scorecards, a board is given a better understanding of the organization’s operations as a whole. They are effective for gaining a complete picture of an organization.

Balanced scorecards integrate financial elements along with other key elements to compare an organization’s outcomes versus its goals. The Harvard Business School Press describes balanced scorecards as “provid(ing) executives with a comprehensive framework that translates a company’s vision and strategy into a coherent set of performance measures.”

Four Quadrants of Balanced Scorecards

These four quadrants are performance measures that can be used to monitor and improve an organization’s effectiveness. Within these quadrants are additional measurement suggestions. A particular organization may prefer certain assessments over others depending on its own unique success combinations.

Financial Perspective Quadrant

  • Return on Capital
  • Competitive Position
  • Volume Growth
  • Reduced Cash Outlays
  • Improved Cash Receipts

Customer Perspective Quadrant

  • Customer Satisfaction
  • Employee Satisfaction
  • Funder Satisfaction

Internal Perspective Quadrant

  • Product Innovation
  • Perfect Orders (error reduction)

Learning and Growth Quadrant

  • Strategic Awareness
  • Mandated Hours of Education per Employee

Developing a Scorecard

Start developing a scorecard using the following steps:

  • Establish an organizational business strategy through the outlining of the key elements that make the nonprofit a success.
  • Adequately describe the strategy in detail to key players such as users and employees to gain their confidence and teamwork.
  • Develop the scorecard framework with objectives and performance measurements that closely embody the strategic objectives outlined by the organization.

Remember, the purpose of a scorecard is to give a full picture of the financial and non-financial goals and to establish a method for monitoring their effectiveness.

Budget Variances

A company goes to great lengths to set a budget, projecting potential income and expenses for the following year. However, a budget is only a plan. There are differences between the budgeted figures and the actual results. In accounting, these differences are analyzed in the form of variances.

Sales Variances

Within sales variances, there are three variances used to calculate for sales: price variance, quantity variance, and product mix variance. Sales variances are calculated by reference to contribution margins.

  • Price variance: Price variance is the measure of the effect on profit of selling at prices different from budget.
  • Quantity variance: Quantity variance measures the effect of selling quantities different from the amounts projected in the budget.
  • Product mix variance: Product mix variance measures the effect of selling products in different proportions from the budget.

A difference in price effects profit but a difference in quantities or mix doesn’t because they involve different costs. Contribution margins can be defined as the selling prices of the products less their variable costs. The company aims for positive sales variances since this signifies higher actual revenues than budgeted revenues.

Cost Variances

When considering selling and administration expenses, the common practice is to calculate difference between actual and budget amounts as budget or spending variances only. Occasionally, budget variances are divided into price and quantity components but volume variances are not calculated.

Higher budgeted amounts rather than actual amounts are considered favorable for the company.

Bill Collection

Bill collection is one of the least desirable areas of accounting. It can be mundane and emotionally draining. Often, it is postponed until it becomes unavoidable. However, bill collection isn’t merely a final effort to collect payment from accounts receivable. It must serve as part of a total credit strategy.

When bills aren’t collected in a timely manner, cash becomes tied up. This cash is needed to fuel other aspects of the business. Therefore, it is crucial to effectively retrieve payment from customers.

Total Credit Strategy

A total credit strategy, according to Robert Low in Accounting and Finance for Small Business Made Easy, involves the following procedures:

  • Decide on customer payment terms
  • Perform credit checks
  • Choose which personnel to involve
  • Monitor receivables
  • Follow up on problem accounts
  • Identify when to look outside the company for extra assistance

It must be determined whether to keep collections as an in house responsibility or to defer it to an outside agency. For in house collections, good record keeping is key to an effective bill collection system. Records must be accurate, timely and complete. It is unlikely to expect timely collection on a bill if the invoice isn’t sent out on time.

Next day billing if products are shipped or weekly billing for a professional service provided is a productive time frame. For large invoices, consider billing through overnight mail or even electronically. It pays to follow-up by phone the day before the payment is due as a friendly reminder to the client. Verify that all the information on the invoice is entered correctly so that the client has little reason to dispute the bill.

If a dispute does occur, accurate record keeping serves as a safeguard. There will be an adequate history of orders, invoices and payments with which to the refute any discrepancy. In addition, document all conversations with clients regarding bill payment.

Budgeting Procedures

All companies operate under a budget. Depending on its size, a company can have multiple budgets for varying departments or just a simple estimate of income for the upcoming year. Managers plan their activities and express them in financial terms. Reports of budgeted expenses versus actual expenses are compiled frequently to access the budget’s accuracy and effectiveness.

Typically, a business calculates a budget according to their fiscal year. Then it divides it into quarterly and monthly periods. Managers are the ones responsible for the formation of the budgets in their department. This holds a two-fold purpose. First, the manager is the one to have the most overall knowledge of budget requirements and needs. Second, the manager’s own performance is measured against his budget.

These budgets are then approved by their superiors. Budgets are not hard and fast. They are estimates at best. They are often based on previous figures, using past experience as a guide. However, the company must account for inflation and the fact that the upcoming year’s circumstances may not reproduce similar financial results.

In addition, the manager must consider discretionary costs. Discretionary costs are expenses that can be postponed without affecting the department’s productivity or operations. In order to do so, the manager uses the procedure called zero based budgeting.

A zero based budget must explain every dollar of cost they predict to be incurred, starting at zero. They cannot take into account pre-authorized funds. It does not rely on past sales and expenditure trends as a starting basis.

All of the budget submissions in a large corporation are commonly reviewed by a budget committee consisting of the budget director, president, the senior production, sales and financial executives.

Consolidated Financial Statements

Consolidated financial statements are the combined financial statements of the parent company and its subsidiaries. The accounting principles necessitate assets, liabilities, revenues, and expenses of majority-owned subsidiaries be incorporated with their parents. To do so, accountants must eliminate any transactions between the parent company and its subsidiaries. This step is a necessity because otherwise, the assets, liabilities, revenue and expenses of the combined company would be exaggerated.

To clarify the relationship between companies, it is best to define how the relationship is established. A parent/subsidiary relationship is created when the parent company purchases more than 50% of the common stock of another company. Acquiring more than 50% of the common stock entitles the owner to majority representation of the board of directors of its subsidiary. This gives the parent company ultimate control over the company’s undertakings.

Minority Interest

Minority interest is created when the parent company does not own 100% of its subsidiary’s voting stock. Minority interest can be defined as the owners’ equity held by the other shareholders of the subsidiary. Accounting principles permit all the assets and liabilities of a subsidiary to be recorded in the consolidated financial statements. Therefore, the amount of assets and liabilities of the subsidiary not fully owned must be classified as minority interest.

There are two ways to record minority interest on the consolidated financial statement:

  1. As a liability. This representation denotes the amount the parent “owes” the minority shareholders.
  2. As a part of consolidated owners’ equity.

Additional activity of the subsidiary is included in the notes of the financial statements under “segments.”

Certified Public Accountants

The accounting profession is highly respected in the business world. In fact, accountants are considered the most trusted professional group in America (What Financial Problems? p.54). Given the amount of education and experience required to receive certification this is an understandable designation. Perhaps so many trust accountants’ expertise because people outside the accounting profession may feel ill-equipped to handle the detailed responsibilities as accountants do.

The certified public accountant (CPA) is the best-known and prominent accounting certification. To become a CPA, a four-part exam is administered nationwide by the AICPA. Although other certification requirements vary from state to state. All four parts must be passed. However, this can be done over time.

Four-part Exam Includes

  • business law and professional responsibilities
  • auditing
  • accounting and reporting-taxation, managerial, governmental, and nonprofit
  • financial accountant and reporting for business enterprises

In addition to the exam, accountants must also work for a certain amount of time in public accounting. However, general accounting experience is sometimes an acceptable substitute. Like other professions, to maintain certification, continuing education is necessary.

The Big Four

CPAs work in both the private and public practice. The largest public accounting firms are known as the “Big Four.” These are international firms offering a wide variety of services. In addition to accounting, they provide consulting services as well. They handled the majority of audits for publicly traded companies.

  • PricewaterhouseCoopers
  • Deloitte & Touche
  • Ernst & Young
  • KPMG

The big four are the giants of the accounting industry. Their annual revenue ranged from $22-29 billion in 2011. Each firm employed between 140,000 and 182,000 employees. Deloitte & Touche has their headquarters in the United States. Whereas, the other three have their headquarters based in Europe. Even though they may be internationally based, all four have a presence in most major U.S. cities.

Contingent Assets and Liabilities

In the accounting field, a business is defined by its assets. The sum of the assets is the accounting entity. The accounting entity is the economic unit, the business, being accounted for. It is not necessarily a legal entity. A proprietorship is not a legal entity. Although a corporation is legally recognized, it may operate more than one business and muddle the description.

Assets are considered part of a business if the economic benefits and risks of ownership accrue to that business. When the existence of an asset is uncertain, it is known as a contingent asset. As a result, they are not recorded formally in accounts but are merely listed and described in the notes of the financial statements.

The equity of an accounting entity is defined by its assets. They are the amounts that will have to be paid in respect of its assets. If a property is being leased is defined as an asset, then all the lease payments are considered liabilities. A liability is established in reference to how an asset is defined.

When the existence of a liability is called into question, it is considered a contingent liability. If it is probable the amount will have to be paid, the liability is considered real. But if there is reasonable doubt involved, it would be classified as contingent. Just as with contingent assets, contingent liabilities are not recorded in actual accounts but are only noted on financial statements.

There are times when money will have to be paid but the specific amount is not determinable. Therefore, the liability is real because it is certain money will be paid out but the amount cannot be reasonably estimated. The least probable amount is then recorded in the accounts while a note is made in the financial statements explaining the situation along with its range of possible liability.

When calculating assets, one must consider that many companies lease their long-term assets. This may include buildings, land and equipment. In accounting, a lease is categorized in two ways: as a capital lease or as an operating lease. Their categorization depends on the terms of the lease agreement.

Definition of a Capital Lease

A capital lease defines a lease whose terms of agreement transfers all the benefits and risks of ownership to the lessee. This could be indicated in a variety of ways. For example, by a lease term for 75 percent or more of the economically valuable life span of the asset. Or, it may be quite clear from the agreement that legal ownership will transfer to the leasee or that the leasee may purchase the item for a discounted price. Additionally, the present value of the minimum lease payment is equal to 90 percent or more of the fair market value of the asset.

To record a capital lease, one treats it similarly to a depreciable asset. However, there are two slight differences in procedure.

  1. With a depreciable asset, the asset is written off during the lifetime of the asset. For a capital lease, the ability to write off the asset is limited to the term of the lease. If actual ownership of the item is transferred, then obviously it would no longer be a leased item and thus treated as one would a depreciable asset.
  2. The current and accumulated expenses are amortized rather than depreciated.

GAAP requires that the details of the capital lease are revealed and disclosed in order to demonstrate further legitimacy to the lease.

Credit vs. Debit

The foundation of accounting is double entry bookkeeping. The use of the terminology debits and credits in accounting differs from how banks use them with their customers. Initially, for some, this can be confusing.

But it is important to understand the fundamental difference. In double entry bookkeeping, assets are called debits and equities are called credits. The terms debit and credit originate with the words debtor and creditor. To be exact, a debtor of a business is someone against whom the business has a claim. For the business, this is translated as an asset.

A creditor is someone who has a claim against the business, which is considered an equity. In contrast, for a bank, the accounts of their depositors are called credits. They are called that in the banking world because for the bank, it owes the amounts deposited to their customers.

In accounting, revenues are credits and expenses are debits. Debits can be defined by what the money bought like assets or expenses. When a business pays wages, it is essentially buying labor and is considered a debit. On the other hand, credits show where the money came from. For example, these could be liabilities, ownership or revenues.

Just like there are two sides to every coin, there are two sides to every accounting transaction. Bookkeeping involves recording the exchange. Whether something is bought or sold, some other commodity must have been exchanged in the process of the transaction. The things that are received in the exchange are recorded as debits. Whereas the things that are given in return for the exchange are recorded as credits.

Calculations for Evaluating Investment Opportunities

Investing capital to expand a company or increase a product line requires capital budgeting. Capital budgeting is the process of allocating funds to investment in assets. There are many opportunities for investment available to businesses. Management must evaluate each of these opportunities because some are potentially profitable while others may cause the company to take a hit financially.

Thankfully, there are four common methods used to evaluate investment opportunities. These methods are payback, internal rate of return, net present value and accounting rate of return.


This method evaluates a potential investment by the length of time it will take to recover the investment. Yet, this is not an adequate method for evaluating risk. It does not consider the lifetime of the investment and it denies the time value of money. Money to be recovered 7 years from now does not have the same dollar value as it does at the time it is invested.

Internal Rate of Return

This method is the effective rate of interest that equally values the cash returns to be received with the cash outlay of an investment. Unlike the payback method, the internal rate of return takes into account both the lifetime of the investment and the time value of money.

Net Present Value

A minimum required rate of return is first decided before the calculation is made. With this rate, the present value of the cash return is calculated. If the present value of the return is greater than the cash outlay of the investment, the investment is considered satisfactory.

Accounting Rate of Return

This method is expressed as a percentage. The annual incremental net income is divided by the average investment.

Circulars Governing Grant Accounting

First of all, applying for a grant itself is a detailed process and is a skill to develop. Once a nonprofit is awarded grant money, it must be very careful how it is managed. To ensure clarity, the federal government’s Office of Management and Budget (OMB) monitors the universal administrative procedures drafted by 26 federal agencies on the use of grant money.

The OMB has three circulars or rule books for the accounting, administration and auditing of grants. Thankfully, when a nonprofit is awarded a grant, the many details of these circulars is included. In addition, most federal agencies also offer specific training on grant management.

Circular 1: 2 CFR Part 215

The purpose of this circular is to define the administrative requirements of all nonprofit organizations, institutions of higher education, and hospitals. These standards for the administration of grant money are to help establish that all nonprofits are treated equally.

OMB Circular A-122

The intent of this circular is to determine the cost of work performed or purchases made by nonprofit organizations. The nonprofit’s auditor will verify whether all its costs are in compliance with generally accepted accounting principles (GAAP) and the cost principles outlined in this circular. Costs are classified as:

  • Reasonable cost: The cost for an item isn’t any higher than what another person would pay under similar circumstances.
  • Allocable cost: The cost is for an expense incurred specifically for the grant, benefits the grant or is necessary for the operation of the nonprofit.
  • Allowable cost: A cost that is reimbursed by the federal government in accordance with the cost principles.

OMB Circular A-133

The purpose of this circular is to address the government’s audit requirements for grant money. The nonprofit is required to keep copies of all grant documents. Not following the rules could lead to loss of grant money or loss of the right to serve the community as an organization.

Components of a Budget

Many employees are involved in the formation of a corporation’s budget. Essentially, the chief executive sets the upcoming objectives and expectations for the business. These are communicated to each manager who must keep these goals in mind when projecting his department’s budgetary needs for the future year.

The budgeting process usually begins with a budget of forecast sales. The sales manager and his staff are put in charge of this. They must use their expertise and knowledge of the economy, their industry, customers and competition to make accurate projections. Establishing the number of units and selling prices for each product in each territory each month is the foundation for production schedules and the cost and expense budgets that follow.

Based on the sales budget, budgets of selling and administrative expenses are then formulated by various managers of those areas. Next, if plant and equipment must be purchased in the near future, they are budgeted separately in a capital expenditures budget. All the operating budgets are then completed.

A cash budget is next to be prepared. The budget director and his staff are in charge of combining the operating data with the projected capital expenses and any budgeted changes in debt and equity financing. Lastly, all the data is integrated to complete the budgeted statements of income and balance sheets.

There are fixed and flexible budgets. Fixed budgets are also known as planning budgets. They are purposeful for planning and coordinating business activity. However, for cost control purposes, flexible budgets are advised. Their benefit is they provide accurate comparisons for costs incurred at actual levels of activity.

Components of the Income Statement

The income statement measures the economic performance for a business over a given period of time, typically a quarter or a year. To provide this adequate measurement, all revenues, expenses, gains and losses must be summarized resulting in the business’ net income. Net income indicates the profit which is essentially all revenues and gains over the period minus the expenses and losses. Net income exhibits a company viability.

The income statement represents a period of time within which the business was in operation. In contrast, the balance sheet is a snap shot of the company’s performance at a single moment in time. Businesses produce income statements. However, charitable organizations do not. They use a similar format to produce a Statement of Activities which demonstrates the sources of funding in contrast to program expenses and administrative costs etc.

Components of the Income Statement

  • Net Revenues: This is a summary of revenue received from the sale of goods and services as a result of a company’s normal operations.
  • Cost of Goods Sold: This represents the amount of inventory sold to customers during the period if it is a retailing company. If it is a manufacturing company, this measures the cost of goods manufactured that have been sold. This includes the raw materials, labor and everything used in the manufacturing process.
  • Selling Expenses: These expenses involve those used to generate sales like sales commissions, advertising and promotions.
  • Administrative Expenses: These include all general operating expenses such as salaries, office supplies and insurance.
  • Discontinued Operations: Any gains or losses from the selling or disposing of part of the company’s operations.
  • Extraordinary Items: This refers to a gain or loss from an unusual event like a natural disaster.
  • Earnings Per Share: This reports the amount of earnings per each outstanding share of a company’s stock. It is calculated by dividing the net income by the number of common stock shares outstanding.

A Company’s Profitability

Profitability is in and of itself, a fairly simple concept. In order for a company to thrive in business, it must make a profit. It must incur income to maintain operations, grow and expand. A company who fails to bring in profit cannot stay in operation. It will last as long as the cash on hand lasts. In effect, this is poor business planning.

Even though this is a basic principle, analyzing profitability is more complicated. It is usually analyzed in two phases. Profitability can be measured in terms of its relation to sales and its relation to investment.

Profitability in Relation to Sales

In this equation, profit (or income) equals a company’s sales minus its expenses. It is necessary to account for cost of goods sold, salaries, rent, utilities, depreciation, interest and taxes on income when considering expenses. Looking at income statements for consecutive years may demonstrate a hearty increase in sales yet this substantial increase may not be reflected in the profits.

To gain a better perspective of the cause, look at income statements known as Common-Size Income Statements. This type of statement converts the figures to percentages. Doing so will assist in your analysis.

Normally, in the case when sales increase yet profit remains stagnate, a disproportionate increase in the total expenses is the cause. Further analysis of these particular expense categories will help to correct the profit sluggishness.

Profitability in Relation to Investment

Capital must be invested in assets like equipment, inventory, and research. Determine the basic earning power of the business by calculating the return on total assets (ROTA). Following must be a comparison of the debt-to-equity ratio. These assets may have been obtained through the use of debt or equity.

Cash Flow Statements

A continuous cash flow is essential for any business, regardless of its size. A cash flow statement is an important tool for managers to have at their disposal to evaluate the financial position of the business.

Numerous businesses end up failing because they grow too quickly. Their cash flow is outweighed by their debt obligations. For small businesses, cash flow is equivalent to income. This is because often all of the cash receipts come from sales and the payments simply go to current expenses.

But this is not always the case. For businesses that don’t just run on a cash basis, an accountant compiles a statement of cash flows from the statement of income and the balance sheet. It is sometimes divided into categories such as operating, investing and financing.

Operating enterprises generate income which is revenues minus expenses. But the cash flows that result differ from income for two distinct reasons.

  • Some expenses, like depreciation, don’t involve cash payment. As a result, depreciation and any other non-cash paid expenses are added back to income to arrive at cash flow.
  • When sales and purchases are made on credit or items are bought for inventory, cash receipts and payments don’t equate revenues and expenses. To compensate for this, income is adjusted for changes in current asset and current liability accounts when calculating cash flow.

Investing enterprises are comprised of long-term asset transactions. On the other hand, financing enterprises involve borrowing and ownership. The portions of the balance sheet such as short-term borrowings and long-term debt and ownership are used to reflect this section on the cash flow statement.

Combining the Accounts of Foreign Companies

Mergers and take-overs are commonplace in today’s market. As a result, the accounts of both companies must be combined. Yet, how are the accounts combined of two companies when one is in a foreign country? It is helpful first to define the exact relationship between the domestic and foreign company.

The methods used to translate the accounting of the foreign company depends on whether it is independent of its American parents or if the two companies are closely integrated. Those responsible for creating the financial statements are the ones to determine the foreign company’s classification.

In order to properly define the company’s relationship, the accountant must answer questions like the following. Where are the foreign company’s products sold? Does cash flow openly between the American and foreign companies? Where does the foreign company purchases its goods and services?

Once the foreign company has been defined as either independent or integrated, the next step is to translate the foreign currency amounts into American dollars.

  • Independent Foreign Company

The accounts of an independent foreign company are translated at current exchange rates. The balance sheet dates determine the exchange rate in which all assets and liabilities are translated. An average exchange rate of the rates throughout the year is used for revenues, expenses as well as depreciation for that year.

  • Integrated Foreign Company

The accounts of an integrated foreign company are handled like they had occurred in American dollars instead of the foreign currency. Intangibles, tangibles, plant and equipment and inventories are translated using the exchange rate at the time these items were obtained. Monetary items are translated at the current rate. Revenues and expenses are translated at an average rate of the rates in effect all year. Only depreciation and amortization of intangibles are translated using a historical rate.

Because different accounts are translated at varying rates, the accounts will not balance. The measure of the exchange gain or loss must be added to the account to produce a balanced account.

Common Size Statements

Financial analysts have a variety of ways of sizing up a company’s worth. Ratio analysis is commonly employed. However, sometimes, analysts will use a variation of ratio analysis known as common size statements.

This form of analysis is unique because it evaluates all the financial statement components. Every item in a statement is in the form of a percentage of the largest item in the statement. This is helpful when analysts want to focus on the relationship of all the statement components.

In addition, it is a valuable tool for comparing two different years of the company’s statements or when two companies of varying size are compared. When comparing different size companies, it is easy for the large variations in dollar amounts to mask the differences in the relationship of the income statement components.

A variation of this method can be used taking the financial statements of a selected prior year as the base and then determining the components of all future years as percentages of each component in the base year.

The common size statement method is commonly employed with the income statements and the balance sheet. The largest item listed on the income statement is sales. Therefore, on a common size statement, all items are converted as percentages of sales. The largest item listed on the balance sheet is total assets or total liabilities plus stockholders’ equity. Therefore, on a common size statement, all items are converted as percentages of total assets.

Declining Balance Methods

Recording depreciation is an important part of accounting for long-term assets. Assets undergo wear and tear and their depreciating value must be tracked. There are three methods to choose from and among those choices are the Declining Balance Methods.

The main way this method differentiates from the others is that it charges more depreciation expense in the early years of an asset’s life than do other methods. The reasoning behind this accounting method is that a business uses up more of the asset in its earlier years. Assets tend to have less repair and maintenance in their earlier years. Most repairs tend to be made in the later years of the asset’s usage.

Two Types of Declining Balance Methods

  • Double Declining Balance Method: An accelerated depreciation method is based on the declining book value of the asset. Net book value is the historical cost of the asset less its accumulated depreciation. The Double Declining Balance method initially ignores salvage value which is an estimate of the amount a business anticipates receiving at the end of the asset’s life.

There are two ways to calculate the annual depreciation rate-

    1. Calculate the straight-line expense and double it.
    2. Calculate the expense by dividing 2 by the Estimated Useful Life and then multiplying it by the book value.
  • Sum-of-the-Years’-Digits Depreciation Method: This accelerated depreciation method uses the number of years of the asset’s expected life as a fraction. “The numerator is the number of years of estimated life remaining as of the beginning of the year, and the denominator is the sum of all digits and is the same for each annual computation” (Berry, Leonard Eugene. Financial Accounting Demystified. The McGraw-Hill Companies, Inc. 2011).

Deferred Income Taxes

Corporations pay taxes on their income. Traditionally, accounting income is used for the basis of taxation. However, this is not always the case because there are some forms of income that count as exceptions to this rule.

There are some forms of revenue and expenses that are calculated for both accounting purposes and taxation but not in the same year. In general, most companies use the straight line method when calculating depreciation. The law implores the use of a declining balance method for most tax calculations instead.

As a result, most companies have higher depreciation charges and lower income for tax purposes in the early years of their possession of the asset and lower depreciation and higher taxable income in the latter years. Fines and interest on unpaid taxes are not permitted as expenses for tax purposes.

Deferred income taxes come from these types of differences in recording methods. The most marked difference is seen in calculating depreciation. Because depreciation is calculated over the long-term life of assets, the deferred tax differences are noticeable long-term as well. Deferred taxes are not discounted to indicate future payment.

Consequently, corporations report large amounts that are considerably overstated on the balance sheets in comparison to the present value. Therefore, in financial statements ,the current income tax expense is reported apart from the deferred tax expense. A reconciliation of tax expense to tax levied is demonstrated by public companies to explain the reasons for the differences.

Depreciation and Amortization Transactions

Accurately tracking a company’s assets is essential for determining its net worth. Assets are things owned by the business. There are current assets like cash that can be easily liquidated. There are long-term assets like an office building that are not easily used for immediate needs. Depreciation occurs to tangible assets like equipment and furniture. Amortization is for intangible assets like patents. Both need to be calculated and considered an expense to your accounts. Both account for the wear and tear and decrease in value of an asset.

The Purpose for Tracking Depreciation and Amortization

Depreciation and amortization is used to account for a major purchase that will be used for a period of years. It shows the decrease of an assets value over time. “If you’d declared the total cost as an expense (the year you purchased it) you’d have an understatement of your company’s profit that year, and an overstatement of profit in the following years” (Accounting Savvy For Business Owners p.204).

There are many exceptions to the way depreciation and amortization accounts can be calculated. These regulations have been established by the IRS, the state and through court decisions. Look into the specific laws that apply in your area.

Entering a Depreciation and Amortization Transaction

When entering the depreciation or amortization into the journal, you reduce the value of the asset by posting a credit to the contra-asset account. At the same time, you increase expenses by posting a debit to the depreciation and/or amortization expense account. The company receives a tax deduction against the loss in value of the asset.

You may choose to create specific asset accounts to show accumulated depreciation for each type of fixed asset and separate asset accounts for the amounts of the original purchase price. Or, you may choose to have only one account for each asset category. In this case, when depreciation is posted, the single asset account balance is reduced.

Depreciation Methods

Selecting a method for calculating and recording depreciation will determine what is reflected in the accounting ledger. In fact, an accountant may keep one record using a particular method for tax purposes and another record using a different depreciation method for the company’s purposes. This is a legal practice.

The Generally Accepted Accounting Principles (GAAP) has different requirements than the tax laws when it comes to recording depreciation. This is because the two entities have different objectives. The company’s purpose for financial reporting is to measure it’s economic activity by matching revenues and expenses for a given period of time. The government’s purpose for tax laws is to collect revenue and to stimulate the economy.

Therefore, often accountants will choose the accelerated depreciation method for tax purposes because they offer the greatest tax deductions. But when it comes to using a depreciation method for company purposes, they may choose the straight-line depreciation method.

Steps for Recording Depreciation Expense

  1. Estimate the useful life of the asset: This amount is typically determined when the asset is new. It is measured in years or units of output.
  2. Estimate the salvage value: This is an estimation of the amount the company anticipates receiving at the end of the asset’s useful life.
  3. Compare the depreciation expense: Choose from the methods below. it is important to select a method and use it consistently throughout accounting practices. Typically, except when using the double declining method, the salvage value is deducted from the cost of the asset to determine the depreciable base.
  4. Enter the depreciation expense in the journal: Credit a contra-asset account called Accumulated Depreciation. This account reflects how much depreciation has been accumulated over the asset’s life.

Depreciation Methods

  • Straight-line depreciation
  • Units-of-output depreciation
  • Declining balance depreciation (This method can be broken down into 2 other categories).
    • Double declining balance depreciation
    • Sum-of-the years’-digits depreciation

Disability Insurance Payments

Disability insurance is funded through the federal Social Security program as well as through states and their own programs. For state disability insurance, employees contribute a very minute sum each week to fund the program. It may be as little as 60 cents. However, in some industries, the employer absorbs 100% of the cost usually established due to a labor union’s collective bargaining agreement.

The History of Disability Insurance in the United States

In the late 1950s, in order to be accepted into the program, a worker had to be already out of the workforce. Because working conditions were so much more severe than they are today, someone applying for disability insurance truly had no hope of ever being able to work again.

In the 1980s, the government loosened the tight restraints of disability insurance. An official medical diagnosis was no longer required. Congress widened the qualifications for disability insurance to include more subjective factors like pain and mental illness. Even with the added subjectivity, there were still many rejected. However, those rejected could appeal to an administrative judge without requiring a defense from Social Security explaining the reasoning behind the rejection.

Ultimately, more and more people were accepted into the program. Today, 1 out of 20 Americans from the ages 25 to 64 are on disability. There appears to be a correlation between a struggling economy and disability payments. Workers may be motivated to apply for the program and claim disability benefits when they foresee a layoff coming.

“The trustees said on Monday that the disability fund will be exhausted by 2016, two years earlier than they estimated last year. Disability payments won’t stop. But once the fund is depleted, a bigger share of payroll taxes will be diverted from the fund that pays benefits to old age pensioners and their survivors” (Porter, Eduardo. (2012, April 24). Disability Insurance Causes Pain. The New York Times).

Escrow Funds

Managing escrow funds doesn’t apply to every company. Mainly attorneys and realtors are under strict regulations about how they handle escrow funds for their clients. The rules for managing escrow funds are mandated by state law and the rules of your professional association. For example, all states require attorneys to maintain a separate bank account for escrow funds and professional associations put similar requirements on all those who collect funds from a third party on behalf of their clients.

Escrow funds (or trust funds) belong to your client but are collected from a third party on your client’s behalf. Securities, funds and other assets can be held in escrow. In business accounting, escrow funds are classified as liabilities. The escrow funds liability account is named “Funds Held In Trust.”

Tracking Escrow Funds

  • Open a separate bank account for escrow funds and add it to your chart of accounts. You may also choose to open separate escrow bank accounts for each client. This may assist you in tracking individual client’s escrow funds more accurately.
  • Create your escrow funds liability account named “Funds Held In Trust.” Again, you may elect to create separate liability accounts for each client.
  • The total funds in the liability account must always equal the total of the funds in the escrow bank account (or the combined totals if you have created separate accounts for each client).
  • A good rule of thumb: Every transaction, whether a deposit or a withdrawal, must be posted to the “Funds Held In Trust” liability account and must be linked the particular client.
  • When disbursing funds, make sure to write checks from the specific escrow bank account.

IRS Tip: Track hard costs (the real outlays for expense) and soft costs (internal overhead costs) separately. To create an appropriate audit trail, choose to write separate checks for reimbursed expenses, internal expenses, and fees.

Earnings Per Share

This is the single most used financial ratio and is an invaluable method for evaluating a company’s success. It is a concise way of presenting the company’s profitability. Earnings per share is the earnings of a company divided by the number of shares of stock outstanding.

By looking at a company’s earnings per share, an investor can clearly see how effective it is at creating earning for individual shareholders. As a company increases the number of shares of stock, the total earnings also increase in response to the additional investment made into the company by more shareholders.

For investors to only concentrate on the total earnings would give the impression the company was doing better than before. However, the basic equation for the earnings per share paints a more authentic picture for the investor.

Earnings per share = earnings

number of shares

The number of shares outstanding can decrease or increase based on several factors:

  1. Satisfy employee stock options
  2. Issue or retire shares of stock
  3. Fulfill obligations to convert bonds
  4. Combine with other companies

The above equation simplifies things. However, it gets more complicated than that. There are preferred stockholders and common stockholders. When dividends are paid out to preferred stockholders, they must be subtracted from earnings in order to show what is available to common stockholders.

Diluted earnings per share is the most complex equation. Typically, accountants must use reference materials in making these calculations. For a layman, they are much too complex. Perhaps the earnings per share equation is overemphasized by investors. They would be well advised to consider treating the equation like any other ratio when applying their analysis.

Employer’s Quarterly Federal Tax Return

Meticulous payroll record keeping helps makes filing tax forms less stressful. You only need to file Form 941 to report all of the payroll related taxes. This form must be filed quarterly. It’s required of all employers who pay wages subject to income tax withholding and social security and Medicare taxes. Form 941 must be filed on the last day of the month that follows the end of the quarter.

Accurate federal quarterly spreadsheets will assist in filling out this tax form. There is a voucher as part of Form 941 that small employers can use to pay their taxes. If the tax due for the quarter is less than $2500, monthly payments aren’t necessary. Instead, pay the quarterly tax simply when Form 941 is filed.

A Breakdown of Form 941

Line 1: Equals the number of employees on the payroll

Line 2: Total wages

Line 3: Total federal income tax withheld

Line 4: Check off if no wages subject to Social Security and Medicare

Line 5: Calculation for Social Security and Medicare wages and tips

Line 6: Total taxes before adjustments

Line 7: Calculations for adjustments

Line 8: Total taxes after adjustments

Line9: Report advanced earned income credit (EIC) payments made to employees

Line 10: Subtract line 8 from line 9

Line 11: Total deposits for this quarter

Line 12: COBRA premium assistance payments

Line 13: Add lines 11 and 12

Line 14: Balance due

Line 15: Overpayment

If an error is discovered on a previously filed Form 941, make the correction using Form 941-X. File Form 941-X separately. Only report one calendar quarter per form. Seasonal employers do not have to file Form 941 during quarters where they have no paid wages. Employers of household employees and farm employees are exempt from filing this form.

The Essential Balance Sheet

Although the balance sheet is a very basic financial statement, it provides an essential glimpse of the company’s well-being. It offers a quick picture of the company’s financial condition at a specific point in time. The company’s condition is determined by comparing the assets versus the liabilities and stockholders’ equity. It is called a balance sheet because the two sides must balance each other out.

Three Categories of the Balance Sheet

  1. All assets owned by the business
  2. All liabilities incurred to finance these assets
  3. All contributed capital and retained earnings, any financing provided by stockholders and earnings retained in the business entity.

Assessing Assets

Assets are economic resources possessed by a company that can be converted to cash. The balance sheet records the economic value of the assets held by the company. They may be tangible like an office building or intangible like copyrights and computer software. Tangible assets are divided further into two other categories: current assets and long-term assets.

Current assets account for resources that will be sold with the next year. They include very liquid assets like cash, assets for sale like inventory and productive assets like equipment. These are listed under current assets on the balance sheet with the most liquid assets listed first.

Long-term assets are not intended for resale and are held for longer than one year. In this section, depreciation is taken into account. The accountant chooses a depreciation method and applies it to calculate the annual depreciation charge for each which is deducted from the asset’s value.

Determining Liabilities

Liabilities involve legal debts or obligations to lenders, suppliers, and employees. To remove the debt, a business must transfer assets (money or goods) or provide services. Like assets, liabilities are sub-divided into two categories on the balance sheet: current liabilities and long-term liabilities.

Current liabilities are obligations to be settled within the next year. They include accounts payable, wages payable, advertising payable, for example.

Long-term liabilities are obligations to be settled in the future, beyond a year. Often, these involve periodic payments of a principal with interest. They include mortgage loans, promissory notes and deferred taxes.

Equity Controls

Internal controls are essential for protecting a company’s resources and for protecting it from fraud. Certain systems are established at the operational and management level to ensure the company’s resources are directed in ways intended by the board of directors and upper level management.

Transaction controls monitor the basic transactions of a business like sales, collections, purchases, payments and payroll. Asset controls are put into place to oversee various assets like cash, investments, receivables, inventories, and plant and equipment. Equity controls set up procedures to manage the obligations assumed by a business.

Equity Controls

To operate, a business undertakes various obligations. These obligations can be closely monitored through the establishment of various internal controls.

  • Accounts Payable: Accounts payable must be settled regularly. At the end of the month, the total individual accounts payable is compared to the general ledger control account. Statements from suppliers are compared with amounts shown as payable. Of course, any differences found must be investigated.
  • Short Term Debt: The authorization to borrow is typically in the hands of one or two senior officers. An upper limit is established. Any notes payable should have two signatures for added checks and balances.
  • Long Term Debt and Equity: The board of directors should approve any long term debt and equity financing needed by the company.

It is the practice of large companies to hire an independent agent like a trust company to serve as registrar and transfer agent of their securities. They may also appoint independent agents to perform the function of interest and dividend payment agents as well.

Financial Statements and Notes in an Annual Report

After the glossy and polished pages of the front sections of the annual report have been perused, the meat of the annual report is really comprised of its financial statements. Although the letter from the company’s president is informative, it is the figures of the financial statements which disclose the true state of the company’s finances.

At the very minimum, an annual report always consists of a balance sheet, income statement, statement of cash flows, the notes, report of Management Responsibilities and auditor’s opinion. The notes could be viewed as afterthoughts. However, they can be as valuable as the financial statements themselves.

The Notes

This section includes various information such as accounting methods used, noncurrent liabilities and their due dates, commitments, inventory components, employee pension provisions and many other financial disclosures.

Report of Management Responsibilities

This section is management’s opportunity to offer proof and assurance that its reports are true. There is a short discussion of controls the management uses to ensure accuracy. It is management who is primarily responsible for the precision and thoroughness of the information presented.

Auditor’s Opinion

This section gives the auditor’s opinion of the financial statements prepared by management. It is a short report addressed to the company’s shareholders. An unqualified opinion is a good sign and should be reassuring to investors. However, qualified opinions indicate possible instability. If the phrase “except for” appears, this should serve as a red flag to investors.

In addition to these components, an annual report may also include the following:

  • A summary of quarterly figures for the current and previous year
  • Financial reporting and changing prices
  • Reporting by divisions or other principal departments of the business
  • Five-year summary of operations

FASB No. 117: Financial Statements for Nonprofits

The Financial Accounting Standards Board (FASB) is the authoritative entity that governs over the guidelines for accounting. They dictate the principles to follow so that every nonprofit’s statements can be understood on an equal plane. FASB Statement No. 117 determines the specific information to be reported in financial statements and how to report it.

Financial Statements for Nonprofits Required by the FASB

All nonprofits should provide an exhaustive set of financial statements which includes reporting on assets, liabilities, net assets, revenues, expenses, gains and losses.

The statements are as follows:

  • Statement of Financial Position: This is also known as the Balance Sheet. It is used to give a comprehensive picture of a nonprofit’s finances.
  • Statement of Activities: This reveals how the net assets of the nonprofit have increased or decreased.
  • Cash Flow Statement: This signifies how the nonprofit’s cash position has fluctuated. It is the same statement required for the for-profit companies. it must include net cash from operating activities, financing activities, and investing activities.
    • Operating Activities-This is the change of cash for all other areas not covered in financing and investing activities.
    • Financing Activities-This is the amounts received from long-term borrowing and any repayments.
    • Investing Activities– This is the amounts spent to purchase long-term assets or the sale of them.
  • Statement of Functional Expense: This statement is not required for all nonprofits but it is encouraged. Currently, it is mandatory for voluntary health and welfare organizations. The purpose of the statement is to demonstrate by line item and category the organization’s specific expenses. This is, in essence, a statement categorized by function of the expense like programming and fundraising and by the nature of the expense like rent, printing, salaries etc. Nonprofit accounting software is set up to help generate this statement with its specific expense classifications.

Financial Standard Form 269

This form is required of nonprofits who’ve received grant funding. Although many reports must be submitted to the federal grantor, this one is by far the most important. It is known as the Financial Status Report.

Basically, it informs the grantor how much of the grant money was spent during the current quarter versus previous quarters. It reveals how much money is still left in the grant budget. This report is due quarterly and also when the grant period is over.

Financial Status Reports are available in two forms: a short from (SF-269A) and a long form (SF-269). The grantor will specify which is required for each particular nonprofit. Traditionally, it necessitates 90 minutes for completion.

Forms should be submitted electronically or by fax. Filing them online will expedite the process. However, for extra assurance, the organization may file them both ways.

Details of Financial Standard Form 269

  • Items 1-9 cover general information like the awarding agency, the name of the recipient organization, its account number, the grant period and period covered on the form etc.
  • Item 10 contains 3 columns for transactions-
    • Column 1: Previously Reported. This represents the cumulative amounts from the previous reports. If this is the first report, then the amount is zero.
    • Column 2: This Period. This shows the current amount spent during the current reporting quarter.
    • Column 3: Cumulative. This is the sum of the Previously Reported amount and the amount reported in This Period.

Specific transactions are then broken down into categories. Enter the amount of the transaction in one of the first two above columns and then enter the cumulative total for that category in the third column.

  • Item 11 deals with checking the appropriate type of indirect cost rate.
  • Item 12 is for any additional remarks.
  • Item 13 is for the official certification by the director of the organization. If it is isn’t signed, an auditor will write up the organization.

FASB No. 116 for Nonprofits

In order for a nonprofit organization to maintain good standing with the IRS and the community, it must follow the rules governing the accounting and reporting for nonprofits. The FASB is the entity that sets these standards. The state or IRS enforce the rules they establish.

No. 116: Accounting for Contributions Received and Made

Because most nonprofits rely heavily on donations to fund their programs and activities, following these guidelines will assist nonprofit tracking and accounting.

  • Contributions received are considered revenues in the period they are received. They are to be recorded at their fair market value. It is important to record donations within the time frame they are received.
  • Contributions made are considered expenses in the period they are made at their fair market value. This is the flip side of the above regulation. This applies to donations given by the nonprofit to someone else.
  • Unconditional promises to give should be recognized as revenues in the period received at their fair market values. These are donations received that have no conditions on them as to how and when they should be used.
  • Conditional promises to give, whether received or made, should be recognized when they become unconditional. A donation received with a conditional promise to contribute when certain requirements set by the donor are met are recorded as refundable advance (liability). When the requirements are met and the gift becomes unconditional, then it is to be recorded as revenue in the period it becomes unconditional at its fair market value.

Three Types of Net Assets

Donations need to be classified as one of these three when the nonprofit’s financial statements are completed.

  • Permanently restricted net assets
  • Temporarily restricted net assets
  • Unrestricted net assets

Under No. 116, nonprofits are also required to track contributions of volunteer time. Hours must be recorded for volunteers whose services create or enhance nonfinancial assets like the renovation of a building.

In another case, the services provided by volunteers that require specialized skills that would typically need to be purchased if not provided as a donation must be accounted. Determine the fair market value for services like these and record them on the financial statements.

Financial Statements for External Entities

Financial statements are often produced monthly and some, at the end of a tax year. They assist management in taking the “pulse” of the business. Understanding financial statements and drawing appropriate conclusion from the figures is essential for optimal business growth.

However, financial statements aren’t just for the benefit of the internal operations of a company. Many external entities require them as well. Preparing them properly and according to GAAP accounting principles is vital.

External Entities Who Use Financial Statements

This list is by no means exhaustive. It is meant to demonstrate the purpose financial statements serve beyond the scope of their internal function.

  • Current Equity Investors & Lenders: Just like internal management, current investors and lenders use financial statements to monitor the value of their investment and to evaluate the company’s performance.
  • Prospective Equity Investors & Lenders: Financial statements serve potential investors and lenders with the necessary information to decide whether or not to invest in the company.
  • Investment Analysts, Money Managers & Stockbrokers: They use financial statements to help them make appropriate recommendations to their clients about buying, selling and holding onto the stock options offered by the company.
  • Major Customers & Suppliers: Financial statements assist them in evaluating the financial strength of the company. The statements reflect the company’s stability or lack of as a dependable resource for their business.
  • Labor Unions: In defense of the employees, labor unions monitor the company’s financial statements to see if a pay increase is merited.
  • The Board of Directors: Financial statements provide a snap shot into the performance of the company’s management.
  • Competitors & Potential Competitors: They use a company’s financial statements to compare with their own financials. Potential competitors use them to determine how profitable it may be to enter that particular industry.
  • Government Agencies: Use them for taxing, regulating and investigating a company.

Filing Employee W-2 Forms

Producing W-2 forms for each employee on payroll is time consuming. But minute attention to detail and accurate record keeping will assist in making this process as painless as possible. In addition, today’s accounting software helps facilitate the task. It is advantageous to double check every W-2 sent out by your company. Minor errors can lead to costly penalties. If some information is incorrect, the form is illegible, or some information is not included, the W-2 will require correction. If corrections aren’t filed and the reasons for not filing don’t meet any of the permissible exceptions, you will be required to pay $50 per return.

Employees must receive their W-2s by January 31. This means they must be mailed on or before January 31. If the date falls on a week-end, you are given until the following Monday to give the forms to the employees. If an employee leaves the company, the W-2 form can be supplied before January 31.

The W-2 Form generally contains six copies. Four copies are given to the employee. The employee then disburses them accordingly- one for the employee’s own file, one to file with federal income taxes, one for state income taxes and one for local income taxes. In addition, one copy is kept by the employer and one is sent to the federal government. Some states do require an eight-copy W-2 however. The purpose for this is so an additional copy can be filed with the state tax department and one with any applicable local tax authority.

After all the hard work of compiling and verifying the W-2s is complete, the numbers from the W-2s need to be total and transmitted onto the W-3, also known as “Transmittal of Wage & Tax Statements.” In essence, it serves as a summary of the employer’s total payroll for the year.

Financial Leverage

Levers are necessary in physics to enable the lifting of a nearly impossible weight. With their application, they permit the use of less force than would normally be required without them. There are two forms of leverage applied to companies to bring in an increase of profits to its owners: operating leverage and financial leverage.

Operating leverage balances the mix of fixed and variable costs in its operations. Financial leverage is the degree to which a company utilizes borrowed money. All companies employs some degree of financial leverage. The manipulation of costs and investments allows companies to maximize their profit.

Financial Leverage

Investors may choose to use financial leverage to increase the return on their investment in a company. Instead of investing all the assets a company requires, they may choose to invest some of their own capital while borrowing the remainder needed. Borrowed money does introduce an annual interest charge. Despite the cost of interest, the return on owner’s equity can increase.

However, when interest rates are high or the return on assets is low, financial leverage may be a poor investment tool. When a company enters into debt, it puts the company at risk. It may find itself paying higher interest rates on borrowed funds than predicted.

Financial leverage can maximize the advantages of growth but any damage that occurs if business slows is also maximized. An investor should examine a company’s debt structure and profit patterns to adequately analyze its use of financial leverage. A company will list their costs by function and not by behavior.

The Fundamentals of an Annual Report

An annual report functions to satisfy the informational needs of a variety of entities. Stockholders, economists, financial analysts, suppliers, customers, creditors, even potential stockholders and potential creditors use the published annual report for their particular purposes. Central to every annual report is the company’s financial statements.

These financial statements have been standardized through regulations set by the Financial Accounting Standards Board, the Securities and Exchange Commission, and a variety of committees in the American Institute of Certified Public Accountants. Interestingly, the formulation and publication of annual reports can be a big business in itself.

A large corporation may pay an independent CPA over half a million to audit its financial statements. In addition, another large sum in invested in the publication of the report electronically and in full-color for distribution to shareholders. An annual report is compiled with the financial statements toward the back of the publication. In the front, impressive graphs, artwork and photographs are featured.

Management oversees the publication of the first section of the annual report while accountants control the last section.

The management section includes…

  • Annual Report Highlights

Often, these include the positive trends to which management wants to draw attention. It also covers highlights of the company’s operations, financial statements, stock performance, sales and profits etc.

  • Letter to Shareholders

This letter is from the president or both the president and the chairman of the board. It is often a flowery presentation of optimism about the company. It takes discernment to read between the lines in attempt to discover the true position of the company.

  • Management Discussion and Analysis

This section is required by the Securities and Exchange Commission. Its purpose it to analyze the company’s performance. Management is required to disclose the company’s results of operations, the adequacy of liquid capital resources, and capital resources needed to fund operations.

  • Report Required by the Sarbanes-Oxley Act

The company must summarize its assessment of the adequacy of its internal controls system over financial reporting in this section.

Generally Accepted Accounting Principles

Like many professions, accounting has established principles to standardize its conduct despite jurisdiction. These rules help ensure consistency in concepts and procedures. The Generally Accepted Accounting Principles ( GAAP) are these standards. They apply only to financial reporting in the United States.

Efforts are being made to establish an International Financial Reporting Standards due to the ever-increasing global economy we find ourselves in. Companies the world over following similar accounting principles would enable more accurate comparisons of world-wide financial statements.

The Financial Accounting Standards Board

A board known as the Financial Accounting Standards Board (FASB) sets the accounting standards for the GAAP. It is comprised of business people, financial executives, practicing accountants, and accounting academicians. GAAP have accumulated and evolved over time. Several bodies, including the American Institute of Certified Public Accountants, the SEC, the American Accounting Association give input to the FASB.

The principles set forth by the FASB come from traditional accounting procedures. A lot of the procedures are ethical in nature. For example, the “principle of sincerity” establishes that those tracking a company’s finances will do so honestly, giving a true portrayal of the company’s financial status.

The GAAP is the guide for preparing financial statements for review by outside entities. Currently there are more than 150 “pronouncements” as to how to account for different types of business transactions. GAAP are not static. Changes in the rules have a potentially huge impact on American businesses. The study of accounting involves learning the GAAP and mastering how to apply them to actual business transactions.

In addition to the GAAP, the IRS provides accounting principles and procedures for handling taxation. Being well-versed in these can assist in providing the appropriate financial information required come tax time.

Grant Reporting

When a nonprofit is awarded grant money, it is required to report the specific uses of this money. The Office of Management and Budget (OMB) outlines these requirements and enforces them. There are primarily two reports that are required.

Required Report for Grant Money Use

  • Standard Form 269

This serves as a financial status report. It must be filed quarterly and also when the grant is complete. It is a summary of how much money was awarded the organization, how much money was spent and how much money remains.

  • Standard Form PPR

This is a progress report for the federal government submitted semiannually. It shows whether or not the nonprofit is achieving the program’s goals and objectives for which the grant money was allocated.

These financial status reports must be filed even when no money has been spent during the given quarter. The reports must be filed on time. The federal government is adamant about paperwork. If for some reason, grant reporting ceases, the provision of grant money will stop as well.

When a nonprofit is awarded a grant, it is assigned a program manager. The program manager monitors the program’s progress and is also available to answer any questions pertaining to the grant. They want to help the nonprofit succeed.

Most federal programs are also helpful. They offer an annual grant management meeting to review guidelines for how to manage grant money. it is also an opportunity to interact with others from nonprofits who have been awarded the same grant.

Grant Audit

Grant money can open up programs for the community every nonprofit dreams about. However, as nice as it is to obtain federal funding, there are stringent reporting standards that must be adhered by in order to maintain good financial standing with the awarding agency. In order to properly monitor the nonprofit’s use of funds, a grant audit will be performed.

A grant audit’s purpose is to assess and evaluate the organization’s performance and compliance with federal requirements. When a grant is awarded, a program manager is assigned to the organization as a primary contact. The program manager regularly monitors progress and evaluates documents pertaining to the grant money and programs.

Depending on the grant, some programs have strict monitoring guidelines. In addition to routine contact with a program manager, a program officer performs the audit. He will actually visit the site of the organization and thoroughly evaluate documentation.

The program officers work for the federal agency that awarded the grant money. They use government auditing standards (GAS). When a grant recipient receives $500,000 or more, it must adhere to the rules in the GAS book, also known as the Yellow Book for its yellow cover. The nonprofit’s financial statements are of interest but also how the organization is following the laws and regulations.

The audit performed is in accordance to GAS and the generally accepted auditing standards (GAAS). Three circulars outline specific rules for the use of federal funding- OMB Circular A-133, OMB Circular A-122, and 2 CFR 215.

If the nonprofit receives less than $500,000 in grants in a year, the federal agency awarding the grant will review the records along with the General Accounting Office (GAO).

Handling Subgrantees

When awarded grant money, a nonprofit organization is responsible to account for every penny spent. But there are times when the organization granted the money not only is responsible for its own handling of funds but of other organizations as well. These other organizations are known as subgrantees.

They form a partnership with the lead organization or grantee when applying for the grant. The grantor is the federal agency that awards the grant. The grantee reports directly to the grantor whereas the subgrantees have little direct contact with the grantor. All of their reporting goes directly to the grantee.

Responsibilities of the Grantee

  • Submits all reporting requirements to the grantor.
  • Outlines reporting requirements to the subgrantee.
  • Oversees the actions of its own nonprofit as well as the actions of the subgrantee.
  • Establishes an agreement with the subgrantee that is similar to its own with the grantor.
  • Sets deadlines for financial and progress reports from subgrantee.
  • Submits the overall Performance Progress Report to the grantor for both itself and the subgrantee.
  • Verify subgrantee expenses in order to approve reimbursements.

It is invaluable to have a written agreement or contract between the grantee and the subgrantee. The person responsible for the overall management of the grant should sign the agreement. Typically. this is the nonprofit’s executive director. However, just because he signs it doesn’t mean he has to manage the program. He simply is claiming responsibility for it.

Keep copies of the subgrantee’s paperwork. The grantee is ultimately accountable for the subgrantee’s spending. The grantee will have to answer to the federal agency and justify both its own expenses as well as that of the subgrantee.

Handling Manufacturing Costs

Manufacturing costs are considered assets and are calculated as part of the cost of manufactured units in inventory until the units are sold.

There are three main types of manufacturing costs:

  1. Labor
  2. Materials
  3. Overhead

All three types of manufacturing costs are classified as assets under “work-in-progress inventory. “On the balance sheet, this section can be found under current assets or displayed in the notes section in financial statements.

The accounting for manufacturing costs contrasts with the way nonmanufacturing costs are recorded in the timing of their charge against earnings. Manufacturing costs are called product costs. They are labeled like this because manufacturing costs are not fully expensed until the product is sold.

When the manufactured units are complete, all manufacturing costs that were charged to the work-in-process inventory are moved to the finished-goods inventory. The finished-goods inventory is another asset account. Once the manufactured units are sold, the manufacturing costs are transferred to an expense account known as cost of goods sold.

A Breakdown of Manufacturing Costs Classifications

All raw materials used, direct labor and factory overhead compiled together to form the cost of manufacturing a unit is considered work-in-process inventory which become finished-goods inventory and once sold transfers to a cost of goods sold expense.

Factory overhead is the catch-all for all the indirect production costs that doesn’t include the raw materials and labor directly to produce the unit. Factory overhead includes more specifically factory and equipment depreciations, general supplies, the costs of supervisory personnel, maintenance, energy, and insurance.

Hiring New Employees: Filing Government Forms

All businesses that hire staff must have an Employer Identification Number (EIN). You must have this number in place before hiring. The IRS uses it to track your company’s employees.

Government Forms to File:

  • W-4 or Employee’s Withholding Allowance Certificate
  • I-9
  • W-5 or Earned Income Credit Advance Payment Certificate (if employee is eligible for the Earned Income Credit (EIC)

Start a file for each employee, keeping records of the forms filed as well as proof that this employee has the right to work in the United States. This can be in the form of a driver’s license, birth certificate or Social Security card.

W-4 Form

Normally, keeping this form in the employee’s file is all that is required. However, you need to send it to the IRS immediately if the employee:

  • claims more than 10 withholding allowances
  • will earn more than $200 per week but claims to be totally exempt from withholding tax (often as is the case when hiring a student or part-time employee)

The information received from this form is crucial for calculating the reductions in the employee’s salary for federal, state and local taxes.

I-9 Form

This form proves the employee’s eligibility and identity. Attach copies of the employee’s Social Security card and driver’s license or birth certificate. Keep this information in the employee’s personal file.

W-5 Form

If the employee is eligible for EIC (see above) then this form is required or you may choose to use the “Earned Income Credit Advance Payment Certificate.”

Handling Employee Expense Accounts

An employee travels to a trade show for a few days and incurs business-related expenses for travel, food and lodging. Another employee takes a potential client he’s wooing out to lunch. An employee runs a quick errand to purchase office supplies. Another employee uses his own car for business purposes. These are all typical scenarios of reasons why employees need reimbursements.

The company sets the rules for what qualifies for a reimbursement. Keeping accurate records of these detailed reimbursements will not only be valuable for reconciling accounts but for monitoring employees as well. A well-compiled spreadsheet of employees’ individual ledgers can alert the accounting department of an employee taking advantage of the company’s policies.

How to Post Employee Expense Accounts

Often management must first approve the expense report of an individual employee before it gets sent to accounting. The entries need to be posted in the cash disbursements journal and the corresponding expense accounts. These details must also be compiled in the employee’s records. It is recommended that the expense report and copies of the submitted receipts be kept in the employee’s file. The records could be need for verification if questions arise at a later date.

Sometimes employees are required to submit their expense report immediately upon return or the accounting department may choose to schedule one day a week where the reports are reviewed and paid. This is advantageous because it allows accounting to manage their work load more predictably.


In accounting, numbers must be calculated with precision and books must balance. However, not everything works out so nice and tidy. There are some items where an exact amount cannot be taken into account.

Intangibles are assets whose value can occasionally be difficult to nail down. Intangibles are recorded at cost but only when a cost can be assigned to a legal right or transferable form of intangible asset.

Examples of Recorded Intangible Assets

As a result, intangibles are often left unrecorded. Examples of intangibles represented by legal rights are patents, trademarks, franchises, licenses, and copyrights. Those things referring to transferable trade secrets are customer lists and product formulas.

Patents are only assigned the costs incurred directly from obtaining the patent or sometimes in defending them. If the patent was purchased, the amount paid is an asset. However, if the patent was required through research, the cost of the research is considered an expense, not the value of the patent.

An Exception: Goodwill

When a business is purchased, the amount paid for it includes the tangible and intangible assets. At times, the price of the business may exceed the estimated value of the tangible assets and the legal or transferable intangibles. The excess is for the other intangibles defined as goodwill.

A business in financial distress will be purchased for less than the value of its tangibles and identified intangibles. Therefore, this business would have negative goodwill.

Goodwill is only recorded at the transference of the business, never otherwise. Goodwill appears on the balance sheet at the time of selling the business.

Income Tax Allocation

Why do accountants bother to allocate? It’s a tough enough job determining how much income tax a company owes at the end of any given year so why would an accountant complicate things by attempting to “allocate” portions of taxes to periods other than the ones in which they are coming up as due?

This question has led to countless arguments and debating among accountants and non-accountants, and it has, in general, helped to keep the profession of accounting from being deadly dull. The next couple of blogs I intend to shed light on the reasoning behind some of the theories.

In short and to begin with, the answer to the question “why bother?” can be reduced to a brief statement that we will be elaborating on, but here is the quick of it; “the determination of periodic enterprise income rests upon the process of matching costs with revenue on a logical basis. Such matching is virtually synonymous with accrual basis, rather than cash basis accounting. Therefore, we must allocate. To summarize, the question is: Why isn’t the income tax that we actually have to pay the amount of income tax that should show as our current income tax expense in our income statement? The answer is that the income tax burden must be matched (accrued) with the items of revenue and expense that generate it. To treat the tax as an expense in a given year only because we pay it, or owe it, makes no sense at all”.

Investment Centers

Investment center is a term describing accounting units used by managers responsible for capital investment decisions, revenues and current costs in large corporations. It measures the profit contribution of a particular division in the corporation in terms of the rate of return on the department’s assets. This reflects and measures the manager’s job performance.

Flaws in the Rate of Return Calculations

To calculate the return on investment, one uses the current revenue and expense measurements and historical asset costs and depreciation in a formula. However, this is not always an adequate way to measure investment options. Investment in intangibles is recorded as a current expense at the time of the investment but doesn’t take into account its ongoing value.

Leased assets are not considered part of the investment base although they may signify a large investment commitment. Inflation also plays a part because it can cause distortions in the rate of return. Yet, adjustments for inflation are never made. When depreciation is recorded, it too distorts the calculation because it reduces the recorded value of investments.

If management solely relies on this calculation, they may be lead to make poor business decision based on distorted or inflated figures. In addition, these figures may imply the decision is beneficial for the investment center yet may be a poor business move for the corporation in its entirety. However, the accounting rate of return continues to be a common accounting practice primarily because income is measured and reported in general accounting terms.

Long-Term Assets Accounts & Depreciation

The first category of accounts on the balance sheet is the company’s assets. Cash accounts and inventory are listed as current assets. Next, long-term assets are accounted for. These are things owned that are not easily used for immediate needs.

In taking into account long-term assets, depreciation of the value of these assets needs to be considered. Depreciation reduces the value of a tangible asset over a set number of years and records an expense for that asset as it is depreciated. This is an important business management tool to easily track the life span of assets. Calculating depreciation allows you to determine the remaining useful time of your assets and to budget for replacement and repairs.

You want any asset account and its depreciation account listed next to each other on the balance sheet. This way anyone looking at the balance sheet will easily see the true value of the asset. The depreciation account is always a negative number.

Primary Long-Term Asset Accounts & Depreciation

  • Land: This is one of the few long-term assets that doesn’t depreciate. Its cost is separated from the cost of buildings or other structures on it.
  • Buildings: List the value of any buildings the business owns.
  • Accumulate Depreciation-Building: Because buildings are a depreciable asset, add a line to track the depreciation.
  • Leasehold Improvements: Facilities the company leases are listed here. Record funds spent on improving the property.
  • Accumulated Depreciation-Leasehold Improvements: Note the depreciation of any improvements made to the lease property.
  • Vehicles: List all cars, trucks and other vehicles the business owns. Base the number on the vehicle’s current market value at the time it’s put into company service.
  • Accumulated Depreciation-Vehicle: Track the depreciation of all company-owned vehicles.
  • Furniture and Fixtures: All furniture and fixtures in offices, warehouses and retail stores.
  • Accumulated Depreciation-Furniture and Fixtures: Record the depreciation from wear and tear on these assets.
  • Equipment: Track equipment like computers, copiers, cash registers you expect to use for the business for one year.
  • Accumulated Depreciation-Equipment: Record the depreciation on business equipment.
  • Organization Costs: Record start-up expenses. These are intangible assets (not physical objects) that cannot be written off all in one year. For example, licenses, patents, trademarks and brand names etc.
  • Amortization-Organization Costs: With a tax advisor you can determine how to write off amortization expenses where you decrease the value of intangible assets.
  • Deposits: List deposits made for rental property, to open an utility account or anything else to take care of other business needs. It is considered an asset because it is money that will eventually be returned to the business. When it is returned, the amount is subtracted from this account and added to one of the cash accounts.
  • Other Assets: Functions as a catchall for any other asset that can’t be categorized in the above accounts.

Lease Accounting

Lease accounting has been a sticky issue for analysts, businesses and accounting rule makers for some time. Recently, the Financial Accounting Standards Board and the International Accounting Standards Board came to a conclusion that may appease all parties involved. The new rule is set to be implemented in 2013.

The new rule will shift the appearance of several corporations’ balance sheets. In the past, lease agreements were ways to own something without having to account for it. A company could own something without having to list it as an asset or list the payment as a liability.

For example, airline balance sheets were not true representations of the company’s actual debts and assets. The balance sheet showed an airline owned few planes and had very little debt. In actuality, they were leasing the planes.

Originally, there was a proposal for leases to be treated like a purchase and a loan. This outraged many corporations. When money is borrowed, more interest is paid upfront in the first stages of the loan. It was suggested that a lease be accounted for in the same way.

However, this was not always an accurate portrayal of what was actually paid on the lease each month. Instead, the boards have developed a method that treats the lease differently according to its purpose. If it leads to eventual ownership, it would then be treated as in the original proposal above.

On the other hand, if the lease conveys a small percentage of the life or value of the leased asset, it should be acknowledged evenly over the lease term. These more specified classifications for lease accounting helps corporations and analysts alike support this new accounting development.

Managing Retainer Accounts

The word retainer is most often associated with the law profession. But businesses that provide ongoing professional services use retainers as well. For example, attorneys, accountants, financial advisors, and technical support companies, to name a few, collect retainers. A retainer can be more specifically defined as an amount of money that acts as a fee pre-payment. If it is not entirely used, it is refunded to the client.

As the work is performed, invoices are sent and money collected which is retrieved from the retainer. If the invoice amount exceeds what is left in the retainer, you must collect another retainer fee from the client. If this is a common way for you company to conduct business, it is advisable to open up a separate bank account to hold the retainer funds. Preferably an account that earns interest like a bank savings account or better yet, a money market account. Make sure the total amount of retainers matches the balance in the bank.

Tracking Retainer Funds

To track retainers, create a liability account titled “retainers.” When a client gives your company a retainer, enter this amount as a deposit under the retainer account. A good rule of thumb to keep in mind is “(m)oney you received as a retainer becomes spendable when you earn it” (Accounting Savvy for Business Owners p.112).

At the time you receive payment with the sent invoice, you apply this amount to your income account. Reduce this amount in the retainer account with a line item “applied from retainer.” If the amount exceeds the money in the retainer account, simply issue another invoice for the remaining amount due. You don’t post an amount to Accounts Receivable if there is enough money in the retainer because you are not awaiting payment from the client.

Monthly Credit Card Fees

Today, in business transactions, credit cards are a common form of payment. If your company accepts credit cards as a type of payment, it pays to be aware of the specific credit card fees involved and how to record them. In addition, the bank may charge a start-up fee as well. An awareness of these fees in conjunction with the services to customers the bank provides will help your company evaluate if this arrangement is worthwhile.

Monthly Credit Card Fees

There are a variety of potential fees and hidden fees that might not be obvious. After reviewing this long list of potential fees, a business really needs to evaluate if it conducts enough credit card transactions to off-set the expenses of offering the option to customers.

  • Address Verification Service Fee (AVS): This is a pre-transaction fee designed to prevent credit card fraud. It is primarily valuable for businesses taking credit card information by phone or online because they don’t have the card in hand to verify the signature.
  • Discount Rate: Based on a percentage of the dollar sale or return transaction. The rate varies from business to business depending on its classification.
  • Secure Payment Gateway Fee: A set monthly fee which gives a service to e-commerce merchants to process transactions securely online.
  • Customer Support Fee: A monthly fee is charged to offer the business support and help 24 hours a day all year long.
  • Monthly Minimum Fee: The least a store must pay to accept credit cards even if the credit sales don’t generate enough in transaction fees. Typically, the cost is $10-$30.
  • Transaction Fee: Anytime a credit card transaction is made or even attempted, a fee is charged.
  • Equipment and Software Fees: Most credit card equipment is purchased or leased for a fee. A fee may be charged for use of credit card related computer software.
  • Chargeback and Retrieval Fees: If a transaction is disputed, fees are charged.

Credit card costs are recorded monthly in the Cost of Sales section of the Profit & Loss statement. In the chart of accounts, make sure you have an account marked “Credit Card Fees” to accurately record the specifics of these expenses.

Managing Company Cash: Determine a Cash Budget

Tracking the use of a company’s cash is important. Most every company provides some form of petty cash to have on hand for minor business expenses. Not only is the accountant responsible to record cash flow but he must also assess the amount of any excess cash to be invested in order to maximize the asset’s return to the company.

Cash is the most liquid asset a company has in its possession. Investments of excess cash in short-term investments earn interest. In larger companies, cash management may fall under the treasurer’s function. However, the accountant must provide the necessary information so the treasurer can correctly perform his job.

Determining a Cash Budget

A treasurer will use the cash budget determined by the accountant. A cash budget is necessary to establish the appropriate amount of cash to have on hand. This includes petty cash which is the small amount of cash available for small purchases by employees or for giving change to customers.

In regards to the company’s long-term financial goals, the cash budget also sets a cash level to help conclude if there is excess cash to be re-invested. Excess cash should then be invested in short-term investments.

    • Cash Equivalents: Investments in securities maturing within 90 days. It is advisable that these securities have a low risk of loss of value. This includes money market accounts, government bonds, Treasury bills, and commercial paper.
    • Short-term Investments: Investments in securities maturing in excess of 90 days but within one year.

These cash investments can be converted to cash immediately so they are reported at face value in the Current Asset section of the balance sheet. It is not necessary to list the individual types of cash equivalents. If desired, further explanation can be provided in a footnote.

Managing Inventory Accounts

Just because a company sells items to customers on a typical day of business doesn’t necessarily mean it needs to track its inventory. The main types of businesses where it is important to track inventory are manufacturers, wholesale distributors, and retailers. In these businesses, it is essential to track the quantity and value of inventory because inventory is considered a part of a company’s assets.

Tracking Inventory

There are key pieces of information needed when tracking inventory. Most accounting software programs manage serial numbers.

You need to know:

  • Lot Numbers
  • Serial Numbers
  • Manufacturer’s Part Number
  • Default Number

Inventory Accounts

To properly manage your company’s inventory, you need to create the following inventory accounts.

  • Inventory Asset: Inventory is considered a current asset, easily liquidated. When inventory is purchased, this is not an expense. It is considered an asset and is posted as an inventory asset. The amount entered is the total of the vendor’s bill. If your company has a sales tax license, make sure you aren’t paying sales tax for any items purchased for resale.
  • Cost of Goods Sold (COGS): This is an expense account. The value of the inventory asset is based on its cost, not on its resale value. When a product is sold, the expense is posted and the value of the inventory asset is decreased by the same amount. The value of your inventory asset account is reduced when you post the cost of the item to COGS which increases your expenses. In addition, you post income.
  • Inventory Adjustments: Establish this as either an expense account or a COGS account. You will use this account to adjust for a discrepancy between the inventory quantity on hand and the quantity noted in your accounting records. An adjustment may also be required for damaged goods or for crediting a customer for a returned product.

Management Accounting Systems

A company has a management hierarchy in place to oversee different aspects of the business. Ultimately, the chief executive or president is responsible for the success and failure of a company. He delegates responsibilities to his subordinates who in turn delegate to others. Of course, depending on the size of the company, there could be few to several on each management level.

Management accounting systems function to measure and report the performance of managers at all levels in terms of revenues and costs. Each management department is considered a separate accounting unit. The manager for that department is in charge of controlling the revenues and costs associated with his division.

An Overview of Cost, Profit and Investment Centers

  • Cost Centers: Some managers can control particular costs but cannot influence revenues in their division. In this case, the costs they can control are designated to their cost centers.
  • Profit Centers: Some managers have control over both costs and revenue like a retail store manager. These accounting units are known as profit centers.
  • Investment Centers: These accounting units describe managers in large corporations who are responsible for costs, revenues and capital investment.

Although a manager may delegate responsibilities to his subordinates, still he is ultimately responsible for his division. Therefore, the accounting unit for every manager also incorporates the accounting units for all his subordinates. Each accounting unit is designed to serve a specific purpose. Yet, profit and investment centers can also serve other purposes such as to monitor a product line or the performance of managers.

Managing Grant Funds Properly

Grant money is awarded for a specific purpose. Because it is federal money, every penny must be well accounted for and tracked. It also must be kept separate from for any other income and expenses of the non-profit organization.

When grant money is received, along with it is sent a budget specific to these grant funds. At the time of applying for a grant, the non-profit’s preferential budget was submitted.

The budget received may be very similar or very different from the non-profit’s preferences. Regardless, the federal government has the authority to dictate how the money is spent. Keeping track of how money is spent demonstrates to the auditor and the awarding agency good stewardship.

It is crucial to avoid commingling funds. Mixing grant money with other sources of income can result in an eventual loss of funding. To prevent this, include the grant programs in the chart of accounts by assigning each program a different control number.

In addition, physically establishing a separate bank account for the grant money can also assure that funds remain distinct. Depending on the size of the grant and the undertaking of various programs, it may be beneficial to hire someone just to manage the grant funds.

There is so much at stake in the use of grant funds. It is worth going the extra mile to ensure that grant funding is managed properly. It is absolutely necessary to file reports on time as well as maintain detailed documentation.

Measuring Financial Accounting Transactions

There are four broad concepts that assist accountants in measuring, recording, and reporting financial accounting transactions.

Four Basic Accounting Principles

1. Historical Cost Principle: This is the original monetary value of an asset and liability. For an asset, it is the value of what was given in exchange for the asset at the time it was acquired. Asset values tend to appreciate over time but the use of the historical cost principle does not account for this. For a liability, it is the current cash equivalent received in exchange for the liability. Using the historical cost principle, on a balance sheet, assets and liabilities are noted at the value on the date of their original acquisition. However, this may not be their true value due to appreciation and depreciation. Although the use of this principle reflects some inaccuracy, it remains in use in most accounting systems.

2. Full Disclosure Principle: This is a commitment to provide all information necessary for users of financial statements in order to assist them in making sound financial decisions. Additional information like lawsuits or executive stock options that could have an effect on the future of the company is usually disclosed in footnotes in the financial statements.

3. Realization Principle: This principle acknowledges revenue when the product is delivered or the service completed. This principle, also known as revenue recognition, is a foundational principle in accrual accounting. It pays not regard to the timing of cash flow. Revenue recognition must meet the following three criteria. Most often, these criteria are met at the point of sale and/or delivery.

  1. The earnings process if complete
  2. There is reasonable certainty of the collectability of the asset to be received
  3. The exchange value can be determined

4. Matching Principle: This determines that expenses are recognized in the same period as the related revenue. It is the crossroads where accural accounting and revenue recognition meet. It is based on a cause-and-effect relationship between revenues and the expenses expended in creating the revenues.

Nonprofit GAAP Principles

Not only are nonprofits obligated to follow the Federal Accounting Standards Bureau’s (FASB) guidelines but they must use the Generally Accepted Accounting Principles (GAAP) to do so. GAAP functions like the ground rules for accounting. it creates a consistent way to record and analyze financial statements in the accounting world.

All GAAP financial statements are formulated using the accrual basis of accounting. With this system, all transactions are recorded when they occur, regardless if cash is transmitted or not. There are a variety of GAAP principles nonprofits must follow.

Nonprofit GAAP Principles

  • Cost Principle: Assets are to be recorded at their cost. Do not take into account appreciation or depreciation of the asset.
  • Business Entity Concern: The Separate Legal Entity Concept outlines incorporation for a nonprofit as a separate legal entity from the owner. The advantage of incorporation is that the board and staff are not held legally responsible for lawsuits etc. It separates people from the entity and won’t hold them personally responsible for the organization’s debts or charges of misconduct.
  • Objective Principle: All donated items go on the financial statements as assets. They must be given an objective value. It is recommended to seek a third party opinion to determine an object’s worth. Use sticker prices, sales invoices, property deeds, transfers of titles, Kelly Blue Book values, or a banker or creditor to establish the objective value.
  • Matching Principle: Donations and revenues received as well as expenses incurred must be recorded in the same period as they’re received or incurred.
  • Revenue-Recognition Principle: Recognize donations as revenue when they become unconditional.
  • Expense-Recognition Principle: Expenses are reported as decreases to unrestricted net assets on the statement of financial activities.
  • Full-Disclosure Principle: Any changes made to accounting methods, inventory valuation and pending lawsuits must be revealed in the notes of the financial statements.
  • Consistency Principle: Keep accounting methods consistent for recording transactions throughout.

Nonprofit Tax Form 990

It’s tax time! But one of the benefits of being a nonprofit organization is being exempt from paying taxes on revenue. So, why should a nonprofit concern itself with tax time?

The IRS still requires the nonprofit file a return using IRS Form 990. This form is known as the Return of Organization Exempt from Income Tax. It becomes the primary source of information for the public and government about the standing of the organization. Because of this, it is an important tool for demonstrating good stewardship and financial status.

The nonprofit will most likely receive requests from concerned citizens to see its Form 990. It is considered public record and should be kept handy. The nonprofit may even consider posting it on their website for easy access.

Three Form 990s

The nonprofit’s gross receipts and total assets from grants, donations, and contracts etc. will determine which form it must file. Check the IRS website for the most up-to-date information for concluding which form is appropriate for the nonprofit.

  • Form 990-N: The e-Postcard is for smaller nonprofits.
  • Form 990-EZ: The Short Form Return of Organization Exempt from Income Tax is for medium-sized nonprofits.
  • Form 990: The Return of Organization Exempt from income Tax is for large nonprofits.

Even though the payment of taxes is not required, filing the Form 990 is. If it is not filed or filed late, there are consequences. When a return is filed late, small nonprofits are charged $20 per day, not to exceed the lesser of $10,000 or 5% of the gross receipts of the organization for the year. Large nonprofits with annual gross receipts exceeding $1 million must pay $100 per day with a maximum of $50,000. In addition, the organization risks losing its tax exempt status.

If the form is incomplete or contains incorrect information, the organization is give a fixed time period to resubmit the form.

Nonprofit Tax Form 990-T

Most nonprofits only file tax form 990 declaring financial information then made available to the government and the public. But some nonprofits occasionally will engage in for-profit business. In this case, form 990-T must be filed.

If the nonprofit makes some form of profit, they are held responsible to pay corporate income taxes. Tax Form 990-T is for reporting unrelated business income. Any income is considered unrelated that is generated by a business that is unrelated to the exempt function of the nonprofit.

The IRS requires this form from all nonprofits that have $1,000 or more in gross receipts from an unrelated business transaction. The following information is covered on the Form 990-T. Forms can be filed electronically or in paper form.

  • Unrelated Business Income

If merchandise is sold or a service provided that is unrelated to the cause of the nonprofit and is generated on a regular basis then it must be filed.

  • Unrelated Business income Tax Liability

The tax liability is the amount over $1,000 that your nonprofit earns for unrelated business transactions. This involves all gross income less deductions directly connected with making income.

  • Proxy Tax Liability

This is primarily for lobbying and political campaigning activities by certain membership associations holding the tax-exempt status like 501 (c)4, 501(c)(5), and 501(c)(6).

Engaging in some for-profit activity is permissible by the IRS for nonprofit organizations. But engaging in an excessive amount, more than 50% of its business transactions, can put an organization at risk of changing its status from nonprofit to for-profit.

Normal Overhead Rate

When accounting for inventory, product costs are divided into direct costs and indirect costs also known as overhead. Direct costs are those that relate directly to the formation of the product. Indirect costs are associated with other costs indirectly related to the product like the depreciation of a factory building.

Indirect costs are always semi-variable or fixed. This means the amount of indirect cost incurred per unit of product varies with the level of production. To solve this constant fluctuation depending on production levels when calculating, most manufacturers use a normal overhead rate.

Normal overhead rate is calculated by taking a normal volume of production and what the total indirect costs would be at that volume and then computing the normal indirect cost per unit from there. This amount is the normal overhead rate. The value of production is then consistently accessed by combining the direct material, labor costs and normal overhead. The result is a consistent amount per unit.

Using a normal overhead rate allows the gross margin per unit of sales to remain constant even if when the level of production varies. Although a level of consistency can assist in accounting, too great of a discrepancy is a violation of the conventional accounting practices.

When the difference in amounts are small, they are typically overlooked. However, if they are significant, the accountant should adjust the inventory value and the cost of sales to reflect the actual cost of units produced. Reverting away from the normal overhead rate in this case and returning to the use of the actual overhead costs is judicious.

A Nonprofit’s Sales to the Public

The federal government imposes an unrelated business tax (UBIT) on nonprofits who regularly sell or trade goods or services that are unrelated to their organization’s primary mission. However, the federal government isn’t the only tax collector who comes knocking. The nonprofit will also need to pay state taxes.

To help define the types of business activity income that qualifies for the UBIT, read IRS Publication 598 entitled “Tax on Unrelated Business Income of Exempt Organizations.” For example, paid advertising is considered unrelated business income. Income from paid ads on a nonprofit’s newsletter or website is subject to UBIT.

State Regulations on the Sold Goods of Nonprofits

When a nonprofit sells goods to the public, state sales taxes need to be paid. In addition, the nonprofit may also need to acquire a seller’s permit. Nonprofits must comply with these types of general business requirements. To seek any exemptions for certain sales transactions, the nonprofit must apply for eligibility.

If a nonprofit begins selling goods without fully understanding all of its state rules, it may be charged back taxes and other penalties. At the minimum, most states require a nonprofit to hold a seller’s permit. They may also be required to pay state taxes at the end of the year or even quarterly if sales volume is high.

Typically, in most states, a seller’s permit is only required and sales taxes paid for sales of tangible goods like books etc. Sales of services are often exempt. To clarify exactly what the nonprofit’s state requires, contact the state’s sales tax agency for all the specifications. States like Alaska, Delaware, Montana, New Hampshire, and Oregon don’t have sales tax and may not even demand a seller’s permit.

However, in these states and others, local governments may impose sales taxes and certain transactions may be subject to something like a sales tax, although it is disguised under a different name altogether.

Nonprofit Exemptions From Unrelated Business Income Tax (UBIT)

Although the IRS strictly observes the income producing activities of nonprofits, they do make some exceptions. Unrelated business activities for nonprofits are subject to income tax if they are conducted regularly and are unrelated to the mission of the organization.

There are exemptions from the criteria the IRS has set to define UBIT. If an exemption applies to the nonprofit, they are no longer required to pay UBIT.

Nonprofit Exemptions From UBIT

The IRS defines certain types of activities as well as certain types of income as exemptions from the UBIT.

  • If annual earned income is less than $1,000, it is tax-free. Even if the activities sold goods or services unrelated to its underlying purpose, the organization does not need to file a tax return for income under this threshold.
  • If all the work for the service or products sold were done by volunteers, it is tax-exempt.
  • If the products and services are mainly for the convenience of the group’s members or staff, it is tax-free.
  • There is a tax exemption provided if the nonprofit sells donated merchandise.
  • If the nonprofit uses bingo games for fundraisers, it is considered an exemption. However, bingo must be legal in the nonprofit’s area and not played in a hall that also hosts commercial bingo gaming.
  • When the nonprofit displays a company’s name or logo in return for money, as long as it’s limited advertising, it is tax-exempt.
  • Sometimes a nonprofit exchanges or rents its membership list to another nonprofits. This type of activity is not subject to UBIT.
  • If the nonprofit uses entertainment to promote agriculture or education at a public event, this activity is also tax-exempt.
  • Income from research grants or contracts.
  • Gains and losses from selling property.
  • Dividends, interest, annuities and other investment income.
  • Earned royalties from copyrighted material etc..

Notes on Pension Costs in Annual Reports

At best, pension expenses are only estimates. They are the management’s best guess as to what the cost will be in the future. There are three areas covered in the notes of an annual report- pensions, post-retirement benefits, and pension expenses.

  • Pensions: Pensions refer to actual payments that will be made to former employees in retirement.
  • Post-retirement Benefits: Post-retirement benefits pertain to insurance and health-care costs the company is responsible for in caring for their retirees.
  • Pension Expenses: Pension expenses represent the amount of money management should invest to cover future pension payments at the end of the year.

The pension cost must be estimated because there are a lot of factors at play. For example, in order to determine the exact costs, the company would have to consider the average years of service of an employee at retirement, number of years an employee is expected to live after retirement, salary of employee at retirement, and the interest the invested funds are anticipated to earn.

Because this section of notes is the management’s best estimation, investors don’t pay as much attention to it as to others. However, it is still worth analyzing the fair value of the plan’s assets, the projected benefit obligation, and the difference between the two.

Revisions are often made to pension cost. When management invests more than the current year’s pension expense, it is recorded in an asset account known as Prepaid Pension Cost. When management invests less than the current year’s pension expense, it is recorded in liability account known as Accrued Pension Cost.

The Nature of Costs

When analyzing costs, it is helpful to divide them into three categories: fixed, variable, and semi-variable. Analyzing costs is necessary when a business is evaluating how to maximize profit and minimize loss through its decision-making. These decisions are made with the company’s future in mind.

Looking at cost and revenue data from the past can be helpful but management must seek to make estimates predicting the future. This type of evaluation also involves opportunity costs which cannot be measured in accounting records. Opportunity cost is the income sacrificed by not choosing the best alternative.

  • Fixed Costs

These costs do not change regardless of the level of business activity. Fixed costs are fixed only in the context of existing operations. The management’s decisions to operate the business in a particular way causes the costs to remain fixed until the context of operation alters.

  • Variable Costs

Most costs vary to some extent. Factory costs, materials, overhead and direct labor vary with the volume of production. Selling costs differ with sales volume. Administrative costs and utility costs differ as well depending on a variety of factors.

  • Semi-Variable Costs

These are costs that vary but contains a fixed-cost element as well. The variable component of the cost is payable proportionate to the level of activity. Many semi-variable costs increase in proportion over most levels of activity but out of proportion at very low and high levels.

Operating Leverage

A lever is defined as a rigid bar that pivots about at one point and that is used to move an object at a second point with a force applied to a third point. Operating leverage is a force used to increase the profitability of a business to its owners. Just as a lever functions in physics, operating leverage balances a variety of costs in order to move profits upward when pressure is applied to particular areas of operation.

Operating Leverage

A business can use operating leverage by weighing the mix of fixed and variable costs in its operations. When the fixed costs such as labor and raw materials are manipulated, profits can drastically increase. A company may increase its annual fixed machinery cost by upgrading to automated machinery. As a result, the cost of labor and raw materials needed per unit decreases. The outcome is more profit.

Companies with high leverage at play tend to have greater fluctuations in profits than companies with low operating leverage. A low-leveraged, manual operation will have fairly stable profit returns. They won’t experience the dips from a drastic increase or decrease of sales that high-leveraged companies do.

High-leverage companies also have a higher break-even sales point than the break-even point for a company with less leverage. Overall, operating leverage has the ability to improve a company’s profits for a given level of sales. However, the company must be aware of the risk involved in highly leveraging their operations. They risk an unstable profit pattern and an increased break-even sales level.

Profit & Loss Statement

Good recording keeping and precise calculations are valuable because they provide an accurate assessment of the company. At any time, an executive can take a look at a variety of reports to take the pulse of the business’ success. Your role as an accountant is vital for painting a clear picture of the company’s viability. Most of the information needed to file tax returns is collected in the same accounts set for the profit & loss statement.

Profit & Loss Statement

This statement shows business activity over a period of time, usually during a tax year. The balance sheet provides a snap shot of business activity at a given moment. In contrast, a profit & loss statement shows the bigger picture. For example, the changes and flux of business activity over a year.

It is an excellent tool for drawing conclusions about the company. It can be effective in determining how money spent on an advertising campaign influenced sales. It can demonstrate periods of heavy sale volume so in the future, more inventory can be ordered. A comparison of profit & loss statements from other periods can be done as well. These are just a few examples of how the profit & loss statement can be utilized to benefit financial planning and company projections for the future.

How to Develop a Profit & Loss Statement

It is compiled from actual business transactions. It shows three parts: income, cost of sales, and expenses. Prepare a profit and loss statement at the end of a tax year. However, it is also beneficial to prepare one at the close of each business month. The advantage of using accounting software, a common practice of the day, is a profit & loss statement can be easily generated for a period of choice by the click of the mouse. In double entry accounting, balances from revenue, cost of goods, and expense accounts need to be transferred to the profit & loss statement.

Partnership Equity

When starting a business venture, there are different ways to classify your entity. Business owners are wise to consult an attorney and accountant before deciding on the most advantageous classification. Some vary in tax advantages and their different ways of tracking equity. The company’s equity is essentially it’s capital-the difference between its assets and liabilities.

A company’s equity increases when it makes profit as well as when its owners invest money into it. A company’s equity decreases when it experiences profit loss or when its owners withdraw money from the company. “Equity accounts track the net effect of all your company’s past transactions and are the starting point in calculating the value of your business” (Accounting Savvy for Business Owners p.131).

Tracking Partnership Equity

Each partner must have his/her own equity account designated in the chart of accounts. This will make it easy when you need to print out records and data for each partner’s personal tax return. Initially, record each partner’s contributions to the company in his/her individual equity account. Throughout the tax year, record any additional funding in the same way.

Depending on the partnership, each partner might have a different percentage of ownership and therefore, receive a different percentage of the profits. A withdraw of money by a partner is not considered an expense. Instead, it is classified as an “equity transaction.” Paying expenses for a partner’s health insurance or retirement plan cannot be considered deductible business expenses as they are when paid out for employees. Instead, these payments are posted to each partner’s equity account.

To ease confusion, it is recommended that each partner have a business and personal credit card. He/she must seek to only pay for business expenses with the business card. This will simplify the accounting process.

Pension Plans

Many companies offer attractive benefit packages to their employees. Some of the benefits may include pension plans. Pension plans are typically tax-exempt.

The employer makes contributions towards funds set aside for the employee’s retirement. The employee transfers part of his own income to a retirement fund which is in turn invested on his behalf.

There are two main types of pension plans: defined contribution plans and defined benefit plans.

Defined Contribution Plans

With defined contribution plans, the employer pays specifically defined amounts each year to a third party, a trustee or insurance company, in order to purchase employee annuities. How much an employee receives depends on a variety of factors. An employer may gauge it on the employee’s wage levels, years of service with the company, the age of the employee etc. For accounting purposes, the amounts payable each year are an expense for that year. If any contributions are left unpaid at the end of the year, they are recorded as current liabilities.

Defined Benefit Plans

With defined benefit plans, each year the employer estimates the current cost of future retirement payments. Yearly, the employer puts the estimated amount into investments. Under this plan, the employer guarantees the employee will receive a specified amount upon retirement. The amount is not dependent on the investments performance like it is with defined contribution plans.

The defined benefit plans costs and liabilities are more difficult to calculate. The gains and losses are hard to predict because they are never the same as those forecasted. If an employer provides benefits for past service with the company when a defined benefit plan is started, the cost is amortized.

Periodic vs. Perpetual Inventories

Inventory transactions can be recorded using the periodic inventory method or the perpetual inventory method. Recording inventory is detailed business. The accounting department must choose a method and keep it consistent throughout the books.

Because these two methods vary in their way of tracking inventory data, the calculations of inventory and cost of goods sold amount can be different depending on the method used.

Periodic Inventory

The cost of goods used in manufacture or sale is calculated and recorded at the end of each accounting period. The accountant must add the cost of goods purchased to the value of inventory at the beginning of the period and then deduct the final value of inventory at the end of the period.

Fewer details are required with this method. It is only necessary to record purchases and values at the beginning and end of the accounting period.

Perpetual Inventory

The cost of goods used is calculated and recorded constantly as inventory is used. A separate account must be kept for each inventory items. Unlike with periodic inventory, when inventory items are obtained or sold, the quantities and costs of the units must be noted on the account.

Preparing for a Grant Audit Review

An audit may be a nerve-racking process. But it doesn’t have to be. However, a nonprofit needs to be prepared to have everything scrutinized by the auditor. No stone is left unturned, so to speak. They are very thorough.

They must be. Especially when the government has entrusted its money to an organization. It needs to verify the proper use of the funds.

There are some things a nonprofit organization can do to prepare for a grant audit review. Papers, documents and records can be put in order to facilitate the process, making it less stressful on the organization and easier to review for the auditor.

3 Tasks Performed by the Auditor During Review

Knowing what an auditor looks for will help unveil some of the mystery of the entire auditing process. It also enables the organization to be better prepared. These 3 tasks are typically performed.

1. Searching for Improper Payments

At the time the organization received its grant money, it was given a list of cost principles. These are the rules stating what is permissible to purchase with grant money and what is forbidden. An auditor will look for improper payments and determine whether the organization is abiding by the cost principles.

2. Checking Internal Controls

Internal controls protect the nonprofit’s assets. A form of checks and balances must be in place to help adhere to the rules of administrating of the grant program.

3. Determine the Risk Factor

This task is simply detecting if there’s trouble on the horizon for the nonprofit. After reviewing the organization’s purchasing, accounting, and inventory systems, the auditor will determine if the organization is at risk for any problems.

The Pros and Cons of a Proprietorship

There are three legal forms a business can take. Each as its own advantages and disadvantages. Before legally defining a business endeavor, it’s important to evaluate the possible pros and cons.

A proprietorship is most simply defined as an individual in business for himself. It is probably the simplest way to form a business but there are significant risks involved as well. The proprietor manages the business and collects the profits made for personal gain. The law makes no distinction between a proprietorship and the proprietor.

Businesses that often function as proprietorship include retailing, small scale farming and other professions of the sort. They include mainly businesses that can be run without large investments.

The Pros of a Proprietorship

  • Lacks legal form
  • The proprietor can pocket whatever profits are made
  • Because proprietorships aren’t legally distinct from the proprietor, the business can do anything an individual can do
  • Not subject to income tax apart from the proprietor (Can be an advantage but it depends on the circumstances)

The Cons of a Proprietorship

  • Any business creditors have legal right to demand payment from the proprietorship as well as from the proprietor’s personal wealth
  • Unclear distinction between what things are business and which are personal making everything a proprietor owns vulnerable to collectors
  • Dependent on one individual for its existence and continual success
  • Not subject to income tax apart from the proprietor (Can be a disadvantage but it depends on the circumstances)

If the business operates on a small scale and relies on many of the proprietor’s own resources to function, classifying it as a proprietorship may bring some tax advantages and legal flexibility that a business owner might find attractive.

Posting Payroll

Depending on the size of the company, it may choose to outsource its payroll and taxes to a company that specializes in these fields. If payroll remains an inside job, a lot of record keeping, reporting and paper pushing is involved. Payroll is considered a company’s liability.

How Payroll is Posted Depends on Company Size

If the company is on the smaller side, post all your payroll taxes into the balance sheet liability account called Accrued Payroll Taxes. Usually, you will only have one balance sheet account for accruing payroll taxes. However, if you are dealing with several employees, you may choose to set up individual accounts for each type of tax and benefit the company compensates to its employees. A long list of individual accounts will be the result.

Individual accounts include:

  • Accrued Federal Withholding Payable
  • Accrued State Withholding Payable
  • Accrued Federal Unemployment Payable
  • Accrued State Unemployment Payable
  • Accrued Employee FICA Payable
  • Accrued Employee Medical insurance Payable
  • Accrued Employee Elective Insurance Deductions Payable
  • Accrued Garnishments and Other Withholding Payable

Post any employer expenses related to payroll as well. You record the tax and insurance expenses related to that payroll period even though you won’t pay these expenses until they are due. Accrued insurance payments are posted to the Accounts Payable account or to individual payable accounts for each insurance company.

In addition, it is important to keep a payroll ledger for each employee that lists the details of each employee’s paycheck at the end of each pay period. This information helps track paid vacation and other benefits related to days off. When an employee is hired, make sure to begin a record of his/her payroll information like the individual’s W-4 withholding allowances, their particular benefits, deductions and wage.

The Basics of Quarterly Statements

Publicly -traded companies are required by the New York Stock Exchange (NYSE) and the Securities and Exchange Commission (SEC) to produce quarterly financial statements for their shareholders. In reality, quarterly reports are published only three times a year. There is no need for the fourth quarter report because the annual report is made at that time.

Quarterly financial statements may resemble an annual report. However, there are some major differences. For various reasons, estimations are made for most key figures on the quarterly reports which are more accurately depicted in the annual report.

For example, it is too costly and time-consuming for a company to take a detailed inventory more than once a year. Therefore, ending inventory for that quarter is only estimated. Another example is the annual tax rate. In quarterly reports, the annual tax rate must be estimated for the purpose of recording the annual tax rate as closely to what the company actually dispenses in taxes.

Another variation from an annual report is seasonality. Seasonality occurs when the data experiences regular and predictable changes every calendar year. In some companies, particular quarters typically do better financially than others. In this case, seasonality must be noted on the quarterly financial statement as to alert the shareholder that sales are not level throughout the year.

Quarterly financial statements must also be considered unaudited. The CPA who reviews them is only obligated to make this proclamation: “I do not know of any material changes that must be made to make the statements conform to the Generally Accepted Accounting Principles (GAAP).”

Ratios for Financial Statement Analysis

Ratio analysis is a primary analytical technique that when used properly is an effective way to evaluate a company’s financial standing. A key to the proper execution of ratio analysis is the employment of a variety of ratios to give a balanced view of the company existence. These ratios include profitability, activity, liquidity and cash flow.

Ratios for Financial Statement Analysis

Profitability Ratios
Profitability ratios measure a particular aspect of management’s operating efficiency. Three different ratios are used to evaluate management’s performance and help answer the following questions.

  • How effective is management in employing assets profitably?
  • How successful is management in maximizing the return on owners’ investments?
  • How well has management done with the profit generated on sales?

Activity Ratios
Whereas profitability ratios determined management’s effectiveness in generating profit, activity ratios evaluate management’s effectiveness in using the profit/assets. To calculate an activity ratio, an asset is divided into the best measure of that asset’s activity. For example, for accounts receivable, the best measure of asset activity is sales.
Liquidity Ratios
The purpose of liquidity ratios is to determine the company’s ability to pay its short-term obligations. Two ratios are utilized to do so.

  • Current ratio: The ratio defines the relationship between current assets and current liabilities.
  • Quick or acid test ratio: This ratio is calculated like a current ratio except inventory is removed from current assets because inventory is usually not directly convertible to cash.

Cash Flow Ratios
The employment of cash flow ratios examine the adequacy of a company’s cash flows and the quality of its earnings. The cash flow ratio determines the extent to which cash flow from operations is enough for the company’s investing and financing activities.

Ratio Analysis

When financial analysts seek insight into annual reports, they employ ratio analysis as a primary tool. In fact, ratio analysis is the dominant analytical technique used in the analysis of financial statements. Although it is an important tool, it isn’t a magic formula.

Ratio analysis isn’t often easy to understand. Having this valuable tool is crucial but it requires hard work and diligence to make it work in one’s favor.

A ratio is a measure of relative size that is calculated by dividing one number into another. A ratio describes the relative size of the two numbers or quantities but it doesn’t explain the absolute size. Ratios can be especially useful if a standard of reference for a company in that particular industry is used in comparison.

Ratio Comparison

A ratio for a company can be compared to…

  • The company industry average or standard
  • Another company in the same industry
  • The same ratio for the company in prior years

A financial analyst uses the comparison of ratios within a company differently than a comparison with the industry average or a similar company. Comparing ratios from previous years may reveal a pattern, for better or for worse.

In ratio analysis, it is important to use a variety of ratios to make an accurate determination. There are ratios to help analyze profitability, solvency, liquidity and activity. One area may reveal a strong ratio. Yet, when other ratios are used as well, weakness in the company can be unveiled. A financial analyst needs the whole picture.

Responsibility Accounting

The accounting field has expanded to include at least three main purposes: financial reporting, product or service cost reporting, and performance evaluation reporting. Responsibility accounting structures systems and reports to focus the accountability of specific people. Accounting is then assigned to specific departments or functions in which the responsibility for performance lies.

In comparison with financial accounting, responsibility accounting segments the business into distinct responsibility centers whereas financial accounting simply groups like costs together. To do so, a measurement process must be established. This measurement process compares actual results against objective goals for the segment prior to the end of a budget period. These goals are part of the operating budget and define targets of operation for every aspect of the business.

Responsibility accounting must be custom-fit to the individual needs of the business. The revenue and expense categories must reflect the functions and operations management values so they can be properly monitored and evaluated with the help of responsibility accounting.

In addition, responsibility accounting compiles the individual centers’ performance reports into successively aggregated collective reports. The purpose of doing so is to recognize broader categories of responsibility. Within these broader categories, much detailed information can be found for further analysis.

A responsibility center can be as minor as a single operation or machine or as major as encompassing the entire business. The entire company is essentially the responsibility center of the chief executive. Most commonly however, a business is broken down into several centers that can be lined up in successive layers like a pyramid.

Recording Sales Tax

Not all states have sales tax. But if your company sells goods or services that are taxable in your state, sales tax must be collected from customers. Sales tax also applies if your company sells goods or services in any state in which it has an office or warehouse as well. The company may also have to charge, collect and remit sales taxes to the customers’ home state if you do business out of your own state. After collecting the sales tax, the money must be given to state tax authorities.

Recording Sales Tax

Interestingly, sales tax is neither income or expense but it is considered a liability. Sales tax is used when both the customer and the goods or services you’re selling are taxable. Occasionally, the customer and/or the goods or services aren’t taxable. Track sales tax by creating a liability account named “Sales Tax Payable.” Enter the sales tax into this account every time you have a sale that requires it. Next, send a check for the total amount in the liability account to the state.

However, it does get more complicated than this. Most state require a lot more information to be included with the sales tax payment. Some states also have special sales tax rates for specific goods or services and require that these amounts be reported separately. Set up your sales tax recording to reflect the specific information your state requires when reporting sales tax. These days, most states only accept sales tax reports and remittances online. Of course, you always need to have good records behind the figures you send.

Many states have a base tax rate and may include additional tax known as surtax. The total of these rates is applied to the sale of taxable goods and services. The surtax is based on location. Tax rates may also vary because some states apply different tax rates for different types of goods or services. You then must calculate the sales tax on a line-by-line basis rather than calculating the tax for the total sale.

Reinvesting Profits in Long-Term Securities

An important accounting function is tracking cash flow. This involves the inflow of cash through sales, services and investment interest and the outflow of cash in the form of expenses and other financial activities. Investing excess cash in securities, either short-term or long-term, is beneficial to the company.

Long-Term Investments

Long-term investments are defined as investments made to earn income. Or, investments made in order to exert significant influence on another company.

  • Available-for-Sale Securities

These include debt and equity securities. Because these securities are held until maturity and are normally for a time period exceeding a year, they are classified as noncurrent on the balance sheet. They are reported at fair value and as a separate component of stockholders’ equity under Other Comprehensive Income. This entry is below the Retained Earnings line on the balance sheet.

Even though the available-for-sale securities experience changes in market value, these changes are considered an unrealized gain or loss. This means that a security can gain or lose market value but this is not accounted for because the security hasn’t yet been sold.

  • Investment in Equity Securities to Gain Control & Influence

A company may seek to influence another company’s policy by purchasing a large quantity of long-term investments in the form of equity in that company. The Financial Accounting Standards Board (FASB) has created guidelines to define this type of control sought by an investing company.

The company with the investment has…

    • Little Influence: With holdings of less than 20%. Account for these using the fair value similar to available-for-sale securities.
    • Significant Influence: With holdings between 20% to 50%. Account for these using the equity method. The investor records the initial investment at cost and includes a proportional share of the investee’s income on its income statement each period.
    • Controlling Interest: With holdings of more than 50%. The financial statements of the investee are consolidated with those of the owner-investor because of their large portion of stock ownership.

Reinvesting Profits in Short-Term Securities

It is a well-known practice for a company with excess cash to invest it in short-term or long-term investments as a way of increasing their profit. In fact, Apple has a separate office designated for the reinvestment of their profits located in Reno, Nevada. This is a strategic way to maintain a positive cash flow.

When a company considers reinvesting some of its profits, it must wisely select from among short-term and long-term investments. Management must establish the time frame of the investment and its purpose. This will aid in determining a proper selection.

Short-Term Investments

Short-term investments are defined as investments by a company that can be converted to cash within the year. There are two types of short-term investments: Held-to-Maturity Securities and Trading Securities.

  • Held-to-Maturity Securities: These securities are purchased with the goal of earning interest or of reselling in the future for profit. They are debt securities that the company is able to hold to maturity. Most often, these securities are classified as noncurrent assets like bonds. Occasionally, they are recorded as a current asset such as when a company purchases Treasury Bills or Corporate Notes that will mature within one year. To report these securities, enter the cost less any impairment like amortized cost plus any accrued interest.
  • Trading Securities: These include debt and equity securities purchased with the purpose of reselling with a quick turnaround, usually within days or weeks. At the end of a reporting period, enter the trading securities at fair market value based on the mark-to-market principle. This established principle requires that securities reflect the current market value rather than the book value. Trading securities are classified as current assets on the balance sheet. Don’t forget to adjust the Trading Securities account for unrealized gain or loss in market value.

Recording Equities

Recording equities is a necessary part of keeping track of the financial progress of the business. The equities account is part of the general ledger. Equities accounts reflect the net worth of the company.

If the business is a corporation, equities can be seen as the value of things owned by shareholders. It also includes retained earnings which is the accumulated profit since the business began. Transactions that involve equity accounts are neither income nor expenses; these transactions don’t affect the taxable profit/loss of the company.

Equity is increased by the money the owners put into the business and by the company’s profit. Equity is decreased by business losses and by withdrawals (not including payroll) made by business owners. For income tax purposes, owners are taxed on the profit and loss of the business, not the amount of funds they withdraw.

These accounts appear after the liability section on the balance sheet. A computerized program will number these accounts in the range of 3000-3999.

Key Equity Accounts

  • Common Stock (3100)

The value of outstanding shares of stock. The number of shares issued is multiplied by the value of each share to calculate this number. Even if you don’t currently have common stock, leave room for this category on your ledger for the future.

  • Retained Earnings (3200)

Tracks your profit or loss, either on a monthly or yearly basis.

  • Capital (3300)

Record the initial money invested into the business to get it started and the contributions made later. Essentially these are the company’s assets. It not only reflects cash but also includes the value of equipment, vehicles even buildings. If the business has partners, each partner should have his/her own named capital account.

  • Drawing (3400)

Record any money that the owner takes out of the business. Again, if the business has partners, each partner should have his/her own name drawing account. If the business is a proprietorship, charitable contributions, health insurance premiums, retirement plan contributions, and taxes may be paid from this account. It is recommended to set up specific Draw accounts for each of these. This will make it easier during tax time to differentiate between payments that are tax deductible and those that are not on the business’ Schedule C.

Reports on Internal Controls

Internal controls protect the company’s assets as well as their shareholders’ investments in the company. Therefore, the SEC requires companies to report on internal controls as part of Management’s Report of Responsibilities.

The Committee of Sponsoring Organizations (COSO) of the Treadway Commission defines internal control as “a process, effected by an entity’s board of directors, management, and other personnel, designed to provide reasonable assurance regarding achievement of objectives in the following categories:

  • compliance with applicable laws and regulations;
  • effectiveness and efficiency of operations;
  • reliability of financial reporting.”

The COSO emphasizes the importance of the company’s top management’s values and integrity. Top management will set the course in which the rest of the company’s employees follow. Their operating style and ethical values influences the rest of the company’s behavior. They themselves must set a good example and work by a high ethical standard.

In addition to management’s incorruptibility, COSO recommends internal controls should be monitored regularly and updated when necessary in order to remain highly effective components of a company.

COSO advises the report of internal controls summarizes the following information:

  • the type of controls reported on
  • the inherent limitations of the internal controls in place because no system is foolproof and without fault
  • the established procedures for supervising controls and for reacting to any known deficiencies
  • concluding remarks about the control system and details about its shortcomings

Along with the recommendations of the COSO, the Sarbanes-Oxley Act also states its requirements for the formal reporting on the effectiveness of internal controls.

Stockholder’s Equity

Stockholder’s equity comprises the third portion of the balance sheet, in addition to assets and liabilities. It reveals the amount invested into the company by the shareholders. It is the amount of capital received from investors in exchange for stock. Stock that has been sold is also known as paid-in capital. in order to determine stockholder’s equity, deduct the total liabilities from total assets.

Stockholder’s equity can be broken down into two major categories: paid-in capital and retained earnings. Retained earnings is the amount a company accumulates over time. It is the net income kept by the corporation rather than being given out to shareholders in the form of dividends. Sometimes it is reinvested into the company and other times it is used to pay off debts. The company may choose to restrict a part or all of its retained earnings.

Common Stock

Common stock is issued at par value. It is the basic ownership of a company which gives the shareholder certain rights. Common-stock holders have a right to vote on important corporate matters. They have a right to share in any dividends. They also have a preemptive right to buy a proportional amount of any additional shares issued by the company. Common-stock holders receive periodic financial statements and get a share in the liquidation of the company after creditors and preferred-stock holders are offered the opportunity.

Preferred Stock

Preferred stock is also issued at par value. However, unlike common-stock holders, preferred-stock holders don’t have any voting rights in the company. They are not true owners. Dividends are usually paid each period as a percentage of the preferred stock’s par value. Preferred-stock holders are in line after creditors in the event of a company’s liquidation. The company also will buy back the stock from the shareholder at a set maturity date.

Treasury Stock

This is created when a company buys back its own stock and chooses not to retire it. On the balance sheet, treasury stocks are listed after retained earnings and deducted from contributed capital. If you’ve ever received stock options as a part of your compensation plan as an employee, most likely treasury stock was used for this purpose.

Sales Tax Reporting

Every city, county and state has different tax rules. It is recommended to take time to research the specifics of sales tax reporting in your state. Sales tax usually only applies when you are selling a tangible good or product. However, in some states, certain services are taxable as well.

Due to the vast amount of sales over the Internet, there is a drive to collect sales taxes for Internet-based sales. In addition to Internet sales, if your company operates in various counties then you’ll need to be current with how each county taxes sales as well as the different types of taxes based on the products being sold.

It pays off to be thorough in this matter. Unfortunately, changes in tax rules can happen frequently-monthly for city and county governments but only yearly for state governments. So keep current!

You need to have only one Sales Tax Collected Liability account on your chart of accounts. However, you will be using it to pay sales tax in different percentages to the city, the county and the state according to their tax laws.

All Government Entities Want This Basic Information in Your Sales Tax Reporting

  • Gross Sales
  • Tax Rate Used
  • Tax Rate collected

Next, enter the amount of sales tax paid in the general ledger.

Here’s where good record keeping comes in. After you’ve paid the sales tax, attach any work papers, a copy of the forms filed with the city, county and state, and a copy of the tax check in your sales tax files. If need be, you have accurate records to prove your numbers.

Remember to always file your tax forms on time to avoid paying late fees.

Specialized Journals

In accounting, business transactions must be entered regularly into the accounting records. The place where the original entry is made is called a General Journal. This is the catch-all for transactions that don’t necessitate entry in specialized journals. In large companies, where there might be thousands of transactions, specialized journals are a necessity.

Specialized journals are used to record repetitive transactions. Furthermore, businesses use subsidiary accounts. “Transactions are first recorded into a specialized or the general journal; then they are posted to a ledger account (usually a control account) periodically, and finally, if appropriate, they are posted to a subsidiary account daily” (Berry, Leonard Eugene. Financial accounting Demystified. USA: The McGraw-Hill Companies, 2011. p. 74).

Four Specialized Journals

  • Sales Journal

A simple sales journal format includes the date, invoice number, customer name, reference and the amount A/R dr. sales cr..

  • Purchases Journal

A purchases journal format contains the date, invoice number, vendor name, reference. Dr. inventory purchases, Dr. supplies, Dr. equipment, Cr. accounts payable. An Accounts Payable Control account is created along with a subsidiary ledger for each individual vendor’s account.

  • Cash Receipts Journal

A cash receipts journal format consists of the date, customer name, reference, Dr. cash received, Dr. sales discounts, Cr. A/R, Cr. sales. Only cash receipts are recorded here.

  • Cash Disbursements Journal

A cash disbursements journal includes the date, check number, reference, Dr. account name, Dr. accounts payable, Cr. purchases discount, Cr. cash.
It is critical that the information entered in the specialized journals is also entered into each customer’s subsidiary account daily. Periodically, at least by the end of the accounting period, transactions must also be posted to the respective general ledger accounts.

Selling and Retiring Fixed Assets

Tangible, long-term assets like computers, office equipment, and company cars wear out. (They are classified as long-term because they have been in use for more than a year.) Everyday life produces wear and tear on a company’s possessions. When tracking an asset, you always account for its depreciation which reduces the company’s taxable income.

However, how do you balance journal entries when an asset is sold or simply retired from use? It’s imperative to remove the fixed asset from your Balance Sheet. If you don’t, this could affect the way lenders, investors and insurance agents view your assets and concurrently, your company’s net worth.

Selling a Fixed Asset

When selling a fixed asset, keep in mind the original cost and depreciation of the asset while also, recording the income received from the buyer of the asset.

Here’s how:

  1. Record any depreciation allowed for the final year of ownership
  2. Add back all the depreciation taken over the years including the final year
  3. Reverse the original cost of the fixed asset
  4. Record the bank deposit for the payment received from the buyer

Even after entering the accumulated depreciation and the amount received from the buyer, the entry won’t balance. The difference is the net gain or loss on the sale of the asset. The posting is then usually to an income account named “Gain on Sale of Fixed Assets” if the income is indeed a credit. However, if it is a loss, it is considered a debit. In essence, it is a “contra-income” which is treated the same way as an expense.

When you deposit the money received from the buyer into your bank account, create an account under Other Income named “Proceeds from Fixed Asset Sales” to post the deposit.

Retiring a Fixed Asset

When you retire a fixed asset because it simply wore out and is no longer in use, recording this transaction is much simpler. A retired fixed asset has already been completely depreciated, so the cost of the fixed asset and the accumulated depreciation will be the same. A zero balance results for the fixed asset. It still must be completely removed. To do so, post a credit to the original purchase account and a debit to the accumulated depreciation account.

Specific Nonprofit Ratios

There are two ratios specific to a nonprofit’s financial statements used in ratio analysis: program spending ratio and fundraising ratio. Ratio analysis is a method for taking two or more informational elements and using them together to obtain additional information about the performance of an organization.

Program Spending Ratio

The program spending ratio is effective for comparing the percentage a nonprofit is spending on programs to how much it is spending on fundraising and administration. The higher the number the better. For charity groups, it is recommended to have at least sixty-five percent. The following equation is used to determine this calculation.

Program Expense

Total Expenses

Not only does the nonprofit’s board of directors find this ratio useful but more and more donors, charity rating groups and regulators and using it to indicate whether a nonprofit is indeed using funds prudently and effectively.

Fundraising Ratio

The fundraising ratio is also being closely watched by donors, charity rating groups and regulators alike. This ratio allows a snapshot of the percentage of dollars being spent to raise a nonprofit’s contributions and grant revenue. The following equation is used to determine this calculation.

Fundraising Expenses

Contribution Revenue + Grant Revenue

A high ratio is cause for alert. It indicates fundraising is inefficient and perhaps the nonprofit’s funds could be better allocated to serve its mission and programs. Interestingly, in 2002, the IRS sent out “educational” letters to nonprofits with proportionately low fundraising expenses. The letter advised the nonprofit to review their fundraising tactics and warned them the IRS would continue to monitor this in the future.

Staying in Compliance with the Non-Profit Status

There are certain rules and regulations a non-profit organization must adhere to in order to maintain its non-profit status. The IRS has the power to give or take away this status. It is essential to have a detailed awareness of the non-profit laws to ensure the organization is abiding by government standards.

Learn what the IRS and state officials specifically require. Refer to the Financial Accounting Standards Board (FASB) for how to prepare, present and report financial information. The IRS and state government recommend adherence to these specific rules. If these are neglected, the non-profit status may not remain active. This means the federal tax-free status could be revoked. In addition, it is vital the organization maintains good standing in the community by stewarding its donations well.

Four Components for Maintaining the Non-Profit Status

  1. Register with the proper state authority: How an organization registers varies from state to state. It may be required to register with the secretary of state’s office, state department of revenue, and/or state attorney general’s office. Some states offer a similar tax-free status to the IRS by offering an exemption from paying sales tax, for example.
  2. Account for non-profit activities: Present the nonprofit organization’s financial activities in accordance with the GAAP standards.
  3. Have a yearly audit: Hire a CPA to perform a yearly audit of financial statements. The CPA is qualified to view the financial statements and verify they are in compliance with GAAP.
  4. Follow IRS statutes: File an annual report to the IRS about the non-profit’s activities. Use tax-free form 990-Return of Organization Exempt From Income Tax. If the organization neglects to file its annual return 3 years in a row, the non-profit status may be revoked.

Segmental & Company-Wide Information on the Annual Report

When an investor buys a share of stock in a large corporation, often this means he has purchased a share of a conglomerate. Typically, there is a parent company with subsidiaries in different areas of business the investor as bought into with the purchase of his shares.

Not all the subsidiaries’ components may be thriving. An investor needs to know how each of the components are doing. FASB Statement No. 131 requires corporations report financial and some descriptive nonfinancial information about all its operating components.

The FASB defines these components as “the components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance.”

The report should mirror the way the information is utilized by management internally for operating decisions etc.

Segment Information

The company must report the following information about each component it owns and operates:

  • profit & loss
  • certain revenue & expense items
  • the component’s assets
  • the component’s revenues
  • total assets
  • major customers
  • the countries in which the enterprise earns revenues and holds assets
  • the revenues from the enterprise’s products or services

Descriptive Information

The company must report the following descriptive information:

  • the products and services offered by the operating components
  • the way in which the operating components were determined
  • any changes in the measurement of amounts from period to period for the components and the over-arching corporation

Understanding how each component contributes to the corporation’s overall finances and performance will assist any investor in evaluating the soundness of his investment.

Standard Audits

Shareholders and creditors rely on a company’s financial statements to reflect the financial status of the business. However, they need assurance that the information on the statements is credible and reliable. Standard audits by public accountants provide this assurance.

A standard audit is a yearly event for public companies. Their financial statements are audited by public accountants and the audit reports are then published with the statements as verification. The audit report is written to the board of directors and stockholders, not to management since it is management’s statements that the auditors are evaluating.

The Content of a Standard Audit Report

The standard audit report is divided into three paragraphs.

1. Introductory Paragraph

The introductory paragraph establishes the author of the audit. It details the financial statements being reviewed. It attests the financial statements are the responsibility of the management whereas the auditors’ responsibility is to offer their opinion of these statements.

2. Scope Paragraph

The scope paragraph’s purpose is to illustrate how the audit was conducted. It declares the audit was performed in conjunction with the generally accepted auditing standards (GAAS).

Next, it asserts that the objective of the audit was to grant reasonable assurance of the financial statements. Absolute assurance is not possible. But tests are conducted on the supporting evidence of the financial data.

After the testing is performed, sometimes theft, fraud and illegal acts are revealed. But normally, a standard audit is not designed to focus of these crimes.

3. Opinion Paragraph

The opinion paragraph expresses the auditors’ opinion of the financial statements. In other words, to conclude the financial statements are presented fairly in accordance with the generally accepted accounting principles.

State Charitable Reports

A nonprofit organization may be required to register and report in more than one state. However, there are ten states that have no registration and reporting requirements for nonprofits. It must register and report annually to the Secretary of State’s office in the state in which it is active.

To be defined as active requires only a minimum of activity. Even a solicited contribution by mail or email to any resident of the state qualifies it as active. In order to provide adequate information to the state, a nonprofit’s audited financial statements can be used.

If the nonprofit must file in multiple states, many states use the Uniform Registration Form to help standardize information. Form 990 is required by the IRS although most nonprofits approved under Section 501 (c) are exempt from federal taxes. Whereas individual tax forms are guarded as confidential by law, form 990 is available to anyone who requests it from the IRS.

Someone may request it directly from the nonprofit or it may be found online. A nonprofit’s financial information is disclosed to the public, including salaries and other data. Therefore, it is crucial board members review the information filed with federal and state agencies for accuracy.

There are also a variety of charitable rating groups and websites that publicize information about nonprofits. Board members should also monitor these to see what is being written about their organization. A nonprofit’s reputation must be guarded and kept credible in order to solicit future donations as well as to accomplish its mission.

Statement of Comprehensive Income

The Statement of Comprehensive Income first made its appearance on the accounting scene in 1998. It can be presented as an independent statement of its own, as part of the statement of stockholders’ equity, or as an addendum to the income statement itself. Regardless of its format, the Statement of Comprehensive Income holds the same basic information across the board from company to company.

The purpose of the Statement of Comprehensive Income is to recognize the net change in owners’ equity during the year from the company’s transactions and events that did not involve the owners themselves.

Items Included in the Statement of Comprehensive Income

  • Net income
  • Adjustments of assets and liabilities that don’t influence the current period’s net income

Examples include the adjustment to market value for available sale securities, certain types of derivatives, and foreign currency translation adjustments.

Items Excluded from the Statement of Comprehensive Income

  • Payment of dividends
  • Issuance of stock
  • Repurchase of stock
  • Declaration

The main crux of the Statement of Comprehensive Income is it involves all value changes recorded through the year from transactions and events not involving the company’s owners. This statement is a valuable piece to analyze from a shareholder’s perspective.

Comprehensive income is calculated on a per-share basis. The accountant reconciles the book value per-share from the beginning of the period to the end of the period. Next, all other line items are calculated. The amount of comprehensive earnings is the result.

Support & Revenue for Nonprofits

Nonprofits accrue forms of revenue unique from other for-profit entities. Among these are service revenues, contributions and grants. A nonprofit’s balance sheet must reflect these particular categories. All records should be in accordance with GAAP standards for the nonprofits specialized sector.

Service Revenues

Fee-based services to clients, patients or students are one of the most common sources of nonprofit revenue. Revenues are recorded for the services provided. These services should be recorded at their net realizable value. Net realizable value is a method of evaluating an asset’s worthwhile held in inventory. Occasionally, discounts are offered to clients. In those cases, the discounts must be applied against all the gross revenue being recorded.


Contributions comprise a large part of a nonprofit’s revenue. They may come in the form of cash, stock, bonds, art, property or other tangible assets with value. When donating a non-cash item, it is the donor’s responsibility to determine it’s worth, not the nonprofit’s.

A unique aspect of recording contributions is they are not only recorded when cash is received but also when a pledge is made by a donor. An organization must record a pledge receivable and contribution income even before it is actually received. A contribution given with restrictions is still recognized and recorded as income as well.


Grants can be restricted or unrestricted. Regardless of their designation, grants must be recorded at their fair market value at the time they are received. Grants are another major source of funding and are often used to supplement a nonprofit’s other forms of revenue.

Troubled Debt Restructuring

Many companies carry long-term liabilities. Noncurrent or long-term liabilities are debt obligations the business is not required to pay back for at least a year from the date on the balance sheet. They are recorded at their present value, the principal and interest except future interest is not yet recorded. The principal that is due within the year is classified as a current liability.

When an investor reviews the financial statements in an annual report, it is vital he reads through the notes carefully. Often management will list any restrictions the business is under due to long-term debt covenants.

When a business is even slightly behind in its obligations, the amount can be called due at any time. In this case, the debt should be reclassified as a current liability unless it can be quickly repaid within the grace period allotted.

When a business has difficulty repaying its debts, the creditor may grant concessions to help the debtor refrain from defaulting the loan. This is called “troubled debt restructuring.”

  • Creditor settles debt for noncash assets or stock with less of a market value than the recorded value of the debt. If this occurs, the debtor must report a gain on the restructuring equal to the amount by which the debt exceeds the market value of the assets given the creditor. This amount falls on the income statement as an extraordinary item.
  • Creditor modifies terms of the debt. The debtor in turn agrees to pay more or less than the recorded value of the debt in addition to the interest due. A gain is recorded when the new payment is less than the recorded value which is noted as an extraordinary item. If the new payment is more than the recorded value, the recorded value is entered as the principal of the restructured debt. The excess amount is labeled as the debtor’s interest expense.

Types of Grant Audits

Depending on the size of the grant awarded and suspicion level, there are different types of grant audits that might be performed. The nonprofit is accountable for every penny spent. An audit is performed to verify whether or not the grant program accomplished its initial objectives.

The Government Performance and Results Act (GPRA) declares federal agencies must demonstrate how the money spent actually accomplishes their mission, goals and objectives. An audit, whether brief or extremely detailed helps to verify this process.

  • Desk Audit

A desk audit is the easiest type of grant audit. It is simply a phone call from the program manager asking a series of questions about the grant. It can last from five to thirty minutes. If the questions were answered honestly and thoroughly, it could be all that is required. However, if there is any reason to doubt or a desire for further investigation, the program manager will schedule an on-site visit for a more detailed audit.

  • Monitoring Site Visit

This isn’t always the next step in the audit process. Frequently, the desk audit is forgone and a monitoring site visit is performed instead. A program officer is the one making the personal call.

A program officer investigates the following:

    • financial systems (internal controls system)
    • program compliance
    • subgrantee monitoring
    • procurement system
    • property management or inventory systems
    • project performance based on the GPRA
    • travel system
    • personnel system (time and attendance records)
    • financial status, progress and closeout reports
  • Inspector General Audit

This audit is performed by the Office of Inspector General under the U.S. Department of State. It is only performed when there is substantial suspicion of fraud, waste, abuse and misconduct. If an organization undergoes an inspector general audit, it means it could be in serious distress. If the accusations are merited, the money may need to be paid back, heavy penalties incurred and jail time ordered.

Tracking Nonprofit Donations

A nonprofit organization’s main source of income is donations. However, revenue may be received as well in exchange for goods and services or from investments. The source of donations varies. They may come from individuals, corporations, foundations, churches and government entities. They may come in the form of cash, grants and even time.

Tracking Nonprofit Donations

Most donations come in the form of checks written by donors. It is advisable to deposit the checks as soon as possible to ensure the money promised is available for the needs of the organization. Keeping the organization’s checking account current will help avoid undesirable overdraft fees. However, if the organization has a website, donations can also be received online through companies like PayPal.

It is also necessary to keep a list of donors. Record the donor’s pertinent information such as name, address and amount donated. The auditor uses this list in conjunction with financial records to verify the donations received.

A Variety of Donations

  • Cash Donations

Cash donations are more difficult to track because they lack a corresponding paper trail. To compensate for this, make sure the donor receives a receipt of donation and that the organization keeps a copy as well.

  • Check Donations

Check donations are a common form of donations but they can lead to bouncing a bad check. Purchase a check-swiping system to verify there is indeed enough money in the account to cover the amount of the check.

  • Credit Card Donations

With credit card donations, there is a user fee or percentage charged for processing the payment. The organization always receives less than the stated amount due to these finance charges. It is recommended to not account for credit card donations before it clears the bank.

  • Direct Bank Draft Donations

Direct bank draft donations allow people to donate a large sum of money divided into smaller amounts over a longer period of time. It is a common practice with large corporations to encourage their employees to make small donations directly from their paychecks.

  • Grant Donations

This a large amount of money given with no obligation for repayment. It is vital to track and monitor how grant money is used. It is advisable to open up a new account in which to deposit just the grant money. A grant can be received in the form of a check or may be directly deposited after the money is spent.

Tracking Interest Payments

Interest payments are made by Accounts Payable. It is one of the most complicated types of payments to record. The complication arises when calculating the interest expenses. When calculating loan repayment, the payment allocated to the principal portion to pay down the loan account (a liability) is separate from the interest portion to track the expenses related to the loan in the “Interest Expense “account. A payoff of loan principal reduces the liability section of the balance sheet and a payment of interest increase the expense section of the profit & loss statement. Remember if the loan payment is late, additional interest is charged and needs to be accounted for.

Calculating Interest Payments

  • Simple Interest

This is calculated on the principal sum, not compounded on earned interest. It computes the interest costs of a loan based solely on the loan principal. Record the amount paid on the principal under “Loan Payable” while recording separately the interest paid under “Interest Expense.” This is a rare form of loan today because most companies prefer to reduce their interest expenses by paying down the principal early.

  • Compound Interest

This is calculated not only on the initial principal but also on the accumulated interest of prior periods. An example of a compound interest loan is a home mortgage loan. A compound interest loan is entered in the same format as a simple interest loan. However, the amount allocated to principal and interest is different. The breakdown may be noted in a monthly statement sent by the bank. Or the bank might provide an amortization schedule indicating the amounts.

Transaction Controls

Every business has internal controls systems in place throughout the entire business operation. However, in the accounting department, there are specific internal controls established to protect the business from errors, theft and fraud. This form of checks and balances primarily monitors the work of employees.

Examples of accounting internal controls include cash registers which record all cash sales. Employee time cards that supervises the honesty of employees’ work hours. Pre-documents like checks and purchase orders give added protection. Accounts are monitored by reconciling them with independent outside records.

Transaction Controls

Various accounting transactions need internal controls to protect the integrity of the transactions. Sales and collections, purchases and payments, payroll and payments all have internal controls in place.

  • Sales and collections: The sales process is lengthy and each activity is performed by a different employee as part of the internal controls. The only exception is the accounts receivable clerk records both the amount invoiced and the amount received.
  • Purchases and payments: Amongst the various purchase activities required, different employees perform each as a part of the internal controls. The only exception is the payables clerk records both the purchase and the payment in the supplier’s account.
  • Payroll and payments: The hiring and dismissal of employees as well as the setting of wage rates is conducted separately from payroll preparations, distribution and accounting. Typically, the first set of operations is carried out by the payroll department in company of average size.

Trending and Benchmarks

Trending and benchmarks are advanced methods used to analyze an organization’s performance. A board of directors can use these calculations to evaluate an organization’s stewardship of funds. In addition to measuring organizational performance, they measure an organization’s financial performance as well.


Trending is an effective and essential method because it permits the display and analysis of data across time. Without the use of trending, a board is only given a snapshot of data, frozen in time. One may analyze a year’s worth of data as well as observe ratios from prior years. Trends are more easily observable using this method. The most effective presentation of trending is through well-designed graphs, charts, and tables. Narrative explanations along with trending can give a board a fuller picture of an organization’s financial performance.


Benchmarking allows for comparisons with other nonprofit organizations in similar arenas. Using this method, an organization compares its ratios, trends and analysis, both financial and non-financial, with equivalent organizations. Perhaps when a board regards a particular ratio of one organization alone, things may look grim. However, when comparing it with other organizations, the board may realize it is very much in step with other organizations’ performances. This may not fully negate the organization’s need to improve in that area but it gives a more realistic perspective of an organization’s true financial state.

Uncollectible Receivables

Most businesses usually extend some form of credit to attract customers. It may be a retail store offering to sell their goods on credit cards or a vendor who allows payment for goods sometime after they are delivered. With offering goods on credit comes the inevitable- not all customers will repay the full amount of their debt.

The Generally Accepted Accounting Principles (GAAP) require that a business reports only receivables on which it expects to receive payment. Therefore, the uncollectible accounts must be provided for in some other way in the accounting ledger.

Accounting for Uncollectible Receivables

  • Direct Write-Off Method

This is the simplest method but not always the most accurate. The uncollectible account is written off and the expense recognized in the period in which the receivable becomes worthless. Although it is a straightforward way of handling an uncollectible account, it is not recognized as GAAP. The only time it would be considered appropriate is,

  • Allowance Method

Because the direct write-off method contains some discrepancies, accountants have developed the allowance method. It is an estimation of uncollectible accounts at the end of each accounting period. When the amount has been determined, the Uncollectible Accounts Expense is debited while the account Allowance for Uncollectible Accounts is credited.

An accountant can use either two methods to determine the estimation of uncollectible accounts expense: the percentage-of-sales method and the accounts receivable aging method.

    • The Percentage-of-Sales Method functions by deciding the total sales for the period based on the income statement. Then, an estimation is made as to how much of these sales will be uncollectible. It isn’t necessary to determine exactly which accounts will fall into this category.
    • The Accounts Receivable Aging Method not only estimates but pays attention to how long the account has been outstanding. It sets up an aging schedule. From there, it can be determined just how much of each age’s balance will not be collectible.

Unrelated Business Income Tax (UBIT)


For nonprofit organizations, the IRS makes a distinctions between income “substantially related” to the organization’s cause from other revenue which is not. Nonprofits with a tax-exempt status who participate in income producing activities around its mission are not subject to any income tax.

However, unrelated business income is subject to income tax. Too much income from these activities can jeopardize the nonprofit’s tax-exempt status in the long-run. Unfortunately, the IRS doesn’t have a clear indicator of when this may get out of balance. So, be cautious when choosing to engage in unrelated business activities.

Unrelated business income can generate much needed revenue for any nonprofit. For example, consider the Girl Scouts’ cookie sales or the Goodwill thrift stores. These activities are high-profile for those organizations and are conducted nationwide. They are extremely profitable forms of fundraising.

Unrelated Business Income Tax (UBIT)

Unrelated business income tax is very similar to the income tax owed by for-profit entities. Its name helps identify that the income tax owed is unique for an organization which normally engages in tax-exempt activities.

A nonprofit will find itself subject to UBIT if some of its revenue results from a “regularly” conducted “trade or business.” ‘Trade or business” is defined as selling goods or services for the purpose of producing income.

The term “regularly” depends on whether the nonprofit participates in these activities as frequently as other similar businesses. Selling items far below their market value may allow the IRS to offer the nonprofit an exemption.

Unemployment Taxes

An employer is required to pay a portion of Social Security and Medicare taxes. Likewise, the employer is required to pay unemployment tax. The unemployment tax is partially based on employees’ salaries. Most employers pay both a federal and state unemployment tax. Each state sets its own unemployment tax rate. The good news for companies is they get a credit toward the federal amount based on the amount paid to the state. In essence, the amount owed in state unemployment taxes is subtracted from what is owed in federal unemployment tax. Your state unemployment office can help you gain a better understanding of how the unemployment tax in calculated in your state.

Unlike the other taxes, only the employer pays the unemployment tax. A portion is not deducted from the employee’s salary. The taxes paid get deposited into an unemployment fund known as the Federal Unemployment Tax Act (FUTA). This accumulated fund then provides unemployment compensation to workers who have lost their jobs.

Paying the Unemployment Taxes

  • For the state unemployment tax, pay it quarterly. To calculate it, multiply the single maximum monthly income paid to all the employees by the number of employees by the new employer rate.
  • For the federal unemployment tax, figure FUTA tax quarterly as well. According to the IRS, determine your FUTA tax liability by multiplying the amount of taxable wages paid during the quarter by 0.6%. Stop depositing FUTA tax on an employee’s wages when he or she reaches $7,000 in taxable wages for the calendar year. Deposit the FUTA tax by the last day of the first month that follows the end of the quarter.

Use Form 940 to report FUTA tax.
There are rules and exemptions for employees that fall under special employment classifications. Be sure to be current with the IRS’ specifications.

Vendor and Contractor 1099 Tax Forms

Come the first month of the year, every employee in your company must receive a W-2 form with which to file their own tax return. However, what do you do for an independent contractor and his/her earned wages? According to the IRS, “an individual is an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done.” If you have hired workers classified as independent contractors, they must receive a 1099 form reporting their income if they were paid more than $600 during the tax year.

There are actually 16 different 1099 forms. Thankfully, only a few are needed by a small business accountant at tax time.

  • 1099-MISC: Use this form for any vendors and independent contractors to whom you pay income.
  • 1099-MSA: Use this form if your business offers an Archer Medical Savings Account program.
  • 1099-R: Use this form if an employee leaves the company and withdraws his/her qualified retirement plan money. It doesn’t matter the purpose of the withdrawal. It can be because he is retiring or to put the money into an IRA. If he withdraws his retirement money then this form is used.

Like W-2 forms, 1099s must be handed out by January 31. However, you don’t have to file them with the IRS until February 28. The IRS compares the forms your business sends in with those reported by the contractors and vendors on their own tax returns. This creates a checks and balance system to keep everyone honest.

Make sure you have three copies of the 1099 form. Obviously, one is given to the vendor or independent contractor. The second one is sent to the IRS with Form 1096 which is the “Annual Summary and Transmittal of U.S. Information Returns.” The third is kept on record in a company file.

Valuning Non-Monetary Assets

The land on which our buildings stand may have high potential value in the current real estate market. So what does that mean when we are valuing a non-monetary asset? Does the strength of a company lie in the fact that it could sell its site land for more than its cost or does the strength of a company lie in its ability to carry out its day to day operations? Needless to say, the market values of most buildings can also be quite meaningless and misleading when ascertaining the worth of a company; often these buildings are built for a specific purpose. If a companies’ worth is of growing concern, it will not usually sell its building or land unless it is going out of business.

Sometimes structures are appraised by a process of finding the present cost of the kinds of materials and labor that were generally expanded in their constructions, but such a procedure may result in a very poor representation of the current value of the structure. Companies will sometimes get an appraisal of a building or land to borrow against the building for a loan, but this does not concern accounting.

This is a very general preliminary look at the subject of asset valuation, but it is intended to warn accountants and accounting students, that in most cases when dealing in the subject of asset valuation, you will be dealing with accounting data that are historical cost and not up to date. The argument for cost can be expressed quite simply. First there is no satisfactory means of determining current costs or current market value of most non-monetary assets economically on a continuous basis; second, the essence, if not the quintessence, of profit determination lies in the matching of cost against revenue.

Withholding Employee Taxes

An employer is responsible for paying Social Security tax, Medicare tax, federal withholding tax and state withholding tax for its employees. All taxes collected from the employees are deposited in the Accrued Payroll Taxes account in the liability section of the balance sheet. It sits there until the company needs to pay the government entities. In calculating the amount withheld, it’s important to know the current withholding percentage for the tax year.

Social Security & Medicare Tax

In 2011, the employee tax rate for social security tax is 4.2%. The employer tax rate remains unchanged at 6.2%. The Medicare tax rate is 1.45% for both the employer and employee. The amounts are withheld from the employee’s paycheck while the employer’s amount is calculated and paid. Both are sent to the IRS. All the employee’s earnings are to be reported by the employer to Social Security. For the social security tax, a percentage is determined yearly by the federal government to reflect increased salary levels. Medicare tax however has no income cap, so this percentage is taken out of the entire earnings for the year.

To calculate either tax, simply multiply the employee’s earnings per month by the percentage to be withheld. Withhold that amount from the employee’s paycheck and make sure the employer’s share matches the amount as well.

Federal Withholding Tax

Calculating the federal withholding tax is a little more complicated. You calculate the tax based on an employee’s income and the tax rate. In addition, you need to be aware of the number of exemptions the employee is claiming on his/her W-4. Use Publication 15 for a breakdown in percentages and to adjust for the number of exemptions selected by the employee.

State Withholding Tax

This varies from state to state. You need to be informed about the specifics of your state’s income tax. Some states base their income tax on a percentage of the federal withholding amount while others use tables or percentage methods similar to the federal withholding tax. The employee may need to complete a form declaring state withholding allowances.

What to Prepare for an Audit Review

This is where meticulous record keeping pays off. The grant’s program manager will inevitably come and ask to see documentation. It is best that a file is kept with copies of everything pertaining to the grant.

During the grant period, the organization has turned in quarterly Financial Status Reports (SF-269) along with other progress reports. These should be accessible to the program manager. Prepare hard copies of other documents as well.

Copies of the following documents should be prepared for an audit review:

  • Grant application
  • Letters and correspondence (including emails) regarding the grant
  • Grant budget
  • Time and Attendance reports
  • Grant adjustment notices (including subgrantees)
  • Grant award document
  • All receipts, invoices, bills, canceled checks etc.
  • Grant employees’ payroll information

The purpose of an audit is to verify the organization has followed the grant’s guidelines. Having these documents in good order will help demonstrate to the auditor the organization’s faithful compliance. It is advisable to keep all records of grant activities on file for three years after the grant ends. However, if the organization is under investigation, the records must be on file until the investigation is over.

In addition to the above documents specific to the grant, the organization must also prove its existence, structure, policies and procedures. Having these on file and prepared for the auditor’s review is crucial for the audit process to go smoothly.

Proof with these records and documents:

  • Board member information
  • Operating budget of the organization
  • IRS letter of determination (proof of tax-exempt status)
  • Organization’s articles and bylaws
  • Indirect cost rate
  • Financial statements