Bookkeeping All-in-One For Dummies book cover

Bookkeeping All-in-One For Dummies

By: Lita Epstein and John A. Tracy Published: 08-27-2019

Manage the art of bookkeeping

Do you need to get up and running on bookkeeping basics and the latest tools and technology used in the field? You've come to the right place! Bookkeeping All-In-One For Dummies is your go-to guide for all things bookkeeping. Bringing you accessible information on the new technologies and programs, it cuts through confusing jargon and gives you friendly instruction you can use right away.

Inside, you’ll learn how to keep track of transactions, unravel up-to-date tax information, recognize your assets, and so much more.

  • Covers all the new techniques and programs in the bookkeeping field
  • Shows you how to manage assets and liabilities
  • Explains how to track business transactions accurately with ledgers and journals
  • Helps you make sense of accounting and bookkeeping basics 

Get all the info you need to jumpstart your career as a bookkeeper!

Articles From Bookkeeping All-in-One For Dummies

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Bookkeeping All-in-One For Dummies Cheat Sheet

Cheat Sheet / Updated 02-25-2022

The title of bookkeeper brings up mental images of a quiet, shy individual who spends countless hours poring over columns of numbers. In reality, the job of a bookkeeper is of vital importance to any business that needs to account for its assets, liabilities, and equity. From the company founders to the investors to the IRS, the bookkeeper must be able to report the financial status by way of balance sheets and income statements and keep an organized and detailed paper trail of every financial transaction. This Cheat Sheet also describes the types of business structures with which bookkeepers must be familiar: sole proprietorships, partnerships, and limited liability companies.

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Internal Profit Reporting

Article / Updated 11-21-2019

External financial statements, including the income statement (also called the profit report) comply with well-established rules and conventions. By contrast, the format and content of internal accounting reports to managers are wide open. If you could sneak a peek at the internal financial reports of several businesses, you’d be probably surprised by the diversity among the businesses. All businesses include sales revenue and expenses in their internal profit-and-loss (P&L) reports. Beyond this broad comment, it’s difficult to generalize about the specific format and level of detail that bookkeepers need to include in P&L reports, particularly regarding how operating expenses are reported. Designing internal profit (P&L) reports Profit performance reports prepared for a business’s managers typically are called P&L reports. These reports should be prepared as frequently as managers need them, usually monthly or quarterly — or perhaps weekly or daily in some businesses. A P&L report is prepared for the manager who’s in charge of each profit center; these confidential profit reports don’t circulate outside the business. (The P&L contains sensitive information that competitors would love to get hold of.) Accountants aren’t in the habit of preparing brief, summary-level profit reports. Accountants tend to err on the side of providing too much detailed data and information. Their mantra is to give managers more information, even if the information isn’t asked for. Managers are busy people, and they don’t have spare time to waste, whether for reading long, rambling emails or multiple-page profit reports with too much detail. Profit reports should be compact for a quick read. If a manager wants more backup detail, she can request it as time permits. Ideally, the accountant should prepare a profit main page that fits on one computer screen, although this report may be a smidgen too small as a practical matter. In any case, keep it brief. Businesses that sell products deduct the cost of goods sold expense from sales revenue and then report gross margin (alternatively called gross profit) both in their externally reported income statements and in their internal P&L reports to managers. Internal P&L reports, however, provide a lot more detail about sources of sales and the components of the cost-of-goods-sold expense. Businesses that sell products manufactured by other businesses generally fall into one of two types: retailers that sell products to final consumers and wholesalers (distributors) that sell to retailers. The following discussion applies to both types. There’s a need for short, to-the-point or quick-and-dirty profit models that managers can use for decision-making analysis and profit-strategy plotting. Short means one page or less (such as one computer screen) with which the manager can interact and test the critical factors that drive profit. If the sales price were decreased 5 percent to gain 10 percent more sales volume, for example, what would happen to profit? Managers of profit centers need a tool that lets them answer such questions quickly. Reporting operating expenses Below the gross margin line in an internal P&L statement, reporting practices vary from company to company. No standard pattern exists. One question looms large: How should the operating expenses of a profit center be presented in its P&L report? There’s no authoritative answer to this question. Different businesses report their operating expenses differently in their internal P&L statements. One basic choice for reporting operating expenses is between the object-of-expenditure basis and the cost-behavior basis. Reporting operating expenses on the object-of-expenditure basis By far the most common way to present operating expenses in a profit center’s P&L report is to list them according to the object-of-expenditure basis. This basis classifies expenses according to what is purchased (the object of the expenditure), such as salaries and wages, commissions paid to salespeople, rent, depreciation, shipping costs, real estate taxes, advertising, insurance, utilities, office supplies, and telephone costs. To use this basis, a business has to record its operating expenses in such a way that these costs can be traced to each of its various profit centers. The salaries of people who work in a particular profit center, for example, are recorded as belonging to that profit center. The object-of-expenditure basis for reporting operating costs to managers of profit centers is practical. This information is useful for management control because, generally speaking, controlling costs focuses on the particular items being bought by the business. A profit center manager analyzes wages and salary expense to decide whether additional or fewer personnel are needed relative to current and forecast sales levels. A manager can examine the fire insurance expense relative to the types of assets being insured and their risks of fire losses. For cost control purposes, the object-of-expenditure basis works well, but there’s a downside. This method of reporting operating costs to profit center managers obscures the all-important factor in making a profit: margin. Managers absolutely need to know margin. Separating operating expenses further on a cost-behavior basis The first and usually largest variable expense of making sales is the cost-of-goods-sold expense (for companies that sell products). In addition to cost of goods sold (an obvious variable expense), businesses have other expenses that depend on the volume of sales (quantities sold) or the dollar amount of sales (sales revenue). Virtually all businesses have fixed expenses that aren’t sensitive to sales activity, at least in the short run. Therefore, it makes sense to take operating expenses classified according to the object-of-expenditure basis and further classify each expense as variable or fixed. Each expense would have a variable or fixed tag. The principal advantage of separating operating expenses into variable and fixed classifications is that margin can be reported. Margin is the residual amount after all variable expenses of making sales are deducted from sales revenue. In other words, margin equals profit after all variable costs are deducted from sales revenue but before fixed costs are deducted from sales revenue. Margin is compared with total fixed costs for the period. This head-to-head comparison of margin and fixed costs is critical. Although it’s hard to know for sure, because the internal profit reporting practices of businesses aren’t publicized or generally available, probably the large majority of companies don’t attempt to classify operating expenses as variable or fixed. Yet for making profit decisions, managers need to know the variable versus fixed nature of their operating expenses.

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Accounting and Financial Reporting Standards

Article / Updated 11-04-2019

The authoritative standards and rules that govern financial accounting and reporting by businesses in the United States are called generally accepted accounting principles (GAAP). When you read the financial statements of a business, you’re entitled to assume that the business has fully complied with GAAP in reporting its cash flows, profit-making activities, and financial condition — unless the business makes very clear that it prepared its financial statements by using some other basis of accounting or deviated from GAAP in one or more significant respects. If GAAP isn’t the basis for preparing its financial statements, a business should make very clear which other basis of accounting it’s using and avoid using titles for its financial statements that are associated with GAAP. If a business uses a simple cash-receipts and cash-disbursements basis of accounting (which falls way short of GAAP), for example, it shouldn’t use the terms income statement and balance sheet. These terms are part and parcel of GAAP, and their use as titles in financial statements implies that the business is using GAAP. You’re lucky that there’s no room here for a lengthy historical discourse on the development of accounting and financial reporting standards in the United States. The general consensus (backed by law) is that businesses should use consistent accounting methods and terminology. General Motors and Microsoft should use the same accounting methods; so should Wells Fargo and Apple. Businesses in different industries have different types of transactions, of course, but the same types of transactions should be accounted for in the same way. That’s the goal. There are upwards of 7,000 public companies in the United States and more than 1 million privately owned businesses. Should all these businesses use the same accounting methods, terminology, and presentation styles for their financial statements? Ideally, all businesses should use the GAAP rulebook. Privately owned companies aren’t required to follow GAAP rules, although many do. The rulebook permits alternative accounting methods for some transactions, however. Furthermore, accountants have to interpret the rules as they apply GAAP in actual situations. The devil is in the details. In the United States, GAAP constitute the gold standard for preparing financial statements for business entities. The presumption is that any deviations from GAAP would cause misleading financial statements. If a business honestly thinks that it should deviate from GAAP to better reflect the economic reality of its transactions or situation, it should make very clear that it hasn’t complied with GAAP in one or more respects. If deviations from GAAP aren’t disclosed, the business may have legal exposure to those who relied on the information in its financial report and suffered a loss attributable to the misleading nature of the information. Unfortunately, the mechanisms and processes of issuing and enforcing financial reporting and accounting standards are in a state of flux. The biggest changes in the works have to do with the push to internationalize the standards, as well as the movements toward setting different standards for private companies and for small and medium-size business entities. Financial accounting and reporting by government and not-for-profit entities In the grand scheme of things, the world of financial accounting and reporting can be divided into two hemispheres: for-profit business entities and not-for-profit entities. A large body of authoritative rules and standards called GAAP has been hammered out over the years to govern accounting methods and financial reporting of business entities in the United States. Accounting and financial reporting standards have also evolved and been established for government and not-for-profit entities. This book centers on business accounting methods and financial reporting. Financial reporting by government and not-for-profit entities is a broad and diverse territory, and full treatment of it is well beyond the scope of this book. People generally don’t demand financial reports from government and not-for-profit organizations. Federal, state, and local government entities issue financial reports that are in the public domain, although few taxpayers are interested in reading them. When you donate money to a charity, school, or church, you don’t always get financial reports in return. On the other hand, many private, not-for-profit organizations issue financial reports to their members — credit unions, homeowners’ associations, country clubs, mutual insurance companies (owned by their policy holders), pension plans, labor unions, healthcare providers, and so on. The members or participants may have an equity interest or ownership share in the organization; thus, they need financial reports to apprise them of their financial status with the entity. Government and other not-for profit entities should comply with the established accounting and financial reporting standards that apply to their type of entity. Caution: Many not-for-profit entities use accounting methods different from business GAAP (in some cases, very different), and the terminology in their financial reports is somewhat different from that in the financial reports of business entities. Getting to know the U.S. standard-setters Okay, so everyone who reads a financial report is entitled to assume that GAAP has been followed (unless the business clearly discloses that it’s using another basis of accounting). The basic idea behind the development of GAAP is to measure profit and to value assets and liabilities consistently from business to business — to establish broad-scale uniformity in accounting methods for all businesses and to make sure that all accountants are singing the same tune from the same hymnal. The authoritative bodies write the tunes that accountants have to sing. Who are these authoritative bodies? In the United States, the highest-ranking authority in the private (nongovernment) sector for making pronouncements on GAAP and for keeping these accounting standards up to date — is the Financial Accounting Standards Board (FASB). Also, the SEC has broad power over accounting and financial reporting standards for companies whose securities (stocks and bonds) are publicly traded. Actually, the SEC outranks the FASB because it derives its authority from federal securities laws that govern the public issuance and trading in securities. The SEC has on occasion overridden the FASB, but not very often. GAAP also include minimum requirements for disclosure, which refers to how information is classified and presented in financial statements and to the types of information that have to be included with the financial statements, mainly in the form of footnotes. The SEC makes the disclosure rules for public companies. Disclosure rules for private companies are controlled by GAAP. Internationalization of accounting standards (maybe, maybe not) Although it’s a bit of an overstatement, today the investment of capital knows no borders. U.S. capital is invested in European and other countries, and capital from other countries is invested in U.S. businesses. In short, the flow of capital has become international. U.S. GAAP doesn’t bind accounting and financial reporting standards in other countries. In fact, significant differences exist that cause problems in comparing the financial statements of U.S. companies with those in other countries. Outside the United States, the main authoritative accounting standards setter is the International Accounting Standards Board (IASB), which is based in London. The IASB was founded in 2001. More than 7,000 public companies have their securities listed on the several stock exchanges in European Union (EU) countries. In many regards, the IASB operates in a manner similar to that of the FASB in the United States, and the two have very similar missions. The IASB has already issued many standards, which are called International Financial Reporting Standards. For some time, the FASB and IASB have been working together to developing global standards that all businesses would follow, regardless of the country in which a business is domiciled. Political issues and national pride come into play, of course. The term harmonization is favored, which sidesteps difficult issues regarding the future roles of the FASB and IASB in the issuance of international accounting standards. The two rulemaking bodies have had fundamental disagreements on certain accounting issues. It seems doubtful that they’ll agree on a full-fledged universal set of standards. But stay tuned; it’s hard to predict the final outcome. Divorcing public and private companies Traditionally, GAAP and financial reporting standards were viewed as being equally applicable to public companies (generally, large corporations) and private companies (generally, smaller companies). Today, however, we’re witnessing a growing distinction between accounting and financial reporting standards for public and private companies. Although most accountants don’t like to admit it, there’s always been a de facto divergence between the actual financial reporting practices of private companies and the more rigorously enforced standards for public companies. A surprising number of private companies still don’t include a statement of cash flows in their financial reports, for example, even though this statement has been a GAAP requirement since 1975. Although it’s hard to prove one way or the other, my view is that the financial reports of private businesses generally measure up to GAAP standards in all significant respects. At the same time, however, there’s little doubt that the financial reports of some private companies fall short. In May 2012, the FASB established an advisory committee for private-company accounting standards. In setting up the council, the FASB said, “Compliance with GAAP standards for many for-profit private companies is a choice rather than a requirement because private companies can often control who receives their financial information.” The council advises the FASB on the appropriate accounting methodology for private companies when changes in GAAP are being considered. Private companies don’t have many of the accounting problems of large public companies. Many public companies deal in complex derivative instruments, issue stock options to managers, provide highly developed defined-benefit retirement and health benefit plans for their employees, enter into complicated intercompany investment and joint venture operations, have complex organizational structures, and so on. Most private companies don’t have to deal with these issues. Following the rules and bending the rules An often-repeated story concerns three people interviewing for an important accounting position. The candidates are asked one key question: “What’s 2 plus 2?” The first candidate answers, “It’s 4.” The second candidate answers, “Well, most of the time the answer is 4, but sometimes it’s 3, and sometimes it’s 5.” The third candidate answers, “What do you want the answer to be?” Guess who gets the job. This story exaggerates, of course, but it does have an element of truth. The point is that interpreting GAAP isn’t a cut-and-dried process. Many accounting standards leave a lot of room for interpretation. Guidelines would be a better word to describe many accounting rules. Deciding how to account for certain transactions and situations requires seasoned judgment and careful analysis of the rules. Furthermore, many estimates have to be made. Deciding on accounting methods requires, above all else, good faith. A business may resort to “creative” accounting to make profit for the period look better or to make its year-to-year profit less erratic than it really is (which is called income smoothing). Like lawyers who know where to find loopholes, accountants can come up with inventive interpretations that stay within the boundaries of GAAP. These creative accounting techniques are also called massaging the numbers. Massaging the numbers can get out of hand and become accounting fraud, also called cooking the books. Massaging the numbers has some basis in honest differences in interpreting the facts. Cooking the books goes way beyond interpreting facts; this fraud consists of inventing facts and good old-fashioned chicanery.

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Looking at Depreciation Expense Accounting Methods

Article / Updated 11-04-2019

In theory, depreciation expense accounting is straightforward enough: You divide the cost of a fixed asset (except land) among the number of years that the business expects to use the asset. In other words, instead of having a huge lump-sum expense in the year that you make the purchase, you charge a fraction of the cost to expense for each year of the asset’s lifetime. Using this method is much easier on your bottom line in the year of purchase, of course. ©Doubletree Studio/Shutterstock.com Theories are rarely as simple in real life as they are on paper, and this one is no exception. Do you divide the cost evenly across the asset’s lifetime, or do you charge more to certain years than others? Furthermore, when it eventually comes time to dispose of fixed assets, the assets may have some disposable, or salvage, value. In theory, only cost minus the salvage value should be depreciated. But in actual practice, most companies ignore salvage value, and the total cost of a fixed asset is depreciated. Moreover, how do you estimate how long an asset will last in the first place? Do you consult an accountants’ psychic hotline? As it turns out, the Internal Revenue Service runs its own little psychic business on the side, with a crystal ball known as the Internal Revenue Code. Okay, so the IRS can’t tell you that your truck is going to conk out in five years, seven months, and two days. The Internal Revenue Code doesn’t give you predictions of how long your fixed assets will last; it tells you what kind of timeline to use for income tax purposes, as well as how to divide the cost along that timeline. Hundreds of books have been written about depreciation, but the book that really counts is the Internal Revenue Code. Most businesses adopt the useful lives allowed by income tax law for their financial statement accounting; they don’t go to the trouble of keeping a second depreciation schedule for financial reporting. Why complicate things if you don’t have to? Why keep one depreciation schedule for income tax and a second for preparing your financial statements? That said, it may be a different story for some large companies. The IRS rules offer two depreciation methods that can be used for particular classes of assets. Buildings must be depreciated one way, but for other fixed assets, you can take your pick: Straight-line depreciation: With this method, you divide the cost evenly among the years of the asset’s estimated lifetime. Buildings have to be depreciated this way. Assume that a building purchased by a business costs $390,000, and its useful life — according to the tax law — is 39 years. The depreciation expense is $10,000 (1/39 of the cost) for each of the 39 years. You may choose to use the straight-line method for other types of assets. After you start using this method for a particular asset, you can’t change your mind and switch to another depreciation method later. Accelerated depreciation: This term is a generic catch-all for several methods. What all these methods have in common is the fact that they’re front-loading, meaning that you charge a larger amount of depreciation expense in the early years and a smaller amount in the later years. The term accelerated also refers to adopting useful lives that are shorter than realistic estimates. (Few automobiles are useless after five years, for example, but they can be fully depreciated over five years for income tax purposes.) Section 179 is an alternative to using depreciation write-offs. This section was greatly expanded with the new law that took effect on January 1, 2018, and may eliminate the use of depreciation for many new-equipment purchases. Under the new tax law, companies can use Section 179 to write off 100 percent up to $1 million in 2018, and the write-off will be adjusted for inflation each year after that, with the benefit being phased out up to $2.5 million. Before the new tax law, Section 179 allowed a 50 percent write-off up to $500,000. The definition of property eligible for 100 percent bonus depreciation was expanded to include used qualified property acquired and placed in service after September. 27, 2017. Certain property is excluded, so before making a major purchase for which you expect to take advantage of Section 179, be sure to review the purchase with your accountant. The salvage value of fixed assets (the estimated disposal values when the assets are taken to the junkyard or sold off at the end of their useful lives) is ignored in the calculation of depreciation for income tax. Put another way, if a fixed asset is held to the end of its entire depreciation life, its original cost will be fully depreciated, and the fixed asset from that time forward will have a zero book value. (Recall that book value is equal to original cost minus the balance in the accumulated depreciation account.) Fully depreciated fixed assets are grouped with all other fixed assets on external balance sheets. All these long-term resources of a business are reported in one asset account called property, plant and equipment (instead of the fixed assets). If all the fixed assets were fully depreciated, the balance sheet of a company would look rather peculiar; the cost of its fixed assets would be offset by its accumulated depreciation. Keep in mind that the cost of land (as opposed to the structures on the land) isn’t depreciated. The original cost of land stays on the books as long as the business owns the property. The straight-line depreciation method has strong advantages: It’s easy to understand, and it stabilizes the depreciation expense from year to year. Nevertheless, many business managers and accountants favor an accelerated depreciation method to minimize the size of the checks they have to write to the IRS in the early years of using fixed assets. This method lets the business keep the cash for the time being instead of paying more income tax. Keep in mind, however, that the depreciation expense on the annual income statement is higher in the early years when you use an accelerated depreciation method, so bottom-line profit is lower. Many accountants and businesses like accelerated depreciation because it paints a more conservative picture of profit performance in the early years. Fixed assets may lose their economic usefulness to a business sooner than expected, and in this case, using the accelerated depreciation method would look very wise in hindsight. Except for new enterprises, a business typically has a mix of fixed assets — some in their early years of depreciation, some in middle years, and some in later years. There’s a balancing-out effect among the different vintages of fixed assets being depreciated. Therefore, the overall depreciation expense for the year under accelerated depreciation may not be too different from the straight-line depreciation amount. A business doesn’t have to disclose in its external financial report what its depreciation expense would have been if it had used an alternative method. Readers of the financial statements can’t tell how much difference the choice of accounting methods would have caused in depreciation expense that year.

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Tax Reporting for Sole Proprietors, Partnerships, LLCs, and Corporations

Article / Updated 11-04-2019

Paying taxes and reporting income for your company are very important jobs, and how you complete these tasks properly depends on your business’s legal structure. From sole proprietorships to corporations and everything in between, this discussion briefly reviews business types and explains how to handle taxes for each type. You also get some instruction on collecting and transmitting sales taxes on the products your company sells. Finding the right business type Business type and tax preparation and reporting go hand in hand. If you work as a bookkeeper for a small business, you need to know the business’s legal structure before you can proceed with reporting and paying income taxes on the business income. Not all businesses have the same legal structure, so they don’t all pay income taxes on the profits they make in the same way. But before you get into the subject of tax procedures, you need to understand the various business structures you may encounter as a bookkeeper. Sole proprietorship The simplest legal structure for a business is the sole proprietorship, a business that’s owned by one person. Most new businesses with only one owner start out as sole proprietorships. (If an unincorporated business has only one owner, the Internal Revenue Service automatically considers it to be a sole proprietorship.) Some of these businesses never change their statuses, but others grow by adding partners and becoming partnerships. Others add lots of staff and want to protect themselves from lawsuits, so they become limited liability companies (LLCs). Those seeking the greatest protection from individual lawsuits, whether they have employees or are single-owner companies without employees, become corporations. Partnership The IRS considers any unincorporated business owned by more than one person to be a partnership. The partnership is the most flexible type of business structure involving more than one owner. Each partner in the business is equally liable for the activities of the business. This structure is slightly more complicated than a sole proprietorship (see the preceding section), and partners should work out certain key issues before the business opens its doors, including the following: How the partners will divide the profits How each partner can sell his or her share of the business if he or she so chooses What will happen to each partner’s share if a partner becomes sick or dies How the partnership will be dissolved if one of the partners wants out Partners in a partnership don’t always have to share equal risks. A partnership may have two different types of partners: general and limited. The general partner runs the day-to-day business and is held personally responsible for all activities of the business, no matter how much he or she has personally invested in the business. Limited partners, on the other hand, are passive owners of the business and not involved in its day-to-day operations. If a claim is filed against the business, the limited partners can be held personally liable only for the amount of money that matches how much they individually invested in the business. Limited liability companies (LLCs) An LLC provides owners of partnerships and sole proprietorships some protection from being held personally liable for their businesses’ activities. This business structure is somewhere between a sole proprietorship or partnership and a corporation. The business ownership and IRS tax rules are similar to those of a sole proprietorship or partnership, but as with a corporation, the owners aren’t held personally liable if the business is sued. LLCs are state entities, so the level of legal protection given to a company’s owners depends on the rules of the state in which the LLC was formed. Most states give LLC owners the same protection from lawsuits as the federal government gives corporation owners. But these LLC protections haven’t been tested in court to date, so no one knows for certain whether they’ll hold up in the courtroom. Corporations If your business faces a great risk of being sued, the safest business structure for you is the corporation. Courts in the United States have clearly determined that a corporation is a separate legal entity and that its owners’ personal assets are protected from claims against the corporation. Essentially, an owner or shareholder in a corporation can’t be sued or face collections because of actions taken by the corporation. This veil of protection is the reason why many small-business owners choose to incorporate even though it involves a lot of expense (both for lawyers and accountants) and government paperwork. In a corporation, each share of stock represents a portion of ownership, and profits must be split based on stock ownership. You don’t have to sell stock on the public stock markets to be a corporation, though. In fact, most corporations are private entities that sell their stock privately among friends and investors. If you’re a small-business owner who wants to incorporate, you first must form a board of directors. Boards can be made up of owners of the company as well as nonowners. You can even have your spouse and children on the board; those board meetings undoubtedly would be interesting. Tackling tax reporting for sole proprietors The federal government doesn’t consider sole proprietorships to be individual legal entities, so they’re not taxed as such. Instead, sole proprietors report any business earnings on their individual tax returns; that’s the only financial reporting they must do. Most sole proprietors file their business tax obligations as part of their individual 1040 tax return by using the additional two-page form Schedule C, Profit or Loss from Business. Download the latest version of Schedule C. Sole proprietors must also pay the so-called self-employment tax, which means paying both the employee and the employer sides of Social Security and Medicare. That’s a total of 15.3 percent, or double what an employee would normally pay, and it’s a bummer for sole proprietors. The table shows the drastic difference in these types of tax obligations for sole proprietors. Comparison of Tax Obligations for Sole Proprietors Type of Tax Amount Taken from Employees Amount Paid by Sole Proprietors Social Security 6.2% 12.4% Medicare 1.45% 2.9% Social Security and Medicare taxes are based on the net profit of the small business, not the gross profit, which means that you calculate the tax after you’ve subtracted all costs and expenses from your revenue. To help you figure out the tax amounts you owe on behalf of your business, use IRS Form Schedule SE, Self-Employment Tax. On the first page of this form, you report your income sources, and on the second page, you calculate the tax due. Download the most current version. Under the tax law passed in December 2017, a new provision called the 20% Pass-Through Tax Deduction for small businesses became effective in 2018. This law provides a deduction for small businesses that report earnings on their personal tax return rather than a corporate tax return. To see whether your company qualifies, you can read the complicated rules. But, be sure to discuss whether your business qualifies with the person who prepares your tax return. This new benefit will end January 1, 2026, unless Congress extends it. As a sole proprietor, you can choose to file as a corporation even if you aren’t legally incorporated. You may want to do so because corporations have more allowable deductions and you can pay yourself a salary, but this practice requires a lot of extra paperwork, and your accountant’s fees will be much higher if you decide to file as a corporation. Because corporations pay taxes on the separate legal entity, this option may not make sense for your business. Talk with your accountant to determine the best tax structure for your business. If you do decide to report your business income as a separate corporate entity, you must file Form 8832, Entity Classification Election, with the IRS. This form reclassifies the business — a step that’s necessary because the IRS automatically classifies a business owned by one person as a sole proprietorship. Download the most current version of the form. As the bookkeeper for a sole proprietor, you’re probably responsible for pulling together the Income, Cost of Goods Sold, and Expense information needed for this form. In most cases, you hand off this information to the business’s accountant to fill out all the required forms. Filing tax forms for partnerships If your unincorporated business is structured as a partnership (meaning that it has more than one owner), it doesn’t pay taxes. Instead, all money earned by the business is split among the partners. As a bookkeeper for a partnership, you need to collect the data necessary to file an information schedule called Schedule K-1 (Form 1065), U.S. Return of Partnership Income for each partner. The company’s accountant will most likely complete the Schedule K-1 forms. The entire information filing for the company is called Form 1065, U.S. Return of Partnership Income. Any partner who receives a Schedule K-1 must report the recorded income on his or her personal tax return — Form 1040 — by adding a form called Schedule E, Supplemental Income and Loss. (Schedule E is used to report income from more than partnership arrangements; it also has sections for real estate rental and royalties, estates and trusts, and mortgage investments.) Find the most current version of this form. Unless you’re involved in a real estate rental business, you most likely need to fill out only page 2 of Schedule E. Pay particular attention to Part II, Income or Loss from Partnerships and S Corporations. In this section, you report your income or loss as passive or nonpassive income — a distinction that your accountant can help you sort out. Partnerships also may qualify for the 20% Pass-Through Tax Deduction. Be sure to check with your accountant regarding this new tax benefit. Paying corporate taxes Corporations come in two varieties: S and C. As you might expect, each variety has unique tax requirements and practices. In fact, not all corporations even file tax returns. Some smaller corporations are designated as S corporations and pass their earnings on to their stockholders. Check with your accountant to determine whether incorporating your business makes sense for you. Tax savings isn’t the only issue you have to think about; operating a corporation also increases administrative, legal, and accounting costs. Be sure that you understand all the costs before incorporating. Reporting for an S corporation An S corporation must have fewer than 100 stockholders. It functions like a partnership but gives owners more legal protection from lawsuits than traditional partnerships do. An S corporation is treated as a partnership for tax purposes, but its tax forms are a bit more complicated than a partnership’s. All income and losses are passed on to the owners of the S corporation and reported on each owner’s tax return, and owners also report their income and expenses on Schedule E. S corporations also may qualify for the 20% Pass-Through Tax Deduction mentioned earlier in this chapter. Be sure to check with your accountant regarding this new benefit. Reporting for a C corporation The type of corporation that’s considered to be a separate legal entity for tax purposes is the C corporation — a legal entity formed specifically for the purpose of running a business. The biggest disadvantage of structuring your company as a C corporation is that your profits are taxed twice — once as a corporate entity and again on dividends paid to stockholders. If you’re the owner of a C corporation, you can be taxed twice, but you can also pay yourself a salary and therefore reduce the earnings of the corporation. Corporate taxation is very complicated, with lots of forms to be filled out, so there’s not enough room here to go into great detail about how to file corporate taxes. Before the new tax law went into effect on January 1, 2018, corporate tax rates ranged from 15 to 38 percent. On January 1, 2018, the flat corporate tax rate is 21 percent. You may think that C corporation tax rates look a lot higher than personal tax rates, but in reality, many corporations don’t pay any tax at all or pay taxes at much lower rates than you do. As a corporation, you have plenty of deductions and tax loopholes to use to reduce your tax bites. So even though you, the business owner, may be taxed twice on the small part of your income that’s paid in dividends, you’re more likely to pay less in taxes overall. Taking care of sales tax obligations Even more complicated than paying income taxes is keeping up to date on local and state tax rates and paying your business’s share of those taxes to the government entities. Because tax rates vary from county to county, and even from city to city in some states, managing sales taxes can be very time-consuming. Things get messy when you sell products in multiple locations. For each location, you must collect from customers the appropriate tax for that area, keep track of all taxes collected, and pay those taxes to the appropriate government entities when due. In many states, you have to collect and pay local (city or county governments) and state taxes. An excellent website for data about state and local tax requirements is the Tax and Accounting Sites Directory. This site has links for state and local tax information for every state. States require you to file an application to collect and report taxes even before you start doing business in that state. Be sure that you contact the departments of revenue in the states where you plan to operate stores before you start selling products or services and collecting sales tax. All sales taxes collected from your customers are paid when you send in the Sales and Use Tax Return for your state; you must have the cash available to pay this tax when the forms are due. Any money you collected from customers during the month should be kept in an account called Accrued Sales Taxes, which is a Liability account on your balance sheet because it is money owed to a governmental entity.

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Types of Cost Data in Businesses

Article / Updated 11-04-2019

Business managers must understand important cost distinctions when making decisions and exercising control based on different types of cost data. These cost distinctions help managers better appreciate the cost figures that accountants attach to products that are manufactured or purchased by the business. The importance of correct product costs can’t be overstated (for businesses that sell products, of course). The total cost of goods (products) sold is the first, and usually the largest, expense deducted from sales revenue in measuring profit. The bottom-line profit amount reported in a business’s income statement depends heavily on whether its product costs have been measured properly during that period. Also, keep in mind that product cost is the value for the inventory asset reported in the balance sheet of a business. Direct versus indirect costs You might say that the starting point for any sort of cost analysis, and particularly for accounting for the product costs of manufacturers, is to clearly distinguish between direct and indirect costs. Direct costs are easy to match with a process or product, whereas indirect costs are more distant and have to be allocated to a process or product. Here are more details: Direct costs: Can be clearly attributed to one product or product line, one source of sales revenue, one organizational unit of the business, or one specific operation in a process. An example of a direct cost in the book-publishing industry is the cost of the paper on which a book is printed; this cost can be squarely attached to one particular step or operation in the production process. Indirect costs: Are far removed from and can’t be naturally attached to specific products, organizational units, or activities. A book publisher’s telephone and Internet bills are costs of doing business, for example, but they can’t be tied to one step in the book editorial and production process. The salary of the purchasing officer who selects the paper for all the books is another example of a cost that’s indirect to the production of particular books. Each business must determine methods of allocating indirect costs to different products, sources of sales revenue, revenue and cost centers, and other organizational units. Most allocation methods are far from perfect and, in the final analysis, end up being arbitrary to one degree or another. Business managers should always keep an eye on the allocation methods used for indirect costs and take the cost figures produced by these methods with a grain of salt. Fixed versus variable costs If your business sells 100 more units of a certain item, some of your costs increase accordingly, but others don’t budge one bit. This distinction between variable and fixed costs is crucial: Variable costs: Increase and decrease in proportion to changes in sales or production level. Variable costs generally remain the same per unit of product or per unit of activity. Additional units manufactured or sold cause variable costs to increase in concert. Fewer units manufactured or sold result in variable costs going down in concert. Fixed costs: Remain the same over a relatively broad range of sales volume or production output. Fixed costs are like dead weight on the business. Total fixed costs for the period are a hurdle that the business must overcome by selling enough units at high enough margins per unit to avoid a loss and move into the profit zone. Note: Understanding the distinction between variable and fixed costs is the heart of understanding, analyzing, and budgeting profit. Relevant versus irrelevant costs Not every cost is important to every decision that a manager needs to make, hence, the distinction between relevant and irrelevant costs: Relevant costs: Costs that should be considered and included in your analysis when deciding on a future course of action. Relevant costs are future costs — costs that you’d incur depending on which course of action you take. Suppose that you want to increase the number of books that your business produces next year to increase your sales revenue, but the cost of paper has shot up. Should you take the cost of paper into consideration? Absolutely. That cost will affect your bottom-line profit and may negate any increase in sales volume that you experience (unless you increase the sale price). The cost of paper is a relevant cost. Irrelevant (or sunk) costs: Costs that should be disregarded when deciding on a future course of action. If they’re brought into the analysis, these costs could cause you to make the wrong decision. An irrelevant cost is a vestige of the past; that money is gone. For this reason, irrelevant costs are also called sunk costs. Suppose that your supervisor tells you to expect a slew of new hires next week. All your staff members use computers now, but you have a bunch of typewriters gathering dust in the supply room. Should you consider the cost paid for those typewriters in your decision to buy computers for all the new hires? Absolutely not. That cost should have been written off and is no match for the cost you’d pay in productivity (and morale) for new employees who are forced to use typewriters. Generally speaking, most variable costs are relevant because they depend on which alternative is selected. Fixed costs are irrelevant assuming that the decision at hand doesn’t involve doing anything that would change these stationary costs. But a decision alternative being considered might involve a change in fixed costs, such as moving out of the present building used by the business, downsizing the number of employees on fixed salaries, or spending less on advertising (generally, a fixed cost). Any cost, fixed or variable, that would be different for a particular course of action being analyzed is relevant for that alternative. Furthermore, keep in mind that fixed costs can provide a useful gauge of a business’s capacity — how much building space it has, how many machine-hours are available for use, how many hours of labor can be worked, and so on. Managers have to figure out the best way to use these capacities. Suppose that your retail business pays an annual building rent of $200,000, which is a fixed cost unless the rental contract with the landlord also has a rent escalation clause based on your sales revenue. The rent, which gives the business the legal right to occupy the building, provides 15,000 square feet of retail and storage space. You should figure out which sales mix of products will generate the highest total margin — equal to total sales revenue less total variable costs of making the sales, including the costs of the goods sold and all variable costs driven by sales revenue and sales volume. Actual, budgeted, and standard costs The actual costs that a business incurs may differ (though I hope not too unfavorably) from its budgeted and standard costs: Actual costs: Costs based on actual transactions and operations during the period just ended or going back to earlier periods. Financial statement accounting is mainly (though not entirely) based on a business’s actual transactions and operations; the basic approach to determining annual profit is recording the financial effects of actual transactions and allocating the historical costs to the periods benefited by the costs. But keep in mind that accountants can use more than one method for recording actual costs. Your actual cost may be a little (or a lot) different from my actual cost. A business that sells products can chose to use the First In, First Out method (FIFO) or the Last In, First Out method (LIFO), for example. The resulting numbers for cost-of-goods-sold expense and inventory cost can be quite different. Budgeted costs: Future costs for transactions and operations expected to take place over the coming period, based on forecasts and established goals. Fixed costs are budgeted differently from variable costs. If sales volume is forecast to increase by 10 percent, for example, variable costs will increase accordingly, but fixed costs may or may not need to be increased to accommodate the volume increase. Standard costs: Costs, primarily in the area of manufacturing, that are carefully engineered based on detailed analysis of operations and forecast costs for each component or step in an operation. Developing standard costs for variable production costs is relatively straightforward because most of these costs are direct costs. By contrast, most fixed costs are indirect, and standard costs for fixed costs are necessarily based on more arbitrary methods. Note: Some variable costs are indirect and have to be allocated to specific products to come up with a full (total) standard cost of the product. Product versus period costs Some costs are linked to particular products: Product costs: Costs attached directly or allocated to particular products. The cost is recorded in the Inventory Asset account and stays in that asset account until the product is sold, at which time the cost goes into the cost-of-goods-sold expense account. The cost of a new Ford Escape sitting on a car dealer’s showroom floor, for example, is a product cost. The dealer keeps the cost in its Inventory Asset account until you buy the car, at which point the dealer charges the cost to the cost-of-goods-sold expense. Period costs: Costs that aren’t attached to particular products. These costs don’t spend time in the “waiting room” of inventory. Period costs are recorded as expenses immediately; unlike product costs, period costs don’t pass through the Inventory account first. Advertising costs, for example, are accounted for as period costs and recorded immediately in an expense account. Also, research and development costs are treated as period costs (with some exceptions). Separating product costs and period costs is particularly important for manufacturing businesses.

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