Information Technology Consulting & Solutions
Copyright 2000 by Data Systems Consultants, Inc.
This document is intended to acquaint you with the accounting concepts necessary to communicate clearly with our clients. While it is not a comprehensive accounting course, it will provide you with the basics.
Fiscal Year – A fiscal year marks the beginning and the end of the tax accounting year for the company. Some companies use a calendar fiscal year meaning that the beginning of the accounting year is on January 1st. Other companies use a fiscal year starting on October 1st. A company’s fiscal year can start on any date within the year but it is usually either January 1st or October 1st.
Income – Income is revenue the company has received in exchange for goods and services.
Expense – Expense is expenditure the company has paid in exchange for goods and services.
Asset – An asset is an item owned by the company that has real value. This is normally something tangible like a piece of furniture, cash in the bank or money owed to the company. Assets are further categorized as either current assets, usually cash and revenue owed to the company, and fixed assets, furniture, equipment, land, etc.
Liability – A liability is money that the company owes. For example, your car loan is a liability. So is your mortgage. Note that a liability is not the same thing as an expense. A liability is money owed, not money paid.
Capital – Capital, now commonly called equity, is the portion of the company belonging to the owners. A rule of thumb is, Assets – Liabilities = Equity.
Account – A category of expense, income, liability, asset or equity. All entries made to an accounting system are applied to an account ledger. Most companies have a wide variety of accounts to help them categorize their expenses and income.
Expense Account – Expense accounts are used to record expenditures of a particular type. For instance, an expense account may be used to record office supply expenditures.
Income Account – Income accounts are used to track revenue received. For instance, an income account may be used to track consulting income.
Asset Account – An asset account tracks the value of assets. Your checking account is an asset account because it represents real money you have. Also, since this account tracks cash, it is a current asset account.
Liability Account – A liability account is used to track money owed. Your car loan is tracked in a liability account because it represents money you owe on your car.
Capital or Equity Account – A capital account is used to track the value of the owners’ shares of the company. For instance, let’s say you start a company and contribute $5,000 for startup costs. On the day you open for business, your capital account would have a balance of $5,000. This is your share of the business. This money may be sitting in a company checking account and is an asset of the company. It also represents your ownership value.
These next two are very important as you’ll see later on. Make sure you understand them!
Debit – A debit is an increase to an expense or asset account and a decrease to an income, liability or equity account. When you make a deposit to your checking account you are debiting the asset account.
Credit – A credit is a decrease to an expense or an asset account and an increase to an income, liability or equity account. When you write a check from your checking account you are crediting the asset account.
Double Entry Accounting – The most common method of accounting in practice and the method most accounting applications are based on. What this means is that every transaction that takes place will result in at least two accounting entries. One will always be a debit and one will always be a credit.
For example, if you write a $50 check to petty cash, you are crediting your checking account and debiting your petty cash account. Or, you are decreasing the amount of money in your checking account, an asset account, and increasing the amount of money in your petty cash, also an asset account.
Balancing the Books – Accounting books are balanced when the debits minus the credits equal zero. In the above example, the amount of money in your petty cash (the $50 debit) minus the amount of money taken from your checking account (the $50 credit) equals zero. The books are balanced.
If you enter the wrong amount in your check register, the balance will not be zero so the books are out of balance. This is the indicator to the accountant that an entry error has been made somewhere. This cross checking is what insures accurate accounting and the reason why double entry accounting is so popular.
Chart of Accounts – The chart of accounts is simply a list of the accounts. Accounts are traditionally assigned numbers for identification purposes. Some sample entries in the Data Systems chart of accounts might be:
Sub Account – A sub account is a further breakdown of a primary account for more closely tracking expenses or income. Continuing with the example of the Data Systems chart of accounts, some sub accounts for the Consulting Income account might be:
Note that sub accounts are distinguished by a second set of numbers following the primary account number. These are called sub account numbers. The primary segment of the account number for a sub account will always be the same as the primary segment of the parent account. Also the account type of the sub account will always be the same type as the primary account.
Parent accounts may not have sub account numbers but, if they do they are almost always all zeroes as shown above. Different accounting applications have different account number formats. Indeed, many do not require account numbers at all.
By adding sub accounts to the Income account, we can now track our total income, account 1000-0000, which is a sum of the amounts in the sub accounts, and each individual income category defined by the sub accounts. Normally, but not always, when there are sub accounts, no entries are made directly to the primary account.
AR – Accounts Receivable. Entries to accounts receivable accounts result from the sale of a product or service. In other words, a customer owes the company money. That money, is a receivable to the company and is therefore an asset. Once the payment from the customer is received it is no longer a receivable.
AP – Accounts Payable. Entries in accounts payable accounts result from a company buying a product or service. In other words, the company owes a vendor money so it’s a liability to the company. That money is a payable to the company. Once the payment is made it is no longer a payable.
GL – General Ledger. A company's general ledger contains a summary of all of the entries for all of the accounts in the chart of accounts. The general ledger has two columns for entries, one for debits and one for credits. By adding the amounts in each column the accountant can balance the books.
Petty Cash – Most companies keep a bit of real money around to handle small, miscellaneous expenses. This is called petty cash. Petty cash is a current asset.
Accounting Period – Accounting periods are usually months, quarters and years. As each accounting period expires, the books are closed for that period.
Closing the Books – Simply means the books are balanced for all transactions in the period and balances forward are generated for each account. A balance forward is simply the sum of all entries from the closed accounting period plus the balance forward from the accounting period previous to the one being closed.
A simple example of a balance forward can be found in your check register. When you fill a page of your register, you copy the last balance of the filled page to the top of the next page. The number you copy at the top of the next page is a balance forward amount and you have effectively closed the filled page.
The advantage of accounting periods is that, should the books be out of balance at the end of the current accounting period, there is a limited number of transactions to check to locate the errors in the books. This process is exactly the same as when you balance your checkbook. You know that the transactions prior to your last statement date are correct because your checkbook was balanced for that statement. Thus, if your checkbook is out of balance for the current statement, you need to check for errors only in the transactions made since your last statement was balanced.
Current Transactions – Current transactions are transactions that are entered during the current accounting period.
History Transactions – History transactions are transactions that were entered during accounting periods that are closed.
Adjusting Entry – Adjusting entries are entries that affect the company's value but for which no transaction occurred to be posted. A common use of adjusting entries is to correct entry errors. In general, once a transaction is entered in an accounting system it is never changed. Rather, if the transaction is in error, an adjustment is made to correct the error. This provides a paper trail that can be used for tracing back to the error and the correction made.
For instance, suppose a payment of $10 is accidentally entered as $100. The customer’s balance would now show a credit of $90 which is incorrect. Rather than changing the $100 transaction from $100 to $10 an adjusting entry would be made debiting the customer’s account $90 dollars. This transaction corrects the entry in error and the customer’s account balance is now $0.00.
Journal - A journal is the original book of entry for an accounting transaction. Your check register is actually a journal.
Posting Transactions – Transactions are posted to a journal. This simply means that entries are made to some journal and eventually summaries are posted to the general ledger. For our purposes, what this means is that transactions are entered to a temporary file and then, after validation of the entries, they are moved to the production accounting data. This isn’t technically posting but we use the term because accountants understand it.
Invoice – An invoice is a request for payment for services or products sold. It usually includes a summary of each product sold, the quantity sold and the price. These summaries are called line items.
Credit Memo – A credit memo is the opposite of an invoice. When a customer returns merchandise, a credit memo may be issued to correct the customer’s balance. Sometimes, a credit memo will result in a check being written to the customer for the amount of the credit memo. Credit memos are often not issued for a customer with a credit balance. Instead, the credit is simply applied to the customer’s next invoice.
Statement – Also called a Statement of Account is a summary of invoices, credit memos and payments within a time period. It usually includes a balance forward amount and an ending balance amount.
Terms – Terms are the terms arranged for payment of AR and AP balances. For instance, very common terms are "NET 30" meaning that the net amount is due within thirty days of the invoice date. Another common term is simply NET meaning that the net amount is due upon receipt of the invoice. Sometimes, to encourage the customer to pay on time, a discount is offered if the payment is made within the number of days allowed by the terms. Such terms may be denoted as "NET 30 10 DAYS 10%" meaning the payer may discount 10% of the invoice total if the payment is made within 10 days.
Aging – Aging is simply a means of determining how much is owed and for what time periods also called aging periods. Here is an example of an aging for a particular customer:
This aging shows that the total balance owed by this customer is $2,731.19. $1,500 of the balance is "current" meaning it is not past due. Remember this is determined by the terms of the invoice. In the case of NET 30 terms, this means that there has been $1,500 worth of invoices billed within the last thirty days. $357.29 worth of invoicing is past due from 30 to 60 days, etc. An aging helps to analyze a customer’s payment history and helps concentrate collections efforts for those customers most overdue.
Credit Limit – A credit limit is a maximum amount that a customer is allowed to maintain in unpaid charges. If you have a credit card, chances are it has a credit limit. You are not allowed to charge purchases on the card if your credit limit has been reached.
Recurring Expense or Income – Recurring transactions are transactions that take place on a repeated cycle. An example of a recurring expense might be rent payments.
Balance Forward and Open Item Customers – Customer billings are usually handled either as open item or balance forward customers. This has to do with how payments received are applied to the customer’s account. When a payment is received for a balance forward customer, the payment is simply applied to the balance the customer owes. No attention is given to which invoice the customer is paying with the payment.
An open item customer’s payments are handled differently. In this case, payments received are applied to specific invoices the customer has not yet paid in full. For many accounting systems, transactions for open item customers cannot become history transactions until they are paid in full.
Prorate – When something is prorated it’s cost or income is spread equally over separate time periods or people. An example of this might be a payment for an insurance policy. Let’s assume that a company pays a six month renewal of a policy in January. The expense will be recorded in January because that’s when the check is written, but the cost should be equally divided among the six months for which the renewal pays. So, the cost of the renewal is prorated for six months, or one sixth of the cost is allocated to each month from January to June. This is recorded by an adjusting entry each month.
Depreciation – Depreciation is a method for reducing the value of a fixed asset over time. For example, suppose a company buys a car for $20,000. When the car is purchased, the company has a fixed asset worth $20,000 or, the car has a book value of $20,000. This amount would be added to a fixed asset account’s balance. The $20,000 value is called the depreciation basis of the car. Depreciation basis is always the original value or the purchase price.
The car will be worth less as it grows older. Thus, the company’s $20,000 asset is no longer worth $20,000 in the second year of ownership. In the second year, it may be worth only $16,000. This means that during the first year of ownership, the company lost $4,000 worth of value for its fixed asset.
This is where depreciation comes in. The accountant must reduce the value of the fixed asset by $4,000 but there have to be two entries. So, he credits the fixed asset account $4,000 and debits a depreciation expense account $4,000. How the depreciation amount is determined is a bit more complicated than this but this is the idea. The important thing to remember is that the asset’s book value is reduced and the company incurs an expense for the reduction.
As time goes by, the cost of the car will be completely depreciated. The car is fully depreciated when the car’s depreciation expense is equal to the car’s depreciation basis. At this point the car is said to have zero book value.
Loans, Principal and Interest – I’m sure you know what these are but there’s a bit more involved from an accounting standpoint. A loan, also called a note payable, means to borrow money from a lender or to buy something on terms. Principal is the amount of the payment that reduces the loan amount still to be paid. Principal is exclusive of interest costs. Principal paid decreases the liability of the loan and increases the asset’s equity value. Interest is the cost incurred by the company for borrowing and is an expense to the company.
Equity – Equity is the owner’s value of an asset. For instance, if you have a mortgage, you and the bank share in the ownership of your house. Your share of the ownership is your equity in your home. As you make loan payments the loan amount, a liability, is decreased and your equity, an asset, is increased. Also, as the value of your home appreciates, your equity increases.
Amortization – For our purposes, amortization is used to calculate loan payments. The result is an amortization schedule or am schedule. The am schedule lists, the payment date, the amount of principle being paid and the amount of interest being paid for each payment.
P & L – Profit and Loss Statement. This is a summary of expenses and income. If the profit or loss is positive, the company is making money or is profitable. If the profit or loss is negative, the company is losing money.
Balance Sheet – A balance sheet is a summary of all of the assets, liabilities and equity for the company as of a date. The owner’s equity, is equal to the asset values minus the liability values.
Cash Basis Accounting – Companies that operate on a cash basis use cash basis accounting. Cash basis means that accounting entries are not made until the transaction actually takes place. In other words money must change hands for an entry to occur. Companies that operate on a cash basis do not have AR or AP accounts. See below for a comparison of this method of accounting with accrual basis.
Accrual Basis Accounting – Most companies operate on an accrual basis. Accrual basis accounting means account entries will be made prior to money changing hands. While more complex than cash accounting, accrual accounting provides a more realistic view of the company’s financial status. See below for details.
Putting It All Together – Accounting Concepts
T-Accounts – A Simple Tool
Accountants often express accounting entries in T-accounts. Here’s what a T-account looks like.
Credits are entered on the right side of the T and debits are entered on the left side of the T. This is a simple way to express the entries in an account and we’ll use this here to illustrate the entries.
Cash Basis Accounting
Whether you realize it or not, you are an accountant and chances are you run your books on a cash basis. I’m speaking of course about your personal finances. Let’s take a look at what you do every day in terms that an accountant would use.
In your personal finances and life you…
Congratulations! You’re a company!
Let’s create a set of books for your company. We’ll start out on a cash basis since it’s simplest, then we’ll take a look at accrual basis so you can see the differences.
The First Step – The Chart Of Accounts and Opening Balances
Before you can use your accounting system, you have to create a chart of accounts and determine the opening balances for each account. So let’s set up a chart of accounts that you might use in your personal finances. These accounts are not complete and are just examples, your own set of accounts can be anything you want. However, this is usually dictated by tax reporting requirements. Each account must always fall into one of the following categories:
Chart of Accounts
Note that there are no opening balances for the primary accounts. There actually would be. In this case, assume that the primary account balances are equal to the sum of the sub account balances.
We’re Ready to Do Some Accounting
We now have our chart of accounts and opening balances and we understand a bit more about how the accounts work by using T-accounts. Now let’s put them to use. Remember, we are on a cash basis so no transactions are made until we physically receive or pay money. Also, remember that, for each entry made in one account there will be a corresponding entry to offset it elsewhere so that the books balance.
As we go along here, we’ll be entering several transactions and making several entries to T accounts. The entries being made for the current transaction will always be bold.
Transaction 1 – You pay a $150 electric bill.
There are two entries to be made.
Entry 1 – Debit your Electricity expense account. This increases the balance of this account because you have paid an amount on this expense account.
Entry 2 – Credit your checking account balance. This decreases the balance of this account because you have paid an amount from this asset account.
Time for a quick review. We’ve made two entries, one is a debit and one is a credit and they offset each other. This is always the case and it’s very important. If it’s not done, the books won’t balance. There will always be one or more debits and one or more offsetting credits.
Now let’s strike a trial balance. A trial balance is a test to make sure the accounts are balanced. It’s done in the general ledger which now has these transactions:
Add the debits and subtract the credits and you end up with 0.00. The books are balanced.
Transaction 2 – You deposit a $2,000 pay check from Data Systems.
There are two entries to be made.
Entry 1 – Debit your checking account by $2,000. This increases the balance of this account because you have added an amount to this asset account.
Entry 2 – Credit your Salary Income account. This increases the balance of this account because you have added an amount to this income account.
Did you get that? You added to your checking account with a debit and added to your income account with a credit. Take a look at the definitions of debits and credits above to see why. This means that you just increased the net worth of your company by $2,000.
Transaction 3 – You pay a mortgage payment. This one’s a bit more complex. Here we’ve got several entries to make. Let’s say your mortgage payment is $800.00 and is broken down like this.
Here are the entries for this transaction.
Entry 1 – Credit your checking account balance by the total amount of the payment.
Entry 2 – Debit your Interest Paid expense account. This increases the balance of the expense account.
Entry 3 – Debit your Home Insurance expense account. This increases the balance of the expense account.
Entry 4 – Debit your Real Estate Taxes expense account. This increases the balance of the expense account.
We’re not quite through yet. There are two more entries to make.
Entry 5 – Debit your Mortgage Liability account. This is a liability account so debiting the account reduces the balance.
Entry 6 – Credit your Home Equity account. Your Home Equity account is an equity account so crediting this account increases the balance.
Phew! That’s it. Now let’s look at the general ledger and make sure the books are still balanced.
Again, add the debits and subtract the credits and we get $0.00. The books are still balanced. Now, take a look at what happened with these last two transactions in detail.
First, with the deposit, you added to your checking account and your income account by depositing a check. So again, you increased your net worth by 2,000.00.
Then, with the mortgage payment, you reduced your checking account balance by $800 and increased various expense accounts by $743. That’s one part of the transaction. You also increased your net worth by $57. That’s the last two entries. You moved $57 from a liability account to a fixed asset account. The equity you have in your home increased by $57 and you owe $57 less on your mortgage principal.
Think about these entries for a second. If you fully understand them you’ll begin to see the elegance of double entry accounting and will understand completely why debits and credits mean add in one account type and subtract in another. Note the following points.
When you deposited your check, you created both a debit and a credit which conforms to the rules of offsetting entries. However, in doing so, you actually increased the value of your company. This is of course correct since you now have $2,000 more in your checking account. So, even though you used a debit and a credit you added to both the asset and income accounts. This increases your net worth.
Now look at the payment for your electric bill. In this case, you also created two entries, one a debit and one a credit. Here you subtracted from your checking asset account and added to your electrical expense account. This also is correct, you now have $150.00 less in your checking account and that money was spent to pay an electrical bill which is an expense. Your records show an increase in the expense to reflect this.
When you paid your mortgage payment, there were expense transactions similar to the electric bill payment but there was also a change in your liability and equity accounts. You have $800 less in your checking account, but part of that $800, $57 was used to pay principal on your note. A transfer was made from the mortgage liability account to the home equity asset account.
Elegant? Yes. Confusing? Probably. You may be asking yourself why there had to be any change in the asset and liability accounts. Why was this done? Read on and you’ll see why.
That money from the $800 check is at the mortgage company and we can’t get it back. But, what happens at the mortgage company? Let’s follow all of the transactions that take place just with this $57.00 and you’ll see how this works and why there had to be a change in your asset and liability accounts.
$57 credit to your checking account. The money’s not there any more so you’ve got to do this.
$800 debit to mortgage company’s checking account, $57 of which is for principal paid on your loan. They deposited your check so they’ve got to do this.
$57 credit to mortgage company’s asset account. They must do this because they have to offset the debit to their checking account. (They’ll also add other entries to income and escrow accounts to offset the remainder of the $800.)
Now here’s the cool part, their asset account is your liability account. Huh? Yep. Think about it. Your both dealing with the same thing which is the loan and there’s only one loan. You’re just looking at it from different points of view. To them, it’s an asset because they’ve got money coming from you. To you it’s a liability because you owe them money. Since their asset account and your liability account are simply two sides of the same coin, if one company changes it, that change must be reflected in the books of the other company. So…
Notice how the transactions are always in pairs and how the transactions from one company offset the transactions in the other company. That’s the elegance of the system. Everything is tied together and everything balances.
The important thing to note is that these transactions make a chain of entries that represent the actual movement of money from one company to another and within each company. Each step in the chain cross checks the previous step so an error in any one of the steps will be caught by one or more of the other steps.
This happens every time you pay a bill.
Okay. Now let’s do a bit of reporting. We’ve seen how the transactions work, now let’s see if we’re making any money. That’s done with a profit and loss statement.
The Profit and Loss Statement
A profit and loss statement is a summary of your income and expenses. Here is your P&L with the transactions done so far.
Profit and Loss Statement
You’re making a profit! Congratulations! For all companies, making a profit simply means that more money is being earned than is being spent. If the company is spending more money than it’s making, it is incurring a loss. You’ll also note that you have a positive cash flow. Cash flow is a comparison of earned income versus actual expenditures, that is, real money changing hands one way or the other.
Note a few other things here. As you can see, the P&L is simply a compilation of amounts from expense and income accounts for an accounting period and net profit or loss is equal to income minus expenses. These accounts determine the profitability of your company but have nothing to do with the company’s net worth. Note that liability and asset accounts are not included in the P&L. What this means is that the P&L reports the results of income and expense activity during the current accounting period.
The Balance Sheet
The profit and loss statement tells us whether or not we’re making money. But what’s the company worth? To determine this we need to look at your company’s balance sheet.
The net worth of your company is the equity. Equity is equal to assets minus liabilities.
Now, note a few things about the balance statement. The balance statement does not include income and expense accounts. Only asset, liability and capital or equity accounts are included. In other words, the balance sheet is a summary of the value of the things that you own and the money that you owe.
Also note the adjustments that have been made in your Mortgage liability and your Home Equity asset. Those changes result from the mortgage payment we made above. So while you still owe some banks over $63,000 you owe them $57 less than you did before making that payment.
The Problem with Cash Accounting
The biggest problem with cash basis accounting is that it often does not present a clear picture of the financial status of the company at that particular moment. Suppose for example that I contract with you for programming services but, the arrangement we have is that you are not to be paid what you are owed until the project is complete. Suppose further that this project is going to take six months to complete and I agree to pay you at a rate of $3,600 per month.
This means that, at the end of the six month period I will owe you $21,600. In the meantime, I’m billing my client that $3,600 plus a bit for myself as well. Let’s say, $4,000 per month.
Okay. After the first month, I will receive $4,000 worth of revenue from my client and will owe you $3,600 for a net profit of $400. But, because I’m on a cash accounting basis, the books won’t show any money owed to you. The books will tell me that I have a net profit of $4,000.00. After the second month, my net profit will be $8,000, then $12,000 and so on.
After month five, the books show a $20,000 profit and I’ve got money in the bank to back that up. "Wow!", I say, "I guess I can afford that new car after all!" So I go out and buy that new car and I’m just happy as a clam. Until… Month seven. Now you’re due your $21,600 but unfortunately your money is sitting in my driveway instead of in the bank where it belongs.
You see, the problem with cash accounting is that it tells you only what you’ve done in the past, not what you need to do in the future. In reality, my net profit for each of the six months is only $400 per month and I have a payable to you, a liability, of $3,600 per month. This is why people get in trouble with credit cards. Credit cards are a wonderful example of an accounts payable liability. What we need is a system that tells us what we have coming in and what we have going out before it actually happens. This is where accrual based accounting comes in.
Accrual Based Accounting – A Much More Accurate Picture
When a company uses accrual based accounting, some additional accounts are added to the chart of accounts. At a minimum, there will be an accounts receivable account and an accounts payable account. These are special accounts that can be thought of as temporary holding areas for transactions that represent money we’ll receive and money we’ll pay in the future.
These accounts don’t show up on a P&L, I’ll explain why in a moment, but they do show up on a balance sheet. The accounts receivable is counted as an asset and the accounts payable is counted as a liability.
Okay. Let’s see how these accounts work and let’s use the above example to illustrate it. Again, I owe you $3,600 per month for six months and my client owes me $4,000 per month for six months. Here are the transactions that will take place using the Data Systems accounts. Don’t worry about the account numbers but do note which accounts are being used.
Month 1 – Transactions – I bill the client $4,000 and you bill Data Systems $3,600.
First my billing to the client. I Add $4,000 to the Consulting Income account. This is an income account so to increase it I use a credit entry.
As always, there must be at least two entries, one a debit and the other a credit. Here’s the second one. I Add $4,000 to the Accounts Receivable account. This is an asset account so to add to it I use a debit.
Now I’ve got to add what I owe you. Remember I won’t be paying you until the project is complete but I still owe the money and need to account for this in my books. I must add $3,600 to the Contract Labor account. This is an expense account so I use a debit.
Now I must add the second entry to the Accounts Payable account. This is a liability account so I use a credit.
That’s month one. If I look at my balance sheet I’m going to see a $4,000 Accounts Receivable asset and a $3,600 liability. These numbers will also show up in my P&L because I’ve added transactions to the Consulting Income and the Contract Labor accounts. So I’ll see a profit of $400 for the month or my $4,000 consulting income minus my $3,600 contract labor expense. This is why the AR and AP accounts are not shown on the P&L. The amounts are already included in the expense and income accounts.
Also note, that no money has changed hands yet. Still I have an accurate profit amount for the first month so I won’t go out and buy that car.
Month 2 – Transactions
This is exactly the same as month one except that I now receive a check for month one’s billing to the client. This gets deposited to my checking account. Here are the entries added to the account ledgers.
Consulting Income. I simply add the second month’s billing to the client.
The AR account. I’m reducing the amount in the account by $4,000 for the check I received. This is an asset account so I use a credit. I’ve also added another $4,000 debit to offset the second $4,000 added to the consulting income account. The balance in my AR account is now $4,000. This balance is due to the second month's invoice to the client. Add the debits and subtract the credits and you’ll see why the balance is $4,000.
The Checking Account. This is now added to the scheme because I must deposit the check. This is an asset account so to add to the account, I use a debit. This debit offsets the credit in the AR account.
Now I’ve got to add what I owe you for month two. I add another $3,600 to the Contract Labor account.
And the second month’s entry to the Accounts Payable account.
Now my P&L will show a profit of $800 for months one and two. This process continues until month six, you get paid at the end of this month or actually at the beginning of month seven.
Here’s the state of the accounts at the end of month six. I have not yet received the month six payment from the client and have not paid you.
The balance in my checking account is $20,000, the balance in my AR account is still $4,000 and the balance in the AP account is $21,600. My profit for the six months is only $2,400 so I’ve still not bought my new car in spite of the fact that I’ve got $20,000 sitting in the bank.
Month 7 – Transactions
You get paid this month and I receive the last payment from the client. Here are the entries in the AR and Checking accounts. I credit the payment received to the AR account.
At this point the client has paid for all six months so the project is paid in full. The AR account’s balance is now $0.00. Now I debit the checking account by depositing the last payment.
All payments made by the client have been deposited so my checking balance is $24,000. All that’s left to do is to pay you what you’re owed. This means I write a check from the checking account. This is an asset account so to decrease the amount I must add a credit transaction for your pay of $21,600.
This leaves me a checking account balance of 2,400 which is my profit for the project. I still haven’t bought that car.
One more transaction. I have to create the offsetting transaction to your check in the AP account. The AP account is a liability account so I use a debit to reduce the balance.
The balance of my AP account is now $0.00 and you are paid in full for your time.
So, let’s sum up the advantages of accrual accounting using this example to describe them.
Cash Flow versus Profit and Loss
Remember that cash flow is a measurement of real money changing hands. It’s equal to inflows minus outflows.
Let’s look at the profit and loss and cash flow for month two of our example. During this month, I received a payment of $4,000 from the client for the first month’s billing and wrote no checks. This means I had a positive cash flow of $4,000 for the month. That is, I received revenue of $4,000 less expended revenue of $0.00 for a cash flow of $4,000. However, my net profit for the month was only $400.
In fact, the $4,000 payment I received in month two was actually for work done in month one. This means in month one I had a profit of $400 and a cash flow of $0.00. See the difference?
Profit and loss for an accrual based company measures the difference in income and expenses for the accounting period regardless of whether or not any money physically changes hands. Cash flow measures the amount of money that does physically change hands during the accounting period regardless of when the money was earned or expended.
Cash flow and profit or loss are totally unrelated for an accrual based company and, in reality for a cash basis company as well. It’s just that income and expense entries are not made for a cash basis company until money actually does change hands.
Now let’s look at month seven. During this month my profit is $0.00 because the project was completed in month six. That is, I did no work billable to a client and incurred no contract labor expenses. However, my cash flow, is $4,000 income less, $21,600 outflow or ($17,600).
Accountants express negative numbers in parenthesis or brackets, "<" and ">".
For a company to remain in business, cash flow must be given great consideration since cash flow pays the bills regardless of the company's profitability. However, the long term viability of a company is more often determined by its profitability. My company is not profitable in month seven and has a negative cash flow. However, it had cash reserves from the previous months' income. So I was able to pay you.
That’s it! There’s your crash course in basic accounting.