Accounting

Accrual vs Cash Basis Accounting: What’s the Difference?

Accounting is an essential step to running a business. Regardless of industry, all businesses need to keep track of their expenses and revenue so that they can optimize their operations for higher profits and pay the correct amount of taxes. But there are different types of accounting from which business owners can choose, the two most common of which include accrual and cash basis.

How Cash Basis Accounting Works

With cash basis accounting, a business records revenue from the sale of a service or product when it receives payment from the customer. Whether the customer pays using cash, credit card, debit card or check, the business doesn’t record the payment as revenue until it has received the funds from the customer. Some basis exclusively use cash basis accounting. Retail stores, for example, typically use this method because they exchange products for money at the same time.

Cash basis accounting offers certain benefits, such as simplicity. It’s easy for businesses to record revenue when they receive payment from the customer. Furthermore, there’s no need to worry about accounts receivables affecting a business’s books. With cash basis accounting, accounts receivables — unpaid invoices — aren’t recorded as revenue.

How Accrual Accounting Works

Accrual accounting takes a different approach. Rather than recording revenue when a business receives payment from a customer, accrual accounting requires businesses to record revenue when a customer makes a purchase. This may sound confusing, but think of it like this: Purchasing and paying for a product or service are two separate things. You can purchase dinner at a restaurant, for example, and you won’t be required to pay for it until after your meal.

Many businesses allow customers to pay for their products or services after purchasing them. With accrual accounting, businesses record revenue when a customer makes a purchase. Customers may pay for their product or service when they initially purchase them. In other cases, customers may wait and pay at a later date, assuming it’s allowed by the business. Accrual accounting ignores the reception of payment from a customer. Instead, it revolves around recording revenue when a customer purchases or orders a product or service

Accrual accounting is the preferred method among business owners, primarily because it views accounts receivables as assets — which they are. On the other hand, however, it isn’t an effective accounting method for measuring a business’s cash flow.

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What Is Current Ratio in Accounting?

Financial accounting is an important task associated with running a business. If you don’t know how much money you spend and how much you generate, you won’t be able to optimize your business’s operations, resulting in lower profits. But there are a number of metrics used to measure a business’s financial health, one of which is current ratio. As a business owner, you should familiarize yourself with current ratio so that you can effectively use this metric in your financial accounting efforts.

Current Ratio Explained

Current ratio is a financial metric used to determine if a business has the adequate amount of money and resources needed to cover its short-term expenses. It’s calculated by taking a business’s current assets and dividing it by the business’s current liabilities. If your business has $500,000 in current assets and $300,000 in current liabilities, its current ratio would be 1.66.

A current ratio above 1.0 indicates that your business’s assets are worth more than the cost of its liabilities. Of course, that’s a good thing. If your business’s liabilities are higher than its assets, your business may spend more money than what it earns. In this regard, current ratio is primarily used to measure a business’s liquidity.

Current Ratio Vs Quick Ratio

Current ratio is often confused with quick ratio. Both of these financial metrics reveal a business’s liquidity by comparing its assets with its liabilities. However, that doesn’t necessarily mean they are the same. The difference between current ratio and quick ratio is that the former takes into account all assets, whereas the latter only takes into account highly liquid assets that can be easily converted to cash in a short period of time. Examples of assets used in the quick ratio formula include cash and accounts receivables.

How to Improve Your Business’s Current Ratio

There are several steps you can take to improve your business’s current ratio. First, try to keep your liabilities to a minimum. In other words, avoid taking out loans or using credit cards to fund your business. Second, work to increase your business’s current assets. With more assets, you’ll achieve a higher current ratio. There are countless ways to increase assets, such as exploring new markets or releasing new products or services. With a little work, you can improve your business’s current ratio, allowing for greater liquidity.

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The 5 Primary Types of Adjusting Journal Entries in Accounting

Creating adjusting journal entries is an important step in accrual accounting. They are called “adjusting” journal entries because they are made before you generate your actual financial reports, thereby giving you a better understanding of your business’s true financial health. In this blog post, we’re going to cover the five most common types of adjusting journal entries and what they mean.

#1) Deferred Expenses

Deferred expenses are business-related expenses that you’ve already paid for but haven’t received. Whether it’s a product or service, if you pay for something related to your business’s operations and haven’t received it yet, it’s classified as a deferred expense, in which case it should be added as an adjusting journal entry.

#2) Accrued Expenses

Another common type of adjusting journal entry is accrued expenses. While deferred expenses refer to products and services that you’ve already paid for and haven’t received, accrued expenses are the opposite: they are expenses that you haven’t paid for but plan to. If you have a business loan, for example, an upcoming interest payment on the loan is an accrued expense.

#3) Deferred Revenue

There’s also deferred revenue, which is income generated by your business that you haven’t yet fulfilled. If a customer pays for a product or service in advance, you may record this payment as deferred revenue until you deliver the product or complete the service. Once you’ve fulfilled your obligation — either by delivering the product or completing the service — it’s no longer considered deferred revenue.

#4) Non-Cash Transactions

Non-cash transactions are financial transactions made by your business that don’t have any impact on your business’s cash. Some business owners non-cash transactions are simply transactions made using credit cards, debit cards or checks, but this isn’t true. They are actually financial transactions, such as equipment depreciation, that don’t affect your business’s cash.

#5) Accrued Revenue

Finally, accrued revenue is any income that your business has earned but haven’t received payment for. It’s not uncommon for businesses to allow their customers to pay after the product has been delivered or service has been completed. The business sends the customer an invoice, indicating how much he or she must pay and by when. Until the customer pays this invoice, however, the transaction should be recorded as an accrued revenue adjusting journal entry.

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What Is Bad Debt in Business Accounting?

In business accounting, bad debt refers to unpaid customer or client invoices that you don’t expect to collect. It’s not uncommon for businesses to allow customers or clients to pay after their product or service has been delivered. This is particularly true when speaking about business-to-business (B2B) companies. If you sell a B2B product or service, you may send customers an invoice after delivering the product or service. Most customers will pay this invoice in a timely manner. There are times, however, when a customer may fail to pay his or her invoice.

When a customer doesn’t pay his or her invoice, you should continue to pursue them in an attempt to collect the debt. Maybe the customer forgot about the invoice, or perhaps he or she is experiencing financial hardship. With a little persistence, you can often collect these outstanding invoices and earn the revenue to which you are entitled.

Unfortunately, though, some customers will never pay their outstanding invoices. If an invoice is several months past due and the customer has expressed no desire to pay it, you should consider writing off the invoice as bad debt. Doing so ensures that the invoice isn’t counted as income, which would otherwise increase your tax liabilities and, subsequently, hurt your business’s profits.

If you use the Quickbooks accounting software, you can easily write off bad debt such as this. To begin, log in to your Quickbooks account and create a new account by clicking Lists > Chart of Accounts > New > Expense > Continue. From here, you can assign the customer’s account number to to the new account and enter a name (e.g. Bad Debt). When finished, click “Save & Close.”

After creating the account, you must record the customer’s bad debt. This is done by accessing Customers > Receive Payments > select the customer’s name. Next, click the line item, followed by “Discounts & Credits.” You should then click the “Discount Account” drop-down menu and choose “Discounts,” after which you can select the bad debt account that you recently created. Once this account opens, enter the amount of the bad debt (the amount that the customer hasn’t paid and still owes), followed by “Done” and “Save & Close.”

It’s frustrating when a customer doesn’t pay his or her invoice. And while writing it off as bad debt won’t change this fact, it will prevent the unpaid invoice from hurting your business’s books.

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What Is a Trial Balance in Business Accounting?

Still trying to understand the concept of trial balances in business accounting? This report provides insight into the accuracy of your busines’s financial records. Therefore, it’s important for business owners and professional accounts to create a trial balance report on a regular basis.

Trial Balance: The Basics

The primary purpose of a trial balance is to show that the value of all debit balances equals the value of all credit balances. If the debit column in your business’s trial balance reports shows a higher or lower value than the credit column, it indicates an error in the ledger accounts, in which case you must identify and correct it before creating a profit and loss statement. Trial balances are most commonly used for double-entry accounting, which involves giving every transaction two or more accounts.

Basically, a trial balance is a worksheet or report that contains the value of all ledgers, which are separated into debit and credit columns. Most businesses create trial balances at the end of a reporting period. However, there’s no specific rule stating that you must create a trial balance report at a certain time. Some businesses ignore them altogether. In doing so, however, they place their business at risk for accounting errors.

How to Generate Trial Balance Report in Quickbooks

You can easily create a trial balance report using the Quickbooks accounting software in just a few simple steps. Assuming you use Quickbooks Desktop, log in to your account and access Reports > Accounts & Taxes > Trial Balance. Quickbooks will then show you a report containing two columns: a debit and credit column. At the bottom of these columns are the totals for the respective transactions. These two columns should be exactly the same. If one column contains a different amount than the other, you should go back over the transactions to identify and correct the erroneous entry.

You can also run a trial balance report using Quickbooks Online — the cloud-based version of Intuit’s popular accounting software. From the dashboard, click the “Tax” column, hover over the client for whom you wish to run the report and click “Start Review.” Next, click the pencil-shaped icon next to “Tax Year.” This will bring up a new screen with information pertaining to your chart of accounts. If you need help running a trial balance report, contact your Quickbooks vendor for assistance.

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What is a Worksheet in Accounting?

In accounting, a worksheet is a document containing a myriad of financial information about a business for a specific period or cycle. Typically created in spreadsheet format, it provides a detailed analysis of the business’s financial transactions. Normally, an accounting worksheet will contain the following information.

Income Statement

The income statement is a part of the accounting worksheet that features revenue and expense balances. Also known as a profit and loss account, it shows the business’s expenses for the period.

Trial Balance

Another component of an accounting worksheet is trial balance. This component reveals the business’s assets, liabilities, revenue and expenses for the period. Normally, the trial balance section will list all accounts with a debit under the same column and all accounts with a credit under a different column.

Balance Sheet

Of course, you’ll also find a balance sheet section in an accounting worksheet. As you  may already know, the balance sheet contains information about the business’s assets, liabilities and capital account balances. When creating a balance sheet, you should check to make sure the total of the debit and credit columns equals the balance.

Chart of Accounts

The chart of accounts section of an accounting worksheet features a list of all accounts the business has. More specifically, it breaks down this information into several subsections, including assets, liabilities, equity, revenue and expenses.

Adjusting Entries

The adjusting entries section, as the name suggests, reveals all adjustments the business had made to its financial entries. Adjusting entries are made at the end of a fiscal period. Keep in mind, however, that these are not traditional adjustments; adjusting entries are made specifically at the end of a fiscal period.

Retained Earnings Statement

Finally, you’ll also find a section for retained earnings in an accounting worksheet. This statement is intended to show the changes in a retained earnings account. Normally, it shows a credit for the beginning balance and debits for money to paid to owners and shareholders.

These are just a few of the main components in an accounting worksheet. It’s important to note that some companies may structure their worksheet differently. The key thing to remember is that this document contains detailed information about a business’s finances for a specific period. It usually features the sections listed above, though they may contain other sections as well.

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What is Amortization in Business Accounting?

In business accounting, amortization refers to the process of making multiple payments over a period of time. A common example of amortization is a mortgage. Rather than buying 100% of the home’s cost, the homeowner typically takes out a mortgage, which he or she may pay on a monthly basis according to the lender’s terms. However, there are two specific types of amortization used in accounting: amortization of loans and amortization of assets. To learn more about the nuances between these types, keep reading.

Amortization of Loans

As the name suggests, amortization of loans involves the distribution of partial payments over a period of time. The repayment schedule is defined by the amortization, with each payment installment including both principle and interest. The total cost of the purchased product or service is divided into equal amounts by the amount of payments the business/borrower is expected to make. This means the borrower pays the same amount every time he or she makes a payment towards the loan. Because of the simplicity of this repayment model, it’s become the preferred choice among lenders and borrowers alike.

It’s important to note that negative amortization can occur if the borrower’s payments fail to cover the interest of his or her loan. The unpaid interest is added to the outstanding balance of the loan, which subsequently makes it larger than the loan’s original amount. Assuming the borrower pays according to schedule, however, negative amortization shouldn’t occur.

Amortization of Assets

In addition to loans, there’s also amortization of assets. Amortization of assets involves the value decrease of an asset over a period of time. It’s not uncommon for tangible assets to lose value over time. Known as depreciation, this typically occurs to computers, cars, heavy machinery and equipment. Business owners who own assets that depreciate in value must account for that depreciation accordingly, which is where amortization of assets comes into play.

Additionally, amortization can occur to intangible assets. Amortization of intangible is calculated by taking the initial cost of the asset and subtracting that number by the asset’s residential value systemically. When done correctly, this allows business owners to see the financial health of their assets and whether an asset’s value has increased or decreased.

After reading this, you should have a better understanding of amortization and how it relates to business accounting.

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What is Retained Earnings in Accounting?

Retained earnings is best described as a company’s historic earnings minus any dividends it has declared since its formation, expressed as a percentage. In other words, it’s the percentage of a company’s net revenue that hasn’t been paid out to shareholders’ equity on the company’s balance sheet.

The formula for calculating retained earnings is relatively simple. You take your net income and subtract it from any dividends paid to shareholders. If your company has earned $300,000 in net income and has paid out $125,000 in dividends, your retained earnings are $175,000.

This begs the question: why do some companies “retain” their earnings as opposed to distributing profits among their shareholders? Well, this goes back to the old adage of “you have to spend money to make money.” Granted, companies will still distribute some of their profits to shareholders as dividends, but investing it back into the company can help them make even more money.

It’s not uncommon for a company to have negative retained earnings. Normally, this is caused by the distribution of dividends that exceeds its net revenue. However, a negative retained earnings can also occur when a company sustains major financial losses. Regardless, it’s important for business owners to properly record their retained earnings, whether positive or negative. Doing so helps to create a more transparent view of the company’s financial health.

Assuming you use Quickbooks, you can use a retained earnings account for this specific purpose. After logging in to Quickbooks, access Reports > Profit & Loss > Customize. From here, select “All Dates” for the field titled “Transaction Date.” Next, under “Rows/Columns,” select either “Fiscal Year” or “Years,” depending on your preference. You can then click “Run Report” to create the retained earnings report.

Normally, the total in this report should match your company’s retained earnings balance listed on your balance sheet report. If the two items don’t match, it means you probably have journal entries posted to the retained earnings account. So, what should you do to fix this? Click the gear-shaped icon and choose “Chart of Accounts.” Next, click “Run Report” in the “Action” field for “Retained Earnings.” You can then choose “All Dates” from the “Transaction Date,” followed by “Run Report,” after which you can add or subtract the total to match the balance sheet for your retained earnings.

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What is Owner’s Equity in Business Accounting?

Equity can several meaning, one of which is the capital stock of a company. However, it may also refer to the difference between the assets and liabilities owed. Known as “owner’s equity,” it’s a common element used in business accounting. In fact, it’s one of the four primary types of financial statements, attesting to its importance. To learn more about owner’s equity and how it works, keep reading.

Owner’s equity — when used in the context of business accounting — is the net assets of a business. To calculate net assets, you must subtract your total liabilities from your total assets.  If you own $50,000 in assets and have $20,000 in liabilities, for instance, your net assets and owner’s equity is approximately $30,000. Of course, this is just a basic example of owner’s equity. Most business owners will have deeper and more complex calculations.

Some people assume that assets only refers to cash. While cash can certainly be an asset, there are other types of assets — and all of these assets are used to calculate owner’s equity. Assets may consist of both tangible and intangible assets, for instance. See below for a list of common business assets.

Here’s a short list of some of the most common types of assets owned by a business:

  • Common stock
  • Preferred stock
  • Retained earnings
  • Brand names
  • Copyrights
  • Goodwill
  • Equipment
  • Machines
  • Cash
  • Real estate
  • Reserve
  • Treasury stock

It’s important to note that the book value of equity may change in certain circumstances. Issuing new equity, for instance, may increase equity for shareholders. Dividends paid to preferred stock are considered an expense and therefore must be subtracted from net income, which can also change the book value of equity.

Hopefully, this gives you a better understanding of owner’s equity in business accounting. To recap, it’s the net assets of a business. Owner’s equity is calculated by subtracting total liabilities from total assets. And as you can see from the information above, there are many types of assets, including both tangible and intangible assets. All business owners should closely monitor their owner’s equity to better determine the overall financial health of their organization. When owner’s equity begins to drop or even goes negative, it’s usually a sign of poor financial health, in which case changes should be made to reverse the trend.

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What is a Contra Account in Accounting?

You’ve probably heard of a general ledger account, but have you heard of a contra account? Well, a contra account is essentially a type of general ledger account. However, it has a few unique characteristics worth noting. To learn more about contra accounts and how they are used, keep reading.

Contra Accounts: The Basics

As explained by Investopedia, a contra account is a type of general ledger account that’s used specifically for the purpose of reducing an associated account’s balance. In a typical asset account, the balance is negative. In a contra account, however, the balance is positive — and this is the characteristic feature of contra accounts. They have a credit balance instead of a debit balance, allowing them to reduce the paired account’s total balance.

How Contra Accounts are Used

Contra accounts are used in a variety of applications, one of which is for uncollectible accounts. In the same Investopedia article cited above, it explains that contra accounts can be added to an accounts receivable. The balance is used to represent the total amount that’s expected to go uncollected; thus, reducing the amount of revenue reported in accounts receivables. In a perfect world, business owners would always receive payment for the products and services they sell. However, there are times when a customer may not pay, which is where contra accounts come into play. Using a contra account, you can record nonpayments so they don’t adversely affect your accounts receivables.

Another example of a contra account is an accumulated depreciation account. This type of account is used to offset the fixed assets account. While the fixed asset account has the cost of acquisition, the contra account reflects the total cost of all depreciation expenses that have incurred against the respective assets over time. Business owners and accounts typically look at both the contra account and accumulated depreciation account to determine the net dollar value of the assets.

There’s also a contra liability account, which is somewhat confusing given that it’s not an actual liability account. Rather, a contra liability account is used to offset a payable account. A bond discount account, for instance, is a type of contra liability account. When a bond discount account is added to a contra liability account, it reveals the carrying value of the respective bond. Hopefully, this gives you a better understanding of contra liability accounts.

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