Accounting is one of those topics that when mentioned most people shudder and rather dig trenches than have to deal with. When you run a business there is already so much to worry about with operations, hiring employees, managing inventory and dealing with logistics like, should we change the display? Should we extend our hours? Are we meeting health code requirements? And the list goes on. So when it comes to managing finances some of us just rather not – or maybe we would if we knew how non-threatening it could be. In the course Financial Accounting you’ll learn key accounting techniques and practices that could turn you into your own accountant (hey, you’d save money, right?).
If you outsource you’ll end up paying big bucks to keep an accountant on retainer. Accountants can manage our personal and/or business finances and then report financial earnings, losses and other vital information to us. However, even with an accountant or awesome in-house accounting skills we can run into accounting problems that leave us scratching our head. So what are some of the common accounting problems that are encountered and how do you fix them?
Regardless who the bookkeeper is for your business or personal finances, chances are they are going to be using some sort of accounting software that makes analyzing finances a heck of a lot easier. One of the safety features inherent to many accounting programs is double-entry bookkeeping. This prevents clerical errors in data entry from occurring by creating an opposite entry for every record input. For example, if we earn $567 from a client we would need to record these earnings under income but also record these earnings as a debit from our cash account. This measure prevents us from accidentally adding or subtracting important financial information that can cause discrepancies and a serious headache later.
Varying Methods of Accounting
One of the biggest and most catastrophic types of accounting problems people run in to is using different methods of accounting company wide. Maybe you use the first in last out method of inventory management in your grocery department but decide to use the last in first out method of material flow for other departments with non-perishable goods. First in last out (FIFO) says that the first items received into the inventory stock are the first ones to be sold. This makes sense if you run a food store because perishable goods have expiration dates and you don’t want the food to spoil while sitting in the warehouse. Last in first out (LIFO) indicates a company who purchases inventory and then sells it immediately rather than pulling from inventory already in stock. This is a less common form of inventory management but it’s tax-advantageous which is why some company’s use it. If different departments are trying to track and record these two very different accounting protocols it can be confusing and cumbersome when it comes to completing the operational accounting ledgers.
Likewise, if a company manages cash in one system and decides to manage accounts payable in another system, there can be miscommunication between how much cash is available to spend and how many debts are being paid off. It’s important to keep incredibly detailed reports of every penny that comes in and goes out of your business so you don’t end up in the red and wondering where it all went wrong. When the problem really occurs is when the company decides they no longer want to keep separate books and they combine them. Now the cash records and the accounts payable are intertwined but they have independent accounting methods. Make sure you understand what types of accounting are being utilized in the company before making big changes to how you keep the books. Learn more about entrepreneurial finance and accounting in this course.
Failure to Record
Keep up to date financial information! It is so important that you update every single purchase, earning, credit, deferred payments, damaged goods, depreciation, asset disposal and asset acquisition that occurs in your company. Don’t begin practicing the “I’ll do it later” mentality or later may never come and then you are wishing you had just taken the time to enter the relevant data into your almighty accounting program. You can experience serious financial loss and not even know it if your records aren’t kept tidy. This can lead to things the big bag IRS swooping down to audit you and that’s just scary. Understanding how accounting work will help you understand your business better. Check out the course Learn Accounting to review accounting through a business perspective.
Fixed asset depreciation is a difficult thing to calculate. But just because it seems like a lot of work doesn’t mean you can forego doing it and recording it. Asset disposal (selling off an asset) happens all the time, you have a vehicle you don’t use or a machine that is just in the way. If you aren’t using an asset you cannot add it to your cost of operations because technically, it’s not a part of your operations. Fixed assets include anything that directly contributes to generating income for the business. If you use your favorite pen daily to take down work notes – you can consider it a cost of business. The same goes for all of the machinery, tools, supplies, vehicles and so on.
A fixed asset is “fixed” because it experiences depreciation over time. If you miscalculate the depreciation of an asset it can cause your financial records to get a little wacky. To input an asset disposal you must: know the original price you paid for the asset (refer to your handy-dandy-notebook), know how many years you could reasonably use this product before it gives out on you (i.e. you’ve had a truck for five years and it’s likely got another five years of life in it for a total of ten usable years); and then you have to calculate it’s depreciation value (subtract the salvage value from the original price you paid and then divide the answer by the years of useful life remaining). See, that wasn’t so hard? Maybe you’re thinking – yeah right! – if you got a little lost there try this fun course to teach you financial accounting basics (you won’t fall asleep, trust me). Anyways, if you don’t calculate your depreciation correctly, and if you don’t record it correctly (both in the investing activities section and the operating activities section) your net income numbers will be inaccurate.
Yes, your working capital is an important facet of your entire accounting objective. You may have just finished up your income financial statement and your expense sheet but you somehow forgot to take into consideration your working capital (operating assets) and cash flow (current assets). Bollocks. Now you’ve got all the wrong information plugged into your financial statements which means all the wrong information is being analyzed and you’re getting a false reading of your company’s health. Learn how to read and create the essential business financial statements: the balance sheet, income sheet and the cash flow statement in the course Financial Statements.
Within the working capital there is accounts receivable, accounts payable, net operating assets, current assets and fixed assets. This is a lot of information. If you neglect to consider any of these figures your income statement is going to look like you hit the lottery – but you didn’t. You have operating liabilities – or money you owe to creditors and taxes – and then you’ll know what your net operating assets are. Let’s briefly go over the components of the working capital so you understand the importance.
Fixed Assets – as described above these are all of the things you own that contribute directly to generating income. They will depreciate and you will probably sell, replace or upgrade them at some point.
Current Assets – this includes everything that is going to be turned into cash within the next twelve months like inventory and accounts receivable, it also includes cash itself.
Net Operating Assets – when you look at the total amount of your operating assets you may be thinking, wow, I’m doing well! Come back down from cloud nine and let’s do a quick equation to get you the amount of money you actually have to spend on upgrading equipment or investing. To calculate, take your total operating assets and deduct your operating liabilities. That’s better. If you’re accounts payable department is not showing accurate information then your operating liability figure will be skewed and thus your net operating income will be, too.
Accounts Receivable – the total sum of your account receivable may not be what you’re actually owed. How so? It depends on the type of revenue recognition system you’re using. If the company decides to use cost recovery then you aren’t going to be recording all of the profits your due on a working contract until you actually receive the money. So essentially, even though you’re working on a project worth $10,000, you won’t report these earnings as gross profits until you have the money in your hand. That being said, your accounts receivable financial statement may only display all completed projects and the subsequent income.
Simply put: don’t do it. There are of course several reasons you shouldn’t engage in fraud, like it’s illegal and all that, but additionally it can cause paramount financial devastation to your company. If you defer your gross profits by using a revenue recognition system like cost recovery (which is not accepted by General Accepted Accounting Principles, or GAAP) you can end up with a misleading representation of how your company is actually doing. Not to mention you end up paying less taxes (less gross profit incurs less income taxes) and this could come back to bite you in the you-know-what down the line. Other types of fraudulent activity like reporting false figures can completely damage a business, their reputation and can lead to criminal charges. If you suspect there is fraudulent activity going on within your company contact a CPA to gain support in launching an investigation.
Accounting is nothing short of complex and it’s incredibly important that all types of accounting valuation methods are taken into consideration when doing your financial reports. If you feel like you’re missing out on money somewhere review everything in a detailed fashion and remember to remember (easy, eh?) what type of accounting your company is using. You will likely uncover the error this way and be able to fix the records. Learn more accounting basics in Interpreting Financial Statements. Knowing what you’re looking for is half the battle.