Making money and earning a living from your business is great. After all, that’s probably one of the main reasons for setting it up in the first place.

But as a small business owner, how do you go about actually paying yourself? And what are the things that you need to consider when looking at how much to pay? 

There are several ways of paying yourself as a business owner, and how the business is structured will affect how you are able to take money out of the business. It will also impact on how you are taxed on this amount, so there is quite a bit to consider when deciding on the best course of action.

Importantly, it’s also vital to then consider just how much is appropriate to take out of the business, based on what your personal budgetary requirements are and taking into consideration the cash needs of the business in the short to longer term.

Paying yourself as a sole proprietor

As a sole proprietor, you are the owner of the unincorporated business. You are effectively self-employed and not an employee. 

In these circumstances, all of the profit that is earned in the business is yours, and you are able to take this amount from the business as ‘business drawings’. This amount is then subject to personal income tax.

This structure is by far the easiest and most straightforward set up for a business, as there is minimum regulation involved in registration and ongoing, and the arrangements for set up are quick and easy. 

The business structure is most suited to a business that has low risk and low earnings. Quite often, this is the first stage for a new business that is setting up from scratch.

It allows you as the business owner to operate the business as you want and to be rewarded by the profits generated from your activities. 

In the first few years of operation, this structure would suit your level of activity and keep things simple in terms of how your company finances are organized. 

This may be fine for the first few years, or even forever for some small business owners who are looking to earn a living from a relatively small, low risk operation.

In time, however, it may be that your business has grown, or your plans have evolved into generating more revenues and expanding your offering. 

That may be a time that triggers a review of your business structure and to consider other set ups that may have become more suited to your expanding business.

Paying yourself in a partnership

Like the sole proprietor set up, paying yourself in a partnership means that the profits are distributed to the partners via what is termed as ‘partnership drawings’. 

Each partner is then taxed on their partnership drawings and liable to personal income tax on these amounts.

Again, as a partner, you do not receive a salary from the business, as you are effectively self-employed and not an employee of the business.

Paying yourself from a Limited Liability Company (LLC)

This is a business entity that also allows you to pay yourself through an ‘owner’s draw’. It’s a structure that is a bit more complicated than the sole proprietor set up, but also gives you other options for paying yourself that can vary between electing to be treated as either a sole proprietor, partnership, or corporation.

It essentially allows you to be paid from the LLC via different options depending on how many people are involved in the business. 

This may be helpful if the business is growing or evolving, with more people becoming involved in the business.

If it’s just you, then you’ll be treated as a sole proprietor.

If there are others involved, then you can elect to be treated as a partnership or a corporation from a tax point of view.

As a single-member LLC, the company’s profits and your own income are the same. If you decide to take everything out each year, your draw is the total profit for the year.

If you want to keep a bit back in the business, perhaps to upgrade a computer system or buy new shop fittings, you can draw out an amount that leaves some of the profit in the business bank account to pay for the upgrade or new fittings.

In this example, the personal income tax is calculated on the total profits for the year, regardless of whether the full amount was taken out through drawings.

Paying yourself from a corporation

In this structure, with an incorporated business, it is possible to pay yourself with a salary and to receive money from the business as a ‘dividend’ payment. 

A dividend is another way of distributing profits from an incorporated business, that allows a payment (a ‘dividend’) to be made to each of the shareholders. 

In this set up, it may be that you are the only shareholder in the business.

Alternatively, you may have other shareholders if you have people who are working with you and appointed as directors, and this allows the profits to be distributed to all shareholders.

To receive a salary, you need to set yourself up as an employee of the company. This will allow you to be paid a regular salary, most likely monthly, that is treated as a business expense of the business, and you will then pay personal income tax on the monthly salary payment.

Both S-corporations, C-corporations, and a limited liability company that is taxed as a corporation is required by the Internal Revenue Service (IRS) to pay a reasonable salary (or reasonable compensation), which means your salary should be comparable with what someone else doing the same job in your industry would be paid. 

The amount of dividend that can be paid is dependent on the profits that the business has made during the year. 

 The profit that can be distributed (or paid) to all shareholders is calculated by taking all revenues and deducting expenses and corporation tax. The expenses will include any salary that you may have paid yourself during the year.

In this structure, it is common for the business owner, or director as they will be called in a corporate entity, to be paid both a salary and a dividend payment.

The benefit of receiving a dividend payment is that no payroll taxes or self-employment taxes (which include social security and Medicare) are paid on this income. 

Owner’s draw – pros and cons

The upside of taking out an owner’s draw is that is simple and straightforward, with little administration and easy to record and control.

The profits that the business generates can be immediately transferred to you, and this amount is then subject to personal income tax. 

There is no need to set up employee records and it keeps costs minimal.

It’s also important to highlight that you are directly rewarded for the company’s success. More hard work and profits means that you can take out more money from the business.

A downside is that you, as the business owner, are also fully liable for the business. Unlimited liability goes straight from the business to you, and there is nothing to separate between the business and you as an individual in terms of any debts that are payable.

Salary – pros and cons

Paying yourself through a salary gives you more certainty about your income. If the business performs badly for a few months and generates smaller profits, or even a loss, you are still able to take out a set amount by way of wages each month, and able to meet your household bills.

If all you are doing is receiving a paycheck, with no additional dividend payments from profits, you will also build up some cash in the business to expand. This may mean your business will grow faster than if you were taking out all the profits that the business is generating.

How much to pay?

The answer to this question will vary between business owners and depends on various things such as personal budgets and your future ideas and plans for the business.

As an individual, you will have bills to pay and personal desires to spend money on things each month. That figure will determine and guide what amount you want to receive from the business, by whatever means, each month.

If earning a living from your business is the goal, with no plans to grow the business, then this will help determine how much to take out and also help guide whether a draw is simpler and more straightforward in this circumstance.

If, however, you plan to grow the business and to invest in capital items that will help the business to grow even more, then you will need to keep some of the profits in the business bank account. 

In this scenario, you should not take out all the profits generated, but leave some in the business and take out what you need for living and personal expenditure.

Define Total Manufacturing Cost

The accounting and business term, total manufacturing cost, also called cost of goods manufactured, which shows up in the cost of goods line in the income statement, which encapsulates a company’s expenses across departments during the three stages of the manufacturing process:

1. raw materials,
2. work-in-progress,
3. finished products.

It provides a detailed accounting for the costs of labor, material costs, and overhead costs.

Total Manufacturing Cost Formula

While many math formulas used in finance and business require complicated arithmetic, the total manufacturing cost formula does not.

The formula is: Total manufacturing cost = raw materials + direct labor + manufacturing overhead 

While direct labor cost and cost of manufacturing overhead remain a straightforward calculation of summing, the cost of raw materials, also referred to as direct materials cost, used in the total manufacturing cost calculation requires a formula as well.

The formula is: Cost of raw/direct materials = Beginning inventory + Purchases added – Ending inventory 

How To Calculate Total Manufacturing Cost

The simplicity of the formulas belies the work behind calculating them. Your first step, calculating the total cost of direct materials used in the manufacturing purposes, entails an analysis of construction, so you include the cost of each nut and bolt. Determine the actual cost of each component of raw materials required to manufacture the finished product. Sum these expenses for the raw/direct materials component of the equation. Second, calculate the total cost of labor that contributes directly to the manufacturing process. This includes salaries, wages, incentives, and benefits. Third, you calculate the total cost of manufacturing overhead, which takes into consideration indirect costs such as indirect labor and indirect materials, utilities, repair, rent and maintenance costs, taxes and insurance, depreciation, and stolen assets. Total manufacturing overheads are an essential figure when analyzing the overhead expenses during the manufacturing process.

Total Manufacturing Cost Per Unit

You must set a finite period during which you calculate the total manufacturing costs. Typically, this is a fiscal quarter. Once you calculate the total cost, you divide that value by the number of items manufactured during the same period.

Per Unit Cost = Total Manufacturing Cost/Total Number of Items Manufactured 

This provides you an easily understood number to work with to set your asking price, also known as the manufacturer’s suggested retail price, for your product. Comparing the total manufacturing cost to the total revenue generated lets you easily see your company’s profitability. This one simple calculation aids you in multiple ways in your business accounting.

Why Is The Calculation Of Total Manufacturing Costs Important?

Monitoring the company’s financial statements is critical as owners can analyze the manufacturing cost or COGM as a proportion of total sales between accounting periods. Knowing this, management can then look to cost cost-cutting measures to improve profitability.

What Is Bad Debt?

Accounts receivable or invoices that are determined to be uncollectible are expensed as bad debt. Bad debt shouldn’t be written-off unless the receivables are uncollectible in consistency with a company’s bad debt expense write-off policy and U.S. GAAP which is a guide for standard accounting principles. There are two popular methods for performing the write-off; the allowance method and the direct write-off method. Each technique has advantages and gives users of financial statements insight into a company’s financial position.

See how to calculate an uncollectable bad debt expense account.

Definition Of The Allowance For Doubtful Accounts

Under the allowance method for bad debt write-offs, a contra-asset account is created in your accounting books or in your software on the balance sheet that carries a credit balance. When the allowance is netted against accounts receivable, it provides financial statement users with an estimate of receivables that are still collectible. The allowance is determined using an estimate derived from historical bad debt and trends in the marketplace. An amortization table is typically used to track the allowance and the frequency at which it’s recognized on the income statement. The allowance method is based on the matching principle.

What is the Direct Write-Off Method?

When using the direct write-off method, an accounts receivable is removed from the balance sheet and expensed on the income statement, as receivables are determined to be uncollectible. There is no allowance for uncollectible accounts listed on the balance sheet. Instead, accounts receivable is always listed at current value, in the current assets section of the balance sheet. While this method has advantages, the allowance method for estimating bad debt is popular, because it gives users of financial statements a better idea of their net income and financial position.

Bad Debt Journal Entry Example

Under the direct write-off method, the journal entry for a bad debt write-off will include a credit to accounts receivable and a debit to bad debt expense. This entry should have support that illustrates how the write-off ties back past due receivables and the company’s write-off policy for the current period. The journal entry when using the allowance method for doubtful accounts is different.

The credit is posted to the allowance for the doubtful accounts account, and the debit balance is posted to bad debt expense. Bad debt expenses can be found in the general ledger. The amortization table that tracks the bad debt allowance should be used as support for the entry. At year-end, the allowance for doubtful accounts needs adjustment, so that the subsequent year’s allowance can be booked at the new estimated amount. Each year the allowance for doubtful accounts or bad debt reserve should be reviewed and adjusted, to meet changes in payment activity and trends in the marketplace. This, along with past experience, will give you some kind of foundation for the next accounting period.

When expensing bad debt from a customers account or cost of goods sold, the journal entry should be prepared using a method consistent with U.S. GAAP or another set of accredited accounting standards. Remaining consistent will enable investors, owners and management to accurately monitor bad debt and its impact on the bottom-line.

Resources:

What Is Bad Debt?

Accounts receivable or invoices that are determined to be uncollectible are expensed as bad debt. Bad debt shouldn’t be written-off unless the receivables are uncollectible in consistency with a company’s bad debt expense write-off policy and U.S. GAAP which is a guide for standard accounting principles. There are two popular methods for performing the write-off; the allowance method and the direct write-off method. Each technique has advantages and gives users of financial statements insight into a company’s financial position.

See how to calculate an uncollectable bad debt expense account.

Definition Of The Allowance For Doubtful Accounts

Under the allowance method for bad debt write-offs, a contra-asset account is created in your accounting books or your software on the balance sheet that carries a credit balance. When the allowance is netted against accounts receivable, it provides financial statement users with an estimate of receivables that are still collectible. The allowance is determined using an estimate derived from historical bad debt and trends in the marketplace. An amortization table is typically used to track the allowance and the frequency at which it’s recognized on the income statement. The allowance method is based on the matching principle.

What is the Direct Write-Off Method?

When using the direct write-off method, an accounts receivable is removed from the balance sheet and expensed on the income statement, as receivables are determined to be uncollectible. There is no allowance for uncollectible accounts listed on the balance sheet. Instead, accounts receivable is always listed at current value, in the current assets section of the balance sheet. While this method has advantages, the allowance method for estimating bad debt is popular, because it gives users of financial statements a better idea of their net income and financial position.

Bad Debt Journal Entry Example

Under the direct write-off method, the journal entry for a bad debt write-off will include a credit to accounts receivable and a debit to bad debt expense. This entry should have support that illustrates how the write-off ties back past due receivables and the company’s write-off policy for the current period. The journal entry when using the allowance method for doubtful accounts is different.

The credit is posted to the allowance for the doubtful accounts account, and the debit balance is posted to bad debt expense. Bad debt expenses can be found in the general ledger. The amortization table that tracks the bad debt allowance should be used as support for the entry. At year-end, the allowance for doubtful accounts needs adjustment, so that the subsequent year’s allowance can be booked at the new estimated amount. Each year the allowance for doubtful accounts or bad debt reserve should be reviewed and adjusted, to meet changes in payment activity and trends in the marketplace. This, along with past experience, will give you some kind of foundation for the next accounting period.

When expensing bad debt from a customers account or cost of goods sold, the journal entry should be prepared using a method consistent with U.S. GAAP or another set of accredited accounting standards. Remaining consistent will enable investors, owners and management to accurately monitor bad debt and its impact on the bottom-line.

Resources:

https://www.hud.gov/sites/documents/BADDEBTEXPFINDATA.PDF
https://fmx.cpa.texas.gov/fm/pubs/aps/27/c001_all.php

Definition

A post closing trial balance is comprised of permanent accounts and is produced after adjusting entries are posted, and the adjusted trial balance is prepared. A trial balance is a listing of accounts from the general ledger and is typically displayed with two columns – one for debits and one for credits. The trial balance should have a net balance of zero, and the debits should equal the credits. The post closing trial balance is part of the bookkeeping process involving financial transactions and is reviewed when manually preparing financial statements. In automated systems such as those using accounting software, post closing entries may not be reviewed by accountants.

Purpose

This type of trial balance is important for verification. It ensures that closing was performed correctly and that all the temporary accounts were reduced to zero, by closing entries. When manually creating financial statements in Excel, a post closing trial balance is an effective tool. Given that most general ledger systems are automated, these types of trial balances are not as prevalent in accounting departments, as they once were.

Accounts

As previously stated, only permanent accounts should be listed on this type of trial balance. If any income statement accounts still hold account totals or a balance, or if the income summary account is still listed with an amount, the closing process didn’t go as intended. It is important to review the accounts and troubleshoot any errors in the closing process once identified.

Types of accounts included on a post closing trial balance:

• Cash and Cash Equivalents
• Accounts Receivable
• Accounts Payable
• Notes Receivable
• Notes Payable

Preparation

The accounting cycle is an involved process that requires different stages of analysis, adjustments and preparation. Towards the beginning of the cycle, transaction analysis and journal entries are recorded for items such as accounts payable and accounts receivable. At the end of the cycle, an unadjusted trial balance and adjusted trial balance are created, before closing entries are posted and a post closing trial balance is prepared. It is important to know the nuances of the accounting cycle, to understand what a trial balance is.

If the general ledger system has a post closing trial balance feature, then preparing the report is straightforward. If the trial balance is prepared manually in Excel from spreadsheets, it typically takes time at the end of the accounting period to make the adjusting and closing entries, to produce the post closing entries. The amount of time is contingent on the complexity of the business and the experience of the preparer.

Trial Balance Example

One only has to look to the balance sheet to see an example of what a post closing trial balance might look like. The trial balance sheet entries will contain all asset, liability and owner equity accounts or owner’s capital account and will typically be listed in that order. In the asset portion of the trial balance, you will see accounts such as cash, inventory, accounts receivable, fixed assets and accumulated depreciation. In the liability portion, you will see accounts payable, notes payable and customer deposits. In the owner equity portion, you might see paid-in-capital and a retained earnings account. Keep in mind the accounting equation which is assets = liabilities + owner’s equity.

The post-closing trial balance, which does not include revenue, gain, loss, expense accounts such as utility expense, supplies expense, insurance expenses, salaries expense, depreciation expenses, or summary account balances, is an effective tool for ensuring financial statements are accurate, complete and useful. Temporary accounts are reduced during the closing process when closing entries are posted, leaving only permanent accounts displayed on the balance sheet. The post-closing trial balance sheet accounts should show that the total of all the debit accounts balances equals the total of all credit accounts balances, which would then net to zero. The post-closing trial balance is the last step or final step in the accounting cycle, and then the cycle starts all over again for the next accounting period. It is the final trial balance before the new accounting period begins.

What is Cost of Goods Sold?

The inventory cycle is made up of three phases. These include the ordering phase, the production process, and the finished goods and delivery phase. Many of the transactions associated with the manufacturing and shipping of inventory held for sale are classified as COGS, or Cost of Goods Sold. While an expense, these costs are displayed directly beneath sales on the income statement so that users of the financial statement can make determinations about gross margin and profitability. Businesses with these inventory valuation costs listed on the income statement include retailers of consumer or specific products such as shoes, clothing, vehicles, and beverages.

The inventory account on the balance sheet lists the value of inventory and is considered a separate line item relative to the expense recognized on the profit and loss statement. Inventory cost assumptions, such as LIFO and FIFO, are important for recording inventory costs. Accounting policies and U.S. GAAP dictate the appropriateness of the inventory costing method, given the nature of the business and accounting best practices. These methods include the periodic inventory system and perpetual inventory system,

Costs Included in Cost of Goods Sold

There is a simple formula associated with calculating the inventory cost: Beginning inventory plus inventory purchases minus ending inventory equals COGS. If a company makes inventory at a production facility, then the cost of goods manufactured plays a role in determining cost. Expenses such as direct labor cost, direct materials, and overhead costs factor into the equation. Production departments work with purchasing and purchase orders to order the raw materials used in COGM. Accounting personnel must track these costs to ensure accurate financial reporting at the end of the period.

Recording Cost of Goods Sold

When recording the journal entry for the cost of inventory, posting to the appropriate accounting period is critical to remain consistent with the matching principle. Typically Excel spreadsheets are used to track the current period inventory costs. I should use this spreadsheet to support the journal entry and tie it back to general ledger accounts, such as work-in-progress inventory accounts. There should also be a tie-out between production tracking records and the accounting inventory cost spreadsheets.

Knowing the difference between a regular expense and the cost of goods sold is of the utmost importance when preparing journal entries with double-entry accounting. A company policy is typically in place, dictating dollar thresholds, rules, and the circumstances under which costs can be added to COGS. For example, freight-in charges may be added to COGS, but only if specific criteria are met. Knowing the rules will help ensure auditors and business owners alike agree with the costs recorded for inventory.

In summary, when preparing a journal entry for inventory costs, accountants must select the correct expense account and support to justify the entry. These entries must be done with care to remain in compliance with U.S. GAAP and prevent misstatement of the financial statements. Line items such as inventory and accounts receivable are under constant review by auditors at the end of the accounting period, making accuracy a priority.

Of course, there are some intricacies, and it can be a bit more complex depending on the type of business you are in, but here is a basic overview so you can become familiar with the process.

The basic definition for the calculation of depreciation expense is allocating the cost of a particular asset over the course of the anticipated life of that asset.

This includes anything that will not last forever, like a building, equipment, trucks, computers, fixtures, etc.

Even though a company will often pay for that item outright, as far as accounting purposes are concerned, the expense of that item will be spread out through the “lifespan” of that item.

Assets will not all be treated the same way, and there are several depreciation methods that accountants will employ.

Some of these different methods of depreciation that lead to the depreciation calculation are the unit of production method, double declining balance method, accelerated depreciation method, double declining-balance depreciation, digits depreciation method, the modified accelerated cost recovery system or MACRS, the sum of the years’ digits depreciation method and straight-line depreciation rate. The MACRS is the method generally required on a tax return by the IRS. For intangible assets, amortization is the method used for depreciation.

Also see: What is a tangible good?

The two basic methods are straight line depreciation and accelerated depreciation.

Straight-line depreciation is more commonly used and means that each year the same amount or percentage of the value of the asset is depreciated, not including the salvage value of the asset.

Depreciation Expense Methods

There are 2 methods for calculating the depreciation formula; the straight-line depreciation formula and the declining balance depreciation formula.

Straight-Line Depreciation Method

The straight-line depreciation method is the most simple formula and is also the most commonly used by businesses. With a straight line, the cost of a fixed asset is depreciated evenly over the useful life of the asset.

Straight Line Depreciation Example & Formula:

The straight-line depreciation expense formula is Straight Line Annual Depreciation Expense = Depreciable Amount /Estimate Useful Life. The depreciable amount is calculated as the Cost of the Asset – Salvage Value.

In this example, a piece of heavy machinery was purchased for $60,000 and has an estimated useful life of five years, upon which time it will have an estimated salvage value of $5,000. Using the formula above, the depreciable amount is $55,000 ($60,000 – $5,000) and the straight line annual depreciation expense is $11,000 ($55,000 / 5)

Straight Line Journal Entry:

Using the straight-line method of depreciation, the expense would be journalized like:

This journal entry would be posted at the end of the year, showing the increase of accumulated depreciation.

Straight-line Depreciation Calculator

Declining Balance Depreciation Method

The Declining Balance method of depreciation lets a business accelerate the amount of depreciation for an asset. More depreciation is taken at the beginning of the asset’s life than at the end. This is allowed as some assets are more productive when new and then when they are used.

Declining Balance Depreciation Formula & Example

The formula to calculate the declining balance formula is Depreciation Rate × Book Value of Asset. The depreciation rate is found by Accelerator (multiplication factor) × Straight-Line Rate. The accelerator is a multiplication factor that shows increased depreciation at the end of the first year of purchase and then declines for the remaining years.

Let’s say your company bought a computer system and it cost $15,000. It is expected to last 10 years. Here is how the asset depreciation would look:

So your depreciation rate would be $1,000 per year for 10 years in this example.

Accelerated depreciation is, as the name suggests…the asset’s cost is allocated in a much faster manner, with more of the cost being allocated at the beginning and less at the end. The total amount of depreciation or total depreciation expense remains the same, but the rate at which it takes place is different.

In the depreciation accounting example above, the year one amount will be the highest, and every year after that, the amount recorded will be less throughout the 10-year period. There are several depreciation methods for this, including SYD, 150% declining, and double-declining.

Declining Balance Depreciation Calculator

So now you can answer the question of what depreciation accounting is and how does it work. It’s simply a way to spread the cost of any asset you have over the life of that asset, removing its residual value from the equation.

What Is The Difference Between Depreciation Expense And Accumulated Depreciation?

Basically, the difference between depreciation expense and accumulated depreciation is that one appears on the income statement as a business expense, and accumulated depreciation is on the balance sheet as a contra asset. Accumulated depreciation is a running total of depreciation on the balance sheet and shows the purchase price minus the accumulated depreciation over the useful life of the asset.

What Is Salvage Value?

Salvage value is the expected market value of an asset after the end of its useful life. Take, for instance, a truck that was purchased and would fall into a five-year depreciation schedule. While the truck would be fully depreciated on the company’s books, the truck would still have a market value.

When Does Depreciation Increase A Business’s Taxable Income?

Depreciation is the reduction of the value of an asset over time as that asset’s life expectancy decreases. Depreciation expense shows on the income statement and reduces the amount of taxes paid by lowering a business’s net income.

Why Is Depreciation Important To A Business?

Depreciation provides several benefits to a business, but two of the most important are:

• Allowing a business to recover the cost of an asset when it was purchased.
• Proving tax benefits that lower a business’s taxable income and increases tax savings.

If you have any questions about how depreciation works, talk to your accountant. He or she will be familiar with all of the particulars that apply to your business. Together you will be able to figure out the best way to record depreciation for your company.

Doing a cash flow analysis for a small business can make a huge difference when it comes to determining whether or not your business is on the right track.

The objective in any business is to make a profit but you can’t really be sure you’re actually doing that unless you have taken the time to consider your cash flow and remain on top of it on a daily as well as monthly basis.

Cash flow, as the name suggests, is the flow of money into and out of your business.

You should have a starting amount and then you will have both money coming in and various expenses that you have to pay on a regular basis.

Making an estimated cash flow plan can help you to keep track of exactly how much money you have and exactly where it is going so that you can better control spending and maximize profit.

Doing a Cash Flow Analysis

Every cash flow analysis for a small business begins with the starting amount.  That’s the amount of money you have on hand to begin with.

From here, you will move on to estimating what your regular expenses will be, including rent, inventory and payroll.  The more accurately you can assess how much you regularly spend, the better off you’ll be in the long run.

Next, you’ll need to keep careful track of all money that comes in from paying customers.  Using a sequentially numbered invoice system is a good way of keeping your business transactions in order so that you can easily figure out exactly how much money came in and when.

Then you can compare this against the expenses for the month and see what your ending cash, or the amount you are actually left with really is.

Cash Flow Chart

The best way to keep track of cash flow is with a cash flow chart that shows all of these elements in a quick, easy to read format.

If you put together one of these charts each month at year’s end you’ll have an overall picture of your business’s financial records.

This will prepare you to handle any sudden, unexpected expenses that come up and also let you make any necessary adjustments to your financial practices to help your business run more smoothly.

Download a free cash flow chart here.

Advantages of a Cash Flow Analysis

The biggest advantage of doing a cash flow analysis for a small business is to help you better manage your money.

There are many ways that you can take your business profits and make them work for you, including paying off debt, investing, or building an emergency cash fund.

You might also opt to spend a little for capital improvements to make your surroundings more appealing or efficient, or increasing payroll to keep your employees satisfied and productive, both of which can ultimately help to increase profits.

So, as you can see, the simple task of regularly analyzing your cash flow can have a huge impact on your small business.

It is absolutely crucial to ensuring that your business maximizes profits and prevents any unnecessary expenses that can chip away at those profits.

Spending the few minutes it takes each month to stay on top of your cash flow could help to put more money in your pocket rather than going out to lenders or business associates.  And that’s the bottom line for every business.

The process of writing off an asset can be done in several ways depending on the individual items. Depreciation is the process of writing off an asset, such as equipment and land improvements, over the fixed asset’s useful life. Improvements and renovations can increase the useful life, but typically repairs or maintenance aren’t considered when determining the useful life of an asset. Land improvements include such things as parking lots and sidewalks. Amortization is used for intangible assets such as trademarks, copyrights, computer software (there are special requirements for computer software used for internal use), and patents.

When adding an asset cost to the financial statement, businesses have 2 choices. One, they can make it an expense, and it would show up on the income statement. The other option is to capitalize it, where it would show up on the balance sheet through the calculation of shipping costs, invoices and installation costs of the asset. So, how do you capitalize an asset? The IRS has certain thresholds at which fixed assets should be capitalized by a business, however, businesses can choose to increase or decrease those capitalization thresholds to better suit their circumstances. Some things to consider when capitalizing are acquisition cost, capital lease, interest costs, operating leases, fair market value, leased assets, lease term, net book value, salvage value, and certain aspects of the infrastructure.

When To Use Capitalization Of Assets

There are two factors to keep in mind when deciding how to capitalize assets or simply recording the purchase price as an expense which is time and the amount of the expense. 

1.Time – Capitalization (recording a cost as an asset rather than an expense) is used…

when recording a purchase of an asset that…

is not expected to be used up in the current year or time period.

For example, when you purchase office supplies, you can expect you will use those supplies in the near future.

So you would record the purchase in your office supply expense account.

However, if you purchased a building for your business or organization, you would expect to use that asset for a longer period of time. So you would capitalize the building purchase.

2.Amount – Another factor to keep in mind is the amount of the purchase. Smaller purchases of assets are not usually capitalized. Larger purchases that are typically classified as long-term assets are.

Each company and organization usually sets itself a specific dollar amount for that purpose. Above that amount, the purchase is capitalized. Below that amount, it is simply charged to its corresponding expense account. That specific dollar amount is called the capitalization limit or cap limit.

How To Capitalize Assets

There are some simple rules to keep in mind when capitalizing long-term assets. Land is always capitalized!

Keep in mind that when recording the land purchase, you will also include closing costs such as title fees, legal fees, and back taxes.

You will also include in with the cost of land any cost incurred while getting it ready to use, such as:

• environmental testing
• land clearing and grading
• tearing down old buildings
• cleanup cost
• landscaping
• drainage systems
• sewers

The purchase of buildings and equipment or the construction of a new building is also capitalized. As with the land purchase, you will include closing costs and any cost associated with getting the capitalized assets ready for use, such as:

• blueprints
• permits
• architect fees
• shipping and handling cost
• installation fees

Note: if you purchase land and buildings together. You are going to have to separate the two cost and record separately.

For example, you purchase a building for your small business or organization. The total cost was $500,000. The appraiser estimated the building to be worth $350,000.

You would capitalize the cost of the building at $350,000 of the cost of the land at $150,000. This extra step has to be done as you will depreciate the cost of the building, but not the land. Land is never depreciated!

How Does Capitalization Affect Assets?

Since the decision of when to use capitalized costs will either affect the income statement or balance sheet, the resulting changes to the company’s financial statements need to be evaluated.

Total Assets – Total Assets will increase when costs are capitalized.
Net income – Capitalizing costs will typically improve profitability since the cost is shared between financial statements.
Shareholder Equity – Will be higher just after making the entry but will be minimal over the long-term.
Cash Flow – Cash flow will be reduced if the company capitalizes on its expenses.

Capitalized Assets And Financial Statements

The difference between capitalizing an expense and simply recording it under the appropriate expense account in which financial statement it will affect.

The total cost of capitalized assets will show on the balance statement or statement of financial position for nonprofits, whereas recording the purchase under the appropriate expense account will show on the income statement or statement of operations for nonprofits.

Tip: even though the income statement is not affected at the time of capitalization, the cost (except for land) will eventually be recorded and included in your organization’s income statement through depreciation expense.

For example, you purchase a vehicle for your business for $35,000.

Vehicles are usually considered five-year property.

Assuming you use the straight-line method to depreciate the asset, you would record a $7,000 depreciation expense per year on your income statement.

Example Of Journal Entries To Capitalize Assets

(See this page on recording accounting journal entries if you need a refresher course.)

Using the example above, this is what the journal entry to record the capitalized asset would look like:

Vehicle (asset account) $35,000 (debit)

Cash (asset account)              $35,000 (credit)

If you made a $5,000 deposit and financed the rest through your bank, the journal entry to capitalize the asset would be:

Vehicle (asset account)                    $35,000 (debit)

Cash (asset account)                                           $5,000 (credit)

Notes Payable (liability account)                         $30,000 (credit)

A journal entry to capitalize assets mentioned earlier in this article, such as the land and building, would look something like this:

Land (asset account)                   $150,000 (debit)

Building (asset account)               $350,000 (debit)

Mortgage Payable (liability account)          $500,000 (credit)

All of the above sample journal entries would only affect and show on your balance sheet. As stated above, the total cost of capitalized assets (except for land) will be expensed or depreciated out over the useful life of the asset.

We do this through an income statement expense account titled “Depreciation Expense” and a contra account in the asset section of your balance sheet titled “Accumulated Deprecation. “

A contra account is an account that offsets a corresponding account. So an accumulated depreciation contra account offsets or reduces your fixed assets accounts.

Using the example of the $35,000 vehicle and the $500,000 land and building purchases, this is what a basic journal entry would look like:

Depreciation Expense              $15,974 (debit)

Accumulated Depreciation                        $15,974 (credit)

*Based on the assumption that the straight-line depreciation method is used. Vehicles are usually considered five-year property, and a commercial building is a 39-year property.

If we wanted more detail in our reports, we could set up and record it like this:

Depreciation Expense- Vehicle              $7,000 (debit)

Depreciation Expense- Building              $8,974 (debit)

Accumulated Depreciation                        $15,974 (credit)

Note: these offsetting journal entries would be recorded at the end of your organization’s reporting period.

Some of the time, you only fill out those transaction forms once. You might be doing a one-time purchase, like paying for some new office furniture. Other times, though, you’re paying or charging the same companies or individuals on a regular basis.

QuickBooks contains a shortcut to those recurring tasks, called Memorized Transactions. You can save the details that remain the same every time, and use that template every time the bill or invoice is due, which can save a lot of time and improve accuracy. Here’s how it works.

Making Copies

To memorize a transaction, you first need to create a model for it. Let’s say you have a monthly bill for $450 that’s paid to Bruce’s Office Machines. You’d click Enter Bills on the home page or open the Vendors menu and select Enter Bills. Fill in the blanks and select from drop-down lists to create the bill. Then click Memorize in the horizontal toolbar at the top of the form. This window will open.

Figure 1: Before you can Memorize a transaction, you first have to create a model (template) for it.

The vendor’s name will already be filled in on the Memorize Transaction screen. Look directly below that. There are three ways that QuickBooks can handle these Memorized Transactions when one of their due dates is approaching:

• Add to my Reminders List. If you click the button in front of this option, the current transaction will appear on your Reminders List every time it’s due. You might request this for transactions that will change some every time they’re processed, like a utility bill that’s always expected on the same day, but which has a different amount every month.
• Do Not Remind Me. Obviously, QuickBooks will not post a reminder if you click this button. This is best used for transactions that don’t recur on a regular basis. Maybe you have a snow-shoveling service that you pay only when there’s a storm. So the date is always different, but everything else is the same.
• Automate Transaction Entry. Be very careful with this one. It’s reserved for transactions that are identical except for the issue date. They don’t need your approval–they’re just created and dispatched.

Click the down arrow in the field to the right of How Often and select the correct interval. Then click the calendar icon to pick a date for the next occurrence. If you have selected Automate Transaction Entry, the grayed-out lines below Next Date not shown here) contain fields for Number Remaining and Days in Advance to Enter.

How Does QuickBooks Know?

Obviously, you’ll want advance warning of transactions that will require processing. QuickBooks lets you specify how many days’ notice you want for each type. Open the Edit menu and select Preferences. Click Reminders in the left vertical pane, then the Company Preferences tab. You can tell QuickBooks whether you want to see a summary in each category or a list, or no Reminder. Then you can enter the number of days’ warning you want.

Figure 2: QuickBooks lets you specify the content and timing of your Reminders.

Working with Memorized Transactions

Once you’ve created some Memorized Transactions, you will undoubtedly need to review them at some point. QuickBooks makes this happen. Open the Lists menu and select Memorized Transaction List to see all the templates for recurring bills, invoices, etc., that you’ve defined. Right-click on one you want to work with and this menu appears:

Figure 3: The Memorized Transaction List with the right-click window open.

You have several options here. If your list is so long that it fills multiple screens, you can Find the transaction you’re looking for. If you’ve created multiple related transactions, you can save them as a New Group. You can also Edit, Delete, and Enter Memorized Transactions.

Anytime you’re letting QuickBooks do something on its own, it’s critical that you thoroughly understand the mechanics of setting the process up. Please call if you have any questions about the topic of Memorized Transactions. One of our specialists would be more than happy to assist you with this or any other aspect of QuickBooks operations.

If you will take the extra time to set it up properly, you will get more accurate reports and be more likely to continue using the accounting software efficiently.

The following steps can be used to set up any small business accounting financial software, but I will use QuickBooks as an example in this article as that is the accounting software I use.

There are usually two starting dates to consider when setting up your software:

1. The conversion date is the date you start entering new transactions in your accounting software.
2. The start date is the date your accounting software begins tracking transactions in order to produce reports. That date is the first day of your fiscal year.

QuickBooks and other accounting software tracks transactions from the first day of your fiscal year to the last. So you should enter historical transaction information to get accurate balances for your accounts.

You do not have to enter each individual transaction your business has incurred since the first of the year; instead, you can combine transactions and enter the total.

For example, say your conversion date is May 1st. You could enter the total of your income up to that date as one transaction and then enter all of your electric bills as one single transaction and so on.

• If your conversion date is early in the year, you might want to consider entering each single transaction incurred from the first of the year until your go-live date. 
• If you start using QuickBooks in the middle of the year, I would use the combined historical method mentioned above.
• If it is toward the end of your fiscal year I would consider waiting until the first of the next year.

Your conversion date must always be on the first day of a period: the year, the quarter, or the month!

You do not have to enter your historical transactions before you can start using QuickBooks or your accounting financial software. You can enter them later, just be careful to date them correctly. QuickBooks and other similar accounting software uses the current date automatically, so you will have to remember to manually change the date for each transaction.

Second step in setting up accounting financial software is preparing a trial balance. A trial balance lists all of your assets, liabilities, and owner’s equity balances as well as the year to date income and expense numbers on your conversion date.

If you are converting from another small business accounting financial software, such as Quicken or similar software, you can simply have your old system produce a trial balance on the conversion date.

If you are not lucky enough to have this instantly available, you are going to have to do a bit more work.

See the steps below for preparing a trial balance as of the conversion date:

• Cash Balances: You will need bank account balances. Do not grab your checkbook register for this one. You will need to dig out your last reconciled bank statements before your conversion date. Hopefully, your bank statements are on a true month basis (covers first day of month to last). If not, you are going to have to calculate the reconciled balance for your conversion date.(Some accounts you set up as bank accounts in QuickBooks are not really actual bank accounts such as petty cash, but you will need to know the balances of those accounts as well.)
• Accounts Receivable Balance: Figure the total of all your unpaid customer invoices.
• Asset Account Balances: You will need to know what each asset originally costs. Remember your basic accounting? Fixed assets are those tangible assets, such as office buildings, furniture, fixtures, and equipment, used in the operation of your business, that have a relatively long life and are not intended to be sold in the normal process of the your business. For depreciable fixed assets, you will also need to provide any accumulated depreciation that has been claimed for that asset.
• Liability Account Balances: You will need to know the balances of your short term and long term debts.

Tip: You do not have to worry about the owner’s equity accounts as QuickBooks will calculate your owner’s equity account balances for you based on the differences between your total assets and your total liabilities.

Example of a trial balance if you are converting on the first day of the accounting year:

Example of a trial balance if you are converting at some other time other than the beginning of the accounting year:

*Notice this trial balance has year-to-date income and expense balances.