eBay itself does not require that merchants on its platform hold a particular business license. However, depending on the type of business you plan to operate on eBay, the government may require you to register for specific permits or licenses.

Do eBay Sellers Need a Business License?

No, an eBay seller does not need to acquire a business license. However, for certain types of businesses, the government may require certain types of registration for taxation purposes or for restricted goods.

If you intend to operate your eBay business as a reseller or retail operation, then you must acquire a sales tax permit (also known as a resale certificate) to collect sales tax. This seller’s permit will allow you to avoid paying sales tax on wholesale purchases, thereby avoiding a needless tax expense upfront. 

Additionally, in rare instances, the state government may require that you acquire an auctioneer’s license based on whether your business sells items on behalf of others on eBay. Consult an attorney for more information about this rare situation, as well as the legalities around operating auctions on an online marketplace.

How to Register Your eBay Business

To register a business, you should consider the following steps:

• Determine the type of entity under which you plan to operate your eBay store. Options include sole proprietorships/partnerships, LLCs, S corps, and C corps among several other common types.
• If you plan to operate a sole proprietor or partnership, you may want to register a business name or trade name known as a DBA (doing business as). A DBA will allow you to operate with your chosen name in the eyes of the government. 
• Tax IDs: If you plan to hire employees, you should acquire an Employer Identification Number (EIN) from the IRS. This identifier allows the IRS to identify your business as a separate taxation entity. 

For certain types of goods, state and federal governments may require that you apply for separate permits. Your local government may also have additional restrictions that involve permits or other types of registration. 

In addition to the above documentation, you may also want to acquire a Home Occupation Permit. This permit, for a fee, allows you to establish operations from your own home. Many professionals will want to acquire one of these permits, including entrepreneurs, dentists, lawyers, architects, writers, and more. Some municipalities may have additional restrictions on the types of businesses that entrepreneurs may operate from their own homes.

Also see: Licensing requirements for home-based businesses

Common eBay Business Entity Types 

Many eBay business owners operate informally as sole proprietorships. One common business model involves finding goods at steep discounts at various markets or thrift stores and then reselling those goods at a markup on eBay. 

In essence, this process involves taking goods from a local market level to a national or even global market in a type of arbitrage. Other business models exist on eBay in addition to this common type. 

As your business grows, you may want to consider formalizing your business through the formation of a new entity separate from your personal assets and liabilities. The most common types of entities include:

• Sole Proprietorships and Partnerships: These businesses lack the formality and liability separation which organized entities have. However, for entrepreneurs just starting out on eBay, they offer a cheap and easy way to test the waters. 
• Limited Liability Company (LLCs): LLCs provide an easy and affordable way by which to separate yourself from your company for liability protection. Additionally, LLCs offer pass-through taxation, meaning that your year-end tax bill will flow directly from the earnings or losses of your business. 
• S Corporations: An S corporation offers some of the benefits of an LLC with the additional benefit of offering easier ownership transfer. S corporations may carry additional regulatory and legal burdens for owners, however. 
• C Corporations: For most small business entrepreneurs on eBay, a C corporation poses too much complexity to act as an ideal entity. C corporations do, however, offer entrepreneurs easy ownership transfer through common stock, a reputable way to raise equity and debt funds from outside investors, and may also establish credibility for the business as it grows. 

Advice for New eBay Business Owners

As a new business owner on eBay, you should prioritize identifying product-market fit before you go down the rabbit hole of entity formation and other back-office concerns. eBay also recommends that new sellers on the platform consider the following pieces of advice:

• Optimize your listings for Best Match. This allows you to achieve a higher placement when a buyer uses a Best Match screen on the platform. 
• Ensure you adequately identify the condition of your item to avoid misrepresenting its quality post-sale. 
• eBay has recently released a new unified listing tool to help sellers more efficiently deploy new listings. 
• Be sure to block buyers who have previously caused issues with your listings. eBay offers the ability for sellers to block bidders and buyers from all of your business’s listings. 

Additional Requirements for Starting an eBay Business

To register as a seller on eBay, you will need to fulfill the following requirements:

• Individuals: Full name, address, date of birth, and social security number (SSN). 
• Registered Businesses: Identification for all owners or account managers, legal business name, DBA or fictitious business name if relevant, EIN, business address, and phone number. 

You will also need proof of identification. This proof can come in the form of a driver’s license, a government-issued ID card at either the state or federal level, or a valid, non-expired passport. 

On the banking side, eBay wants to ensure that your name matches the name on your checking account. If registering as a business, you should ensure that the business name and the business bank account match in this regard.

eBay will also require you to provide the routing number and account number for your bank account. 

The Accounting Definition of “Tangible Good”

Tangible goods or tangible assets occupy most of the attention of accountants. Humans can interact with tangible assets in a physical sense. These physical assets often have a shorter useful life compared to intangible ones. Examples of tangible assets include some of the following examples:

• Computer equipment such as those used to operate a business headquarters or office. 
• Fixed, long-term machinery such as those used in the production process at an automobile manufacturing plant.
• Software and other digital products sold or used by businesses. 
• Natural resources such as gas, oil, and minerals. 
• Manufacturing overhead supplies like glues, nails, and other miscellaneous items. 
• Physical products sold by retailers to the public, including food, medicine, and disposable products.
• Inventories used by both retailers and manufacturers to generate profits. 
• Retail storefronts such as a spa treatment facility. 

Of course, there exist an incredible number of different types of tangible goods. Accountants typically make use of conservative principles to value tangible assets at either the lower of their original cost or the current market price.

Examples of intangible goods, on the other hand, include:

• Patents: Governments grant patents to individuals and businesses to protect their intellectual property rights for a defined period of time. 
• Goodwill: When a business purchases another business, goodwill often comes into existence as a result of the transaction. It accounts for the excess cost built into the transaction. 
• Licenses: Governments and other firms also grant licenses and permits to businesses to operate in a certain, regulated manner. 
• Trademarks: Companies protect their intellectual property and brands with trademarks granted by the government. 
• The Company’s Brand: A brand itself, including wordmarks, logos, and “voice” function as intangible assets. 
• Intangible Products: These products could include consulting services or creative works such as movies or music. 

Characteristics of Tangible Assets

Tangible assets tend to require additional measures such as security and insurance since they exist in the physical world. Businesses that transact primarily in tangible assets will also need to make different financial decisions compared to those which principally deal with intangible goods and services. 

Current vs Noncurrent (Fixed) Assets

Within the category of tangible assets exist two subcategories: current and non-current or fixed assets. 

Current assets include those assets which exist for a short time on a firm’s balance sheet, including cash and cash equivalents, short-term investments (those which a firm intends to convert to cash within one year), working capital such as inventories and accounts receivable, and prepaid expenses like insurance or prepaid rental contracts. 

Noncurrent assets include those assets which lack liquidity and for which the firm cannot convert to cash in a reasonable amount of time. These include property, plant, and equipment, land, long-term investments, and vehicles such as commercial trucks.

Comparing Tangible and Intangible Assets

Key differences between tangible and intangible assets include:

• They receive different accounting treatments:
  • Companies often route tangible goods through the balance sheet prior to the income statement.
  • Intangible assets often appear first on the income statement as an expense line item.
• Tangible assets have a greater susceptibility to damage and theft. 
• Intangible assets pose valuation difficulties for investors and lenders, whereas tangible assets have settled accounting techniques.  

Examples of Companies with Substantial Tangible Assets

To compile this list, we examined the largest industries in the United States ranked by the total amount of property, plant, and equipment (PP&E) held on their books:

1. Power Utilities: Utilities and power companies must make massive investments in infrastructure and other fixed assets. The capitalized value of these assets sits on the balance sheet for long periods of time. 
2. Retail: Businesses which sell merchandise have large sums in their working capital accounts under the current assets section of the balance sheet. 
3. Auto and Truck: Automotive manufacturers and dealers must contend with large amounts of tangible assets. 
4. Semiconductors: Firms like TSMC must make large capital investments in fabrication facilities and manufacturing plants. 
5. Telecommunications: Telecom firms must invest in significant amounts of fixed infrastructure like towers, wires, and machinery to support the operations of the firm. 

Examples of Companies with Substantial Intangible Assets

The following companies have a large amount of intangible assets as measured by various studies:

1. Apple: No surprises here. Apple has developed tremendous intangible market power over the last two decades thanks to its late charismatic founder and innovative, category-defining products.
2. Amazon: In addition to a vast sum of tangible assets, Amazon always carries tremendous branding power. 
3. Microsoft: While Microsoft has a large amount of assets carried on its books thanks to its array of data centers and marketable software products, the company also invests significant sums in research and development.
4. Alphabet: The holding company of Google also invests in a variety of so-called “moonshot” projects designed to
5. Tesla: Elon Musk’s company may have substantial property, plant, and equipment, but the company pays for no advertising since it has built large amounts of intangible brand equity thanks to its founder. 

Valuation Differences Between Tangible and Intangible Assets

For businesses with a high degree of tangible assets, the task of valuation becomes considerably easier. On the other hand, a business with a large amount of intangible assets may pose valuation difficulties for lenders and investors attempting to value the company. 

Aswath Damodaran, a professor of finance at New York University’s Stern School of Business, prepared a whitepaper on how to value companies with intangible assets. This paper communicates the following valuation principles for analysts seeking to better understand how intangible assets create value for shareholders:

• Damodaran points out that firms with high-value intangible assets often have high amounts of spending in research and development, advertising, and employee recruitment. These income statement line items receive the “expensed as incurred” treatment by the accounting profession which then understates the value of the intangible assets created by those efforts. 
• Manufacturing firms, on the other hand, create capitalized assets on the balance sheet when making large investments in fixed assets such as property, plant, and equipment. Thus, book value appears more closely related to the actual value of the firm.
• Firms with significant intangible assets have a wider discrepancy between their book values and true enterprise value. 

How Businesses with Tangible Assets Operate Differently

A business with significant amounts of tangible assets tends to operate in the following ways:

• Common income statement expenses include depreciation and amortization, cost of goods sold (COGS), and interest expense since these firms tend to use debt to fund large fixed asset purchases. 
• They tend to have large amounts of current assets such as inventories and accounts receivable. 
• Businesses with significant tangible assets may invest greater sums in security and storage of their physical goods. 
• These businesses may require more staff to run operations at an efficient level. 
• These firms may have lower valuation multiples due to the degree of investment capital required to grow operations. 

Why This Matters for Your Business

As a business owner, you should think carefully about how to run your operations based on the types of assets held on your books. For business owners with mostly tangible assets, everyday operational considerations include maintaining sufficient cash flows to sustain those physical assets, securing assets from theft and damage, and carrying sufficient insurance policies to cover possible damaging scenarios. 

For business owners operating in the intangible space, other considerations arise, including the need to communicate the value of those intangible assets through financial metrics which investors and lending institutions alike can understand such as free cash flows to the firm, gross margin, and measures such as EBITDA and NOPAT. 

The key principles of entrepreneurship remain: creating value and communicating that value to outside parties, whether the business focuses on tangible or intangible goods.

Equity Injection Definition

In its simplest form, an equity injection occurs when an investor makes a cash payment to a company in exchange for shares in that company. Other sources might refer to this act as a capital injection. Typically, the word “injection” in this context communicates that the company receiving the funds has experienced a degree of financial distress and needs additional funding to continue operating.

On the other hand, an equity injection can also refer to a rule within the SBA loan framework which requires some applicants to “put some skin in the game” and make a down payment to receive a 7(a) or 504 loan. 

Depending on the context, you might hear this phrase used for SBA loans or more generally to describe the act of an outside investor making an emergency cash investment in exchange for an equity stake in the target company. 

Finally, the phrase may appear during a business acquisition or other types of transactions, although its meaning in those contexts acts outside the scope of this article. 

SBA Loan Equity Injection

Two SBA loan programs will usually require some form of additional equity invested by the borrower: the 7(a) loan program and the 504 program. 

The 7(a) program helps businesses pay for working capital, refinance debt obligations, and purchase assets like office furniture, new fixtures, and other supplies and overheads. 

The 504 program focuses on helping businesses pay for new property, plant, and equipment as well as other expensive fixed assets. Such assets might include new land, buildings, facilities, and long-term PP&E. All 504 loans require an equity injection by the borrower.

Requirements

As of 2018, the SBA put into practice new standard operating procedures which require that all borrowers of 7(a) loans with principles of $350,000 or more must make a 10% equity injection in the form of cash or in assets that constitute 10% of the loaned value. 

The SBA does not allow borrowers to fulfill equity injection requirements with borrowed cash, proceeds from a personal loan, most assets other than cash, or standby debt unless said debt is on full standby with no payments of principal or interest. 

For borrowers who make an equity injection with gifted cash, the SBA requires a letter proving the validity of the gift and a deposit statement. The lender may also have additional requirements with respect to the gift letter. 

For 504 loans, the 10% equity injection requirement also exists. The key fact to note here revolves around the necessity of providing some degree of upfront cash before taking on an SBA loan. Businesses should treat SBA loans like certain other forms of consumer debt like mortgages; ultimately, the government wants business owners to have a stake in the outcome of the funded project. 

Eligible Programs

The following SBA loan programs and associated SBA lenders require some or all applicants to put forward a minimum equity injection prior to receipt of loan proceeds:

• 7(a) loans with principals larger than $350,000.
• All 504 loans regardless of loan size. 

The following SBA loan programs do not require applicants to make a preliminary equity injection:

• Some types of 7(a) loans.
• SBA Express loans.
• SBA Export Express loans.
• CAPLines.
• SBA Veterans Advantage loans.
• SBA microloans. 

Other requirements associated with these programs may exist for your specific circumstances. A lending institution can provide more information about the exact requirements for a given business as well as the exact amount of upfront cash required, a number usually based on the total project cost. Also note that SBA requirements change with some regularity.

Types of Equity Injection Financing

Businesses may use the following sources of cash as a valid equity injection payment when applying for an SBA loan:

• Cash directly from your business’s bank account.
• For non-cash property, the SBA requires a professional appraisal. Your business must have owned the property for a minimum of two years. 
• Cash withdrawn from a personal retirement plan such as a 401(k), IRA, or Roth IRA. 
• Personal loan cash proceeds if the borrower intends to repay the personal loan with non-business-related income or from a salary from an external operation unrelated to the business itself. 

The lending institution will have more information about applicable funding sources for the equity injection requirement for an SBA loan. 

Unique Equity Injection Funding Sources

Outside of SBA loan requirements, businesses may develop a pressing need for additional cash to continue business as usual. Businesses which have reached a point of financial distress due to a downturn in the economy, operational disruptions, or inability to react to changing market conditions may find themselves in a difficult financial position.

The following unique equity injection funding sources may help a business to navigate difficult financial times:

• Friends and Family: Business owners and startups may turn to friends and family to provide much-needed cash during difficult times. In some cases, family and friends may ask for an equity stake in the business in exchange for the cash they provide. 
• Angel Investors: Some types of investors known as angels can provide early-stage financing for small businesses in exchange for a large equity stake. 
• Venture Capital Firms: VC firms can provide financing for businesses which have established a degree of product-market fit and have received a prior angel investing round. 
• Private Equity Funds: PE firms can step in to acquire businesses or purchase large stakes in existing businesses meeting certain EBITDA requirements.
• Government Programs: In some jurisdictions, government financing may help businesses to continue operating during difficult times. For example, during the COVID-19 pandemic, the US government provided businesses with emergency cash injections to pay for employee expenses in a program known as the Paycheck Protection Program or PPP. 

What to Do If Your Business Requires an Equity Injection

When determining the next best step in financing a distressed business, small business owners should consider the following funding sources prior to distributing equity to outside parties:

• If your business needs cash to pay for working capital like inventory, consider an SBA loan first. 
• Consider turning to private-sector lenders for additional debt financing if needed. 
• Avoid the pitfalls of giving outside investors equity by making use of innovative financial products like royalty financing. 
• Consider making use of the services of an invoice factoring firm to turn future customer payments into immediate cash in exchange for a fee. 
• As a last resort, consider a merchant cash advance (MCA) to keep the lights on until your business can achieve a higher level of financial stability. Ensure that your business’s cash flow can handle this type of financing.

Determining Next Steps

Owners and managers should first closely examine the financial statements to determine the exact degree of financing needed. Then, business owners should carefully consider the exact amount and mix of financing needed to bring the business back to a level of financial stability. 

Ultimately, equity acts a precious commodity of any business, and owners should only consider granting this equity to investors if the situation warrants it. Alternative financing options may offer a more appropriate solution for short-run capital challenges.

What Are Overhead Costs?

Overhead costs are fixed indirect costs incurred by businesses. They aren’t directly linked to the creation or manufacture of a product or service. These are the costs a company occurs to stay in business and generally support all revenue-generating activities.

Overhead costs generally include fixed costs, including mortgage or rent, insurance fee, employee payroll, utilities, legal costs, and administration costs. These can be further broken down into two categories: fixed and variable costs.

What Are Fixed Overhead Costs?

Fixed overhead costs do not fluctuate based on a business’ varying levels of activity. They tend to remain constant on a month-to-month basis. For instance, rent is a common example of a fixed overhead cost. Another common examples include mortgage payments, property taxes, business licenses, and more. 

What Are Variable Overhead Costs?

Conversely, variable overhead costs are business expenses that are linked to a business’ activity levels, and tend to fluctuate accordingly. As business activity levels increase, so do variable overheads, and vice versa. Common examples of variable overheads, include shipping costs or maintenance expenses.

Also see: What is the predetermined overhead rate

How Do You Calculate the Overhead Rate?

The overhead rate refers to the percentage of overhead costs that a business incurs in providing services or manufacturing products. To allocate overhead costs to a product or service, businesses apply the overhead rate to the direct costs incurred during production.

To calculate the overhead rate, you first need to determine an allocation measure or an activity driver. Businesses generally allocate overhead costs based on the number of direct labor hours or machine hours worked.

The formula to calculate the overhead rate is as follows:

Overhead rate = Indirect costs / Overhead Rate Measure

For instance, if total overhead indirect costs were $500,000 in 2021, and total machine hours (the overhead rate measure in this manufacturing example) worked were 40,000 to produce goods.

By dividing $500,000 by 40,000, the overhead rate will come out to $12.5. This implies that a company spends $12.5 in overhead expenditure for each machine hour worked during production. This can help with accurately pricing the product.

Examples of Overhead Costs

There are several examples of overhead costs, some of which are discussed below:

Administrative Expenditure

Administrative expenses generally constitute the bulk of overhead costs and mainly include costs associated with handling the day-to-day operations of the business. Administrative expenditure costs are related to purchasing office supplies, paying office associates, including any auditing or legal costs.

Rental Expense and Utilities

Both the rental expense incurred by the company as well as the amount paid for utilities such as gas, electricity, telephone service, or internet costs each month are attributed to overhead costs. In some cases, subscription costs for software might also be included in overhead.

Insurance Costs

The insurance premium paid by the company to protect itself from fiscal loss is also an overhead cost. This includes business liability insurance, health insurance, property insurance, and other types of insurance coverage that the business uses.

Repairs and Maintenance of Plant and Machinery

Plant and machinery often need to undergo routine maintenance, Apart from this, costs associated with the repairs and maintenance of vehicles and other equipment owned by the business are also attributed to overhead costs.

Why Is It Important to Calculate Overhead Costs?

Calculating overhead costs is very important for businesses as it directly impacts a company’s financial statements. Overheads are incurred regardless of a company’s activity levels, so they’re a constant presence on your income statement and balance sheet.

While it’s easy to calculate the cost of inventory, raw materials, or the labor that goes into the final product, it would be a mistake to just look at those costs and add markup as every business as many other costs that need to be accounted for.  

This can help finance leaders make better decisions that can affect a company’s performance. For instance, if a product is priced based solely on direct costs, it can reduce profits. By factoring in normal overhead costs, companies can sell goods without hurting their bottom line.

There are also strict accounting requirements where businesses must allocate costs to the goods or services they produce, which is why calculating and accounting for overhead costs is so important.

What Are the Differences Between Overhead Costs and Operating Expenses?

There are numerous differences between overhead costs and operating expenses. The latter refers to expenses incurred by the company during its normal course of business. They’re generally unavoidable expenses and appear on the income statement. Common examples include direct labor costs or materials required to manufacture a product.

Overhead costs, on the other hand, are costs that don’t directly relate to labor or materials. These are costs that relate to core business functions, including administration expenses, costs of maintenance, or rent. Unlike operating expenses, overhead costs are incurred even if a company does not partake in any revenue-generating activity.

How Often Should You Calculate Overhead Rate?

The overhead rate is used to allocate overhead costs, which is essential for determining the costs of manufacturing a product or offering a service.

Ideally, businesses should calculate their overhead rate after every financial year. They can get relevant figures from the financial statements and use those to determine overhead expenses for the previous year.

Smaller businesses can also calculate the overhead rate each quarter and allocate costs more efficiently. Calculating the overhead rate more frequently allows companies to quickly make key adjustments that prevent indirect expenditure from negatively affecting their product pricing and profit margins.

However, before making such a critical decision, business owners should consider the high costs of merchant cash advances, especially compared to more traditional options such as small business loans, business credit cards, traditional bank loans, or a business line of credit.

If you’re thinking about applying for a merchant cash advance, here are some things to keep in mind:

• The APR on a merchant cash advance is typically higher than the APR on a traditional loan. However, the repayment terms are also more flexible
• The amount you can borrow depends on the strength of your business’s credit card and debit card sales.
• If you’re thinking about applying for a merchant cash advance, it’s important to shop around and compare interest rates and repayment terms.

Are Merchant Cash Advances A Good Idea?

Merchant cash advances can be a good idea for businesses that need short-term financing and have strong credit card and debit card sales. However, the APR on an MCA is typically higher than the APR on a traditional loan, so it’s important to shop around and compare interest rates and repayment terms.

If you’re thinking about applying for an MCA, it’s important to be aware of the risks involved. There is no guarantee that your business will be approved for an MCA, and if you are approved, you may end up paying more in interest and fees than you originally anticipated.

It’s also important to remember that merchant cash advances are not a long-term solution. The repayment terms are flexible, but the loan must be repaid within a certain amount of time.

The Pros And Cons Of Merchant Cash Advances

Merchant cash advances can be a helpful source of financing for small businesses, but they also come with a few risks. Here are the pros and cons of merchant cash advances:

Pros

• Merchant cash advances are relatively easy to obtain. You don’t need a good credit score to qualify, and the approval process is quick.
• The repayment terms are flexible. You can choose to repay the advance through a fixed amount of future credit and debit card sales, or you can pay back the advance over time.
• The amount you can borrow depends on your business’s credit and debit card sales volume.

Cons

• The APR on a merchant cash advance is typically higher than the APR on a traditional loan.
• You are required to repay the advance within a certain amount of time.
• There is no guarantee that your business will be approved for an MCA.
• If you are approved, you may end up paying more in interest and fees than you originally anticipated.

Merchant cash advances can be a helpful source of financing for small businesses, but they also come with a few risks. Before you decide if an MCA is right for your business, be sure to weigh the pros and cons.

Merchant Cash Advances Vs. Other Forms Of Financing

When you’re looking for short-term financing, it’s important to weigh all your options. Here’s a comparison of merchant cash advances to other common forms of financing:

Merchant Cash Advance

• Easy to obtain, no credit score required, and borrowers with bad credit are accepted
• Flexible repayment terms based on daily credit card sales
• Factor rate (essentially the interest rate) is based on the repayment risk
• The advance amount you can borrow depends on your business’s credit and debit card sales volume

Small Business Loan

• Requires a good credit score to qualify
• Collateral and a personal guarantee from the owner will be required to secure the loan
• Fixed repayment terms
• Amount you can borrow depends on the lender’s requirements

Line Of Credit

• Requires a good credit score to qualify
• Flexible repayment terms
• Amount you can borrow depends on the lender’s requirements

Also see: What is a line of credit?

Credit Card

• Requires a good credit score to qualify
• Fixed repayment terms
• Amount you can borrow depends on the cardholder’s credit limit

Are Merchant Cash Advances A Good Idea?

Merchant cash advances can be a good idea for businesses that need short-term financing and have strong credit card and debit card sales. However, the APR on an MCA is typically higher than the APR on a traditional loan, so it’s important to shop around and compare interest rates and repayment terms.

If you’re thinking about applying with an MCA provider, it’s important to be aware of the risks involved. There is no guarantee that your business will be approved for an MCA, and if you are approved, you may end up paying more in interest and fees than you originally anticipated, which could further strain the cash flow of your business.

It’s also important to remember that merchant cash advances are not a long-term solution. The repayment terms are flexible, but the loan must be repaid within a certain amount of time.

If you’re looking for a short-term financing option that is easy to obtain and has flexible repayment terms, a merchant cash advance may be the right choice for you. However, it’s important to be aware of the risks involved and to shop around for the best interest rates and repayment terms.

Accounting Cycle Defined

The process of identifying relevant transactions and economic events, and transforming that information into reliable financial statements, is called the accounting cycle. There are many steps, including journalizing transactions, posting journals to the general ledger, preparing an unajusted trial balance, and posting adjusting entries. The net result of the accounting cycle is financial statements that show assets, liabilities, cash flows, and the relevant accounting period under review, among many other important data points.

Analyzing Transactions

Transaction analysis is one of the most critical elements of all the steps of the accounting cycle because it impacts all the other process steps in the accounting cycle. During this stage, bookkeepers, accountants, and business owners analyze source documents and determine the business purpose of transactions. Sales revenue, expenses, assets, liabilities, and other transactions are reviewed for recordation. Clerks typically work in tandem with supervisors and technical experts, to determine how to treat transactions correctly. The complexity of the transaction dictates the level of review needed.

Journalizing Transactions

Once the business purpose and nature of transactions are identified, then journal entries can be prepared. Debits and credits are entered into the journal based on U.S. Generally Accepted Accounting Principles, or another set of comprehensive accounting principles such as International Financial Reporting Standards. The debits and credits need to equal on the journal entry. Otherwise, the general ledger system will likely reject the entry from being posted. Journal entries typically go through a series of reviews before being posted.

Recording Journals To The Ledger

When a journal entry is prepared, approved, and balanced, it can be posted to the general ledger. In an electronic ledger system, this process is seamless once the journal entry is posted. With a manual ledger, the process of recording a journal to the ledger is more involved. The journal entry must be transferred from a specific journal to a specific ledger. All subsidiary ledgers must, in turn, be closed to the general ledger, before financial statements can be created.

Creating An Unadjusted Trial Balance

An unadjusted trial balance is created after I post journal entries to the general ledger. This information contains all the permanent accounts and temporary accounts listed in the chart of accounts. The trial balance is unadjusted, because the temporary accounts have not been closed out to the income summary and retained earnings accounts. Also, correcting or adjusting entries may not yet be posted to the ledger. The unadjusted trial balance is an excellent tool in the accounting process for gauging the accuracy of financial statements, before they’re published.

Recording Adjusting Entries

Adjusting journal entries to the trial balance can take many forms. Before the temporary accounts are closed to the permanent accounts, journals adjusting revenue, prepaid expenses, and the allowance for bad debt, among many other accounts, can be posted to the ledger. These adjustments are typically done during a month end of the accounting period process by accounting teams. These entries are often standardized using accounting software and repeated systematically to reduce the potential for errors. Once all corrections are made, the closing entries can be made.

Adjusted Trial Balance

Before you prepare financial records using accrual accounting, it’s important to generate an adjusted trial balance and perform a thorough review. This should reflect all closing entries. If there are any business transactions missing from the trial balance, this is the stage to identify the need and record transactions. Supervisors often use this information to perform a final review before publishing financials and conducting a horizontal or vertical analysis.

Creating Financial Statements

Financial statements are derived from the general ledger accounts recorded in the general journal and the adjusted trial balance. The balance sheet is generated from the permanent accounts, and the income statement is created using the activity from the temp accounts. The balance sheet represents a moment in time, and the income statement illustrates transaction activity for an accounting period. The cash flow statement and stockholder’s equity are also created using the adjusted trial balance.

While the presentation of each of the company’s financial statements may differ, depending on the size of the company and industry the organization exists in, the process for financial reporting is similar. Accountants, senior leaders, department heads, and other important stakeholders review the financials looking for trends and variances. These reviews are documented and kept on file if there is an audit of internal control over financial reporting.

Post Closing Trial Balance

To verify the closing process was completed accurately, a post closing trial balance is created. This balance should reflect the closing entries made earlier in the accounting cycle. If there are any temp accounts with remaining balances, then the closing process and financial statements require additional review. Any errors during the closing process should be identified at this time. This final check adds to the credibility of the financial statements and the professionals preparing them.

The accounting cycle is an essential element of preparing financial statements such as the cash flow statement, income statement, and balance sheet because it gives accounting professionals a standard methodology for recording financial transactions. This process helps take complex data and transform it into useful financial information that business owners can make decisions with. Without this process, financial information would be less timely, complete, and relevant.

Definition

Businesses often make a transaction of credit sales to customers and collect payment after the initial sale. Under accrual accounting, an accounts receivable is recorded on the balance sheet, and revenue is booked on the income statement. However, receivables often become uncollectible to the lender because a customer or maker, the person promising to pay, cannot or will not pay. When using the allowance for doubtful accounts method, an expense entry is recognized on the income statement at regular intervals. The direct write-off method records the amount of the bad debt. The bad debt may lead to an interest receivable account as well.

Calculating Uncollectible Accounts Expense

When using the allowance for doubtful accounts method, an estimate is calculated using an aging schedule that considers the number of days as time passes or the receivables method to record uncollectible accounts expense. Hopefully, most clients will pay within a 90-day time frame. The maturity date is usually determined in days. As far as the formula, historical data typically forms the basis for the estimate. However, industry averages can form the basis if the business doesn’t have a history of uncollectible accounts. For example, if a company averages five percent uncollectible accounts for the past two years, it is reasonable to book that percentage as uncollectible over the course of the current year.

The direct write-off method, however, calls for recognition of bad debts expense as accounts become uncollectible. This process requires adherence to internal accounting policies and U.S. GAAP to remain consistent over time. The journal entry to record bad debt expense involves reducing accounts receivable, or the allowance for doubtful accounts, on the balance sheet and recording an expense on the income statement. The entry should debit the bad debt amount and enter a credit balance for the allowance for doubtful accounts.

Differences Between Uncollectible & Bad Debt Expense

Bad debt expense and uncollectible accounts expense are often used interchangeably. They refer to recognizing an expense when the balance of accounts receivable or notes receivable becomes uncollectible. The allowance for bad debt is an adjusting entry known as a contra asset account listed on the balance sheet that reduces the accounts receivable to the net realizable value or realizable value of accounts. While these expenses are listed on the income statement, accurate presentation of uncollectible accounts expense is critical for the financial statements’ sales method analysis.

When accounting for uncollectible accounts receivable and recording the expense entry, it’s critical to follow established write-off procedures and save supporting documentation. Following established accounting best practices will prevent misstatement of the balance sheet. Inevitably some accounts will be uncollectible. Knowing how to record write-offs as part of financial reporting is necessary at the end of the accounting period, which may run from January to December or any other time period.

What is Interest Expense?

When a company borrows money, they typically enter into a repayment agreement that stipulates regular principal and interest payments. Lenders charge interest to make money off the transaction, but the amount of interest is a function of market conditions and the type of financing provided. The type of loan, collateral, loan term, and other variables impact interest. Most companies record the amount of interest expense on a monthly basis and note the accruing interest when interest expense should be recognized.

Interest Expense Formula

Calculating simple interest expense is a function of multiplying the stated annual interest rate, principal amount, and time. This type of calculation can be used every accounting period before financial statements are published to ensure the income statement accurately reflects interest expense. If it doesn’t, or an accrual hasn’t been posted, an adjusting entry can be posted to the general ledger. Compound interest is calculated using a similar method. The formula, however, calculates interest earned on interest. Many accounting departments keep amortization tables illustrating interest expense for the current accounting period.

Examples of Interest Expense Journal Entries

If a company borrows money from a bank via a short-term lending conduit, the loan amount would be recognized as a liability on the balance sheet, with a corresponding debit to cash. As principal and interest payments are made monthly and are usually considered current liabilities, journal entries would be made to credit cash, debit loans payable, and debit interest expense. Interest expense can be charged on all sorts of loans, payables, and bonds. However, it is important to distinguish interest expense from late charges, penalties, and fines. Categorizing expenses accurately will make it easier for management to gauge operations.

Understanding the interest expense account is important from a bookkeeping and managerial perspective. The expense must be recorded monthly, including the accrual method for expenses incurred but not yet paid. Management must know the annual interest expense amounts for the year-end and percentages to adequately plan for cash flow and capital structure.

Resources:

https://www.irs.gov/taxtopics/tc505