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PocketWatch On February - 15 - 2011

This is the fifth in a series of articles that will hopefully educate readers and illuminate the process of doing business in a simple to understand, nuts-and-bolts way.

To read all the articles in this series, click on any of the following:

In the previous articles, we have covered motivation, a Business Plan, the Organization Chart, and how to think about money as it goes in and out of a business.  In this article, I will describe how to set up a rational and useable Chart of Accounts, focusing mainly on the Profit & Loss Statement (P&L).  This will become essential when developing a Financial Plan for your business.

Chart of Accounts – A map of your business…

A properly constructed Chart of Accounts does many things.  First, it simply keeps track of transactions, totals Assets of all kinds, Liabilities of all kinds, and your Equity in the business.  Second, the Chart of Accounts is used to generate two essential reports, the Profit & Loss Statement and the Balance Sheet.  Both of these reports are critical in understanding what is happening in your business.  While I will primarily focus on the P&L because that report concerns itself with money in and money out to tell you whether you are profitable or not at any given time (hence the title of the report), I will address the Balance Sheet briefly.

The Balance Sheet

The Balance Sheet has three sections.

  • Assets
  • Liabilities
  • Equity

———-

Assets are what you might think they are, stuff that is valuable that you own.  Asset categories are typically:

Assets

Current Assets (current means having value within the next 12 month period starting today)

  • Cash & cash equivalents (petty cash, checking and savings accounts, money market accounts, certificates of deposit, etc.)
  • Accounts Receivable (money that’s owed to you through outstanding invoices)
  • Inventory (raw materials, unsold finished goods, supplies)
  • Prepaid expenses (some expenses, like insurance, are prepaid, and have a value to the company until the prepayment period is over)
  • Notes receivable (loans owed to the company, employee loans)
  • Other Current Assets (ask your CPA)

Fixed Assets (longer term assets, typically physical things)

  • Furniture & fixtures
  • Equipment (usually machines used to make things)
  • Vehicles
  • Leasehold improvements
  • Buildings
  • Building improvements
  • Land
  • Accumulated Depreciation(this is a complicated issue as there are at least 4 different ways to calculate Depreciations of various kinds, ask your CPA)

Other Assets

  • Notes receivable non-current (loans owed to the company, employee loans)

On the Balance Sheet, the value of all these things are added up to become “Total Assets.”

———-

Liabilities are generally money that the business owes or things work against the value of the business.  Categories are typically:

Liabilities

Current Liabilities

  • Accounts Payable(stuff you owe, usually unpaid vender and supplier invoices)
  • Taxes payable (lots of subcategories here… sales tax, payroll taxes, income taxes)
  • Employee benefits payable (employees accumulate benefits over time and use them up in chunks and until they are used, its a debt)
  • Current portion of Long Term debt (what you owe on loans over the next 12 months, starting today)
  • Customer deposits (if you take money from customers for work done in the future, it’s not your money until the work is complete)
  • Other Current Liabilities (ask your CPA)

Long-Term Liabilities (debt that is out in time past 12 months from now)

  • Notes Payable
  • Land Payable
  • Equipment Payable
  • Bank Loans Payable

On the Balance Sheet, the value of all these things are added up to become “Total Liabilities.”

———-

Equity is the value you or shareholders have in the business.  Accounts typically are:

Equity

  • Owner’s equity (the money you put up)
  • Capital (the money others put up, can vary in value based on circumstances)
  • Retained Earnings (money that the business has accumulated over time, i.e., add up all the profits or losses at the end of every year you have been in business)

On the Balance Sheet, the value of all these things are added up to become “Equity.”

———-

The reason that the Balance sheet is called the Balance Sheet is simple.  Assets = Liabilities + Equity.  In other words, if you look at a Balance Sheet, look at Total Assets, then look at the bottom of the report.  Liabilities and Equity will be summed, and that number is exactly the same as Total Assets.  It MUST be.  Them’s the rules!  There is a lot that goes on when any transaction occurs, and I recommend that you read a bit about Accounting and Bookkeeping to familiarize yourself with the principles of double-entry bookkeeping.

Whew!  That’s a lot to absorb.  Take a break, and come back, and we will discuss the structure of the Profit & Loss Statement.

 ———-

The Profit & Loss Statement (P&L)

The Profit & Loss Statement (P&L) is much easier to understand than the Balance Sheet.  It deals with the nuts and bolts of your business in a real and immediate way.  As was discussed last time, there are three categories: Sales, Costs of Goods Sold (COGS), and General & Administrative (G&A) Expenses.

The trick to setting up the accounts in the P&L is to think about how your business operates.  Every business is different.  Do you sell one thing? Do you sell 3 types of things?  For example, a residential construction company may build houses and also do renovations.   A grocery store may want to section out meat, dairy, deli, bakery, etc.  A manufacturer may also do design work.

You need to track each income stream and its associated costs (COGS) seperately in order to see what part of the business is more or less profitable, if one part has a different periodicity than another, if materials or labor costs are significantly different from one category of sales to another.

So, think about the business.  Take a piece of paper and play with categorizing the income streams.  Keep it simple, don’t get too complicated.  Once done, your Revenue section of the P&L will look like this:

———-

Revenue

  • Sales 1
  • Sales 2
  • Sales 3
  • Other income (see the previous article for more details on other types of income you may want to track, like shipping charges to customers)

You’re done!

———-

Now, Cost of Goods Sold (COGS)…

Think about each sales stream.  Think about any and all costs for each stream… materials, labor, shipping into your business, etc.  Again, see the previous article for a more detailed discussion.  Then, list the COGS for each income stream seperately.  Your COGS section should then look like this:

COGS

COGS 1

  • Materials
  • Labor
  • Shippping
  • Supplies
  • Outside services

COGS 2

  • Materials
  • Shippping

COGS 3

  • Labor
  • Outside services

That’s it!  Note that each COGS does not have to be and may not be the same.  COGS 2 in this case is reselling something, for example.  No labor or anything else.  COGS 3 is maybe service of some kind your business does.  The key here is to relate each COGS section directly to each sales stream.

———-

We’re almost there… 

Now we come to the General & Administrative Expenses (G&A).  These are expenses that are not directly associated with creating what you sell.  You will see what I mean shortly.  The key in this section is to group expenses so you can look at them and manage them in a rational way,  Again, see the previous article for details on what G&A is all about.

G&A

  • Administrative labor
  • Benefits

Then a General Category

  • Facility expenses (usually repairs and maintenance to the physical property)
  • Dues & Subscriptions
  • Charitable Contributions
  • Office supplies
  • Postage & Delivery
  • Professional fees
  • Training
  • Telecommunication
  • Utilities
  • Insurance

Sales category

  • Marketing
  • Gifts
  • Travel & Entertainment
  • Meals

There are other categories called Other Income, where things like gain/loss on sales of assets and interest income are listed.  Other Expenses are where taxes, bad debt, and interest expense are listed.  Both of these areas need input from your CPA to correctly assign these accounts.

———-

And there you have it!  A rational, organized and easily understood Chart of accounts!

This is critical to managing your business.  Your CPA can help you set it up, but willnot know what is important to YOU.  Popular software like Quickbooks doesn’t either.  You have to take control of this very, very, very important part of your business.

———-

Please contact me offline at microconsulting@aol.com with anycomments, suggestions or ideas for future articles that you may not want to share here.

———-

Related articles

Written by PocketWatch

I am a small town boy from northern Wisconsin, who grew up in the quintessential American family. Dad was a carpenter, mom stayed home, two brothers and a sister. Our politics, and we were political, was always Democrat. My dad always said all you had to do was to look at what each side was fighting for, and it was easy to see, even as a kid, that Republicans were all about big money and rich businessmen, whereas the Democrats were more about social solutions. I spent 6 years in the US Army in the VietNam era as an electronic instructor for NSA, worked as a Field Engineer for a computer firm based in Massachusetts, spent another few years building paper mills around the world for a firm from Washington state, drove long haul truck for a while, did 10 years of servitude in NYC for a large multinational market research company as the Business Manager, spent some more time on the road as a Business Consultant, and the last bit as the Business Manager for a manufacturing firm here north of Houston. I am trying to start up my own consulting firm using all my experience to help small and medium sized businesses stay out of trouble versus waiting until they get into trouble. No one teaches people how to properly run a business. Business schools and MBA programs really don't. There are very basic nuts and bolts that are either assumed or are ignored, and like the house built on sand, businessmen and entrepreneurs ignore these solid foundations at their peril. (Now retired and doing some substitute teaching at a couple of small K-12 schools here in northern Wisconsin. Living in a small hamlet of 340 people, quiet, peaceful, serene.)

13 Responses so far.

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  1. zootliberal says:

    PW- you blow my mind, there is so much useful information here. I have worked for the same company for 15+ years, but before that I had my own little company (film/video production). Seven years, some good, some bad. I had some great contracts and output, but I didn’t pay enough attention to the business side of things. I al considering going out in the cold again and your information here has already got me thinking the ‘right’ way” so thank you!

  2. coffeegod says:

    PW, I stand in awe of you. Accounting isn’t a strong suite but now I actually grok the concept. Thank you, sir.

    Now if I could just find a silent partner…….

    • PocketWatch says:

      coffee --

      I am not an accountant, and I actually am very bad at bookkeeping. I could do it, but I would hate it on a day to day basis. What I do know about is the concepts and the details and the real need to explain it in ways that people can understand. Most texts on the subject are obtuse, much like computer program manuals, full of jargon and assumptions of previous knowledge or experience.

      This series is all about KISS.

      LOL -- As for a partner, most are not-so-silent ones. If you do find one, make sure you have a signed agreement. Many SAY they will not interfere, then do it all the time. And for Allah’s sake, NEVER let them near the money.

  3. Jenuwin says:

    Thanks for all of your articles PW!

    • PocketWatch says:

      Jenuwin --

      You’re very welcome! If you have any questions, comments or need clarification, don’t hesitate! I’m hoping this may be valuable to everyone.

  4. david p canada says:

    Good piece, Pocketwatch.

    Mind you, with all the talk of PL statements, asset accumulation and depreciation, general accounting rules, etc., my eyes went blurry and I had to lie down for a bit.

    Fortunately, I can afford to hire the experts, at least until now (as a farmer, nothing is guaranteed).

    Keep it up, my friend!

    • PocketWatch says:

      David --

      I know… but there is no way to present this stuff in a fun way. I try, but it’s tough. I suggest people maybe copy this article into a word processor and nibble at each piece until they see what I’m talking about.

      This is the worst of it, really. Next comes building a history for analysis… easier than it sounds, and needs only grade school math.

  5. faux mccoy says:

    wow!!! look, those numbers match on the balance sheet 😉

    oh, now let’s have some real fun by explaining the negative asset of depreciation! (i felt like a success when i could do this almost as much as i when could explain baseball’s ‘in field fly rule’)

    something that may or may not help in this discussion is explaining how these concepts would apply to the average citizen who might use quicken or the like to track personal finances. the chart of accounts is basically the same as ‘categories’ as used by quicken etc., but it is usually numerically coded in a series which aids the bookkeeper, the accountant and business manager to code each and every transaction to conform to the format of the P&L/Balance sheet.

    again, i’m still digging on your articles.

    • PocketWatch says:

      @faux mccoy:

      I had to laugh! I have this thing about depreciation… In some texts they have it on the P&L and some on the BS… I don’t like it on the P&L for a couple of reasons, but the main one is that it is not real money, it’s a calculation. I have argued back and forth with CPAs over the years about that one, but, in the end, I don’t use the P&L itself tolook at things. I use a Variance report BASED on the P&L, so it doesn’t really matter. I’ll be getting to that in 3 or 4 articles down the road… LOL

      As to people using this in personal finances, you’re right. I have actually used Quicken in really small and simple businesses rather than Quickbooks. Works real well, and the Accountant keeps the formal books based on the Quicken checkbook with categories. Sometimes simple is best.

      Finally, except in certain cases, I HATE numbered accounts. I have yet to see any numbering system that survives 3 months of use in terms of consistency. Sooner or later you have to break whatever numerical system of categories and subs you are using and it gets confusing. I much prefer real descriptive account names so that there in no question of what transaction goes where.

      For example, “Discounts.” There are two types that are always confused, so I name one “Discounts Given” and the other “Discounts Taken.”

      Of course once a business gets to a certain point, you need to switch over to that standard numbered account system, but, by then, you generally have a well-trained and really good bookkeeper ho knows how to deal with it.

      Thanks for following along!

      8)

      • faux mccoy says:

        the health food store i managed had been in business for 20 years, with the same (very good) bookkeeper for 12. our chart of accounts had been well developed with huge gaps in the numerical sequence to adapt to new ‘categories’. losing that bookkeeper was devastating to me as a manager, but as he left the state, i had to assume it had nothing to do with me personally. (as opposed to the hippies i found smoking dope in the walk in cooler, whose departure had everything to do with me personally). i have major fantasies of writing a farcical handbook called ‘business for hippies’ but we shall see how that goes.

        i do some freelance work now as make up artist (not at all hippie like, but i can swing both ways) and am very glad for my previous life as a business manager. at least i already have a giant list of ‘mistakes to not repeat’. i do use quicken to keep track of this business income/expenses and since i am quite small time, it works very well. i used peachtree at the hippie store, which for it’s price point was fabulous, just not remotely ‘user friendly’ …. more like ‘user hostile’.

        • PocketWatch says:

          @faux --

          I had the great joy to have a client in New Jersey that used Peachtree. Now, I am going to be somewhat non-politcally correct telling this story, but it was the way it was…

          The business is a custom fabric and wallpaper design firm. Been in business for many years, and has outlet stores on Park ave, in NYC and on Rodeo Drive in LA, just to give you a hint about the clientele…

          They had seven(!) lines of business and the owner was a total control freak. So were his managers. Seems as if everyone in the company was gay, with all the attendant hissy fits over nothing in particular every time I turned around. We argued like scalded cats at every turn.

          Turns out this guy had been buying antique fabric and furniture in Europe for years as inspiration for his designs, and somehow all those costs ended up in the books as him oweing the business over $5mm rather than the other way around! Other than that, the books were a mess. Sheesh!

          I had to actually start from scratch and just abandon the old books and build a new set, all in Peachtree, moving balances over and getting everything to link up. I was there for weeks. He wanted every little thing in every line of business in it’s own account! That damned Chart report ran 12 pages!

          Bottom line, I HATE Peachtree!

          8)

    • faux mccoy says:

      p.s. -- i noted you provided your email -- i hope you do not mind an extra-curricular conversation?


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