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Financial statements have been referred to throughout this guide. This chapter will cover
financial statements in more detail. However, the steps to prepare financial statements are not
included, as they are outside the scope of basic bookkeeping.

The totals from the cash receipts journal and cash disbursements journal are “posted to” or
“entered in” the general ledger for the specific time period (monthly, quarterly, annually).
The general ledger is set up by account, which is each of those classifications used in the cash
receipts and cash disbursements journals. Other entries, which are out of the scope of this
guide, are made by your accountant into additional accounts included in the general ledger.
It is from all of these accounts that your financial statements are prepared.

When your accountant has determined that all of your cash activities and all other business
activities have been properly accounted for, they prepare your financial statements, primarily
the following three.

Balance Sheet

The Balance Sheet or Statement of Financial Position is a report of the assets, liabilities,
and net worth of the business at a specific date. It is the company’s financial position or
financial status as of that date. Exhibit G is the statement of Financial Position for Party
Down at June 30, 2012.

Assets of micro businesses can include cash, investments, accounts receivable,
inventory, and furniture and equipment. These are the ‘resources” of the business
or what it controls.

Liabilities of micro businesses can include accounts payable, payroll taxes payable,
and loans payable. These are the obligations of the business.

Net worth is the difference between assets and liabilities. The detail of net worth,
or ownership interest, is slightly different for sole proprietors, partnerships, and
corporations.

Income Statement

The Income Statement, also referred to as the Statement of Profit and Loss or Statement of
Earnings, is a report of the revenues, expenses, and net income or loss of the business for
a specific time period. It is the company’s results of operations for that time period.
Exhibit H is the Statement of Earnings for Party Down for the Six Months Ended June 30, 2012.

Revenues include sales of products or services rendered. They may be cash receipts
and sales on account.

Expenses include the purchases of products for resale, sales expenses, and office
administration. Purchases of furniture and equipment are an asset on the balance
sheet. Expenses may be cash disbursements and purchases on account.

Net income or loss is the difference between revenues and expenses, as determined
by your accountant, or the overall measure of performance of a company.

Statement of Cash Flows

The Statement of Cash Flows is a report of the cash going in and cash going out of the business
for a given time period. It shows how cash is obtained from operations, investments, and
financing, and how it is used. This statement, at times, may be more useful than the Income
Statement because it shows a company’s cash strength.

Summary

The balance sheet, income statement, and cash flow statement are for your use, not just an
exercise to help accountants make money. They can tell you all kinds of things about your
business, but you need to understand them. Your accountant can explain their use to you, and
there are many books available to assist you.

The financial statements are also the basis of your business income tax return. Depending on
your form of business, certain income statements accounts may be handled differently on your tax return.

Preparation of financial statements by an accountant from a business’ books
is not an audit and the accountant expresses no opinion on them.

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Bookkeeping starts with the identification of a transaction or event to be recorded,
generally in the form of a paper business document. Financial transactions are an
exchange of goods and services, which include cash receipts, cash disbursements,
sales and purchases on credit, obtaining loans, and purchasing equipment.

An account is a group of similar items, or an efficient way to categorize transactions.
Examples of accounts are cash, inventory, accounts payable, sales, office expense, rent,
and telephone.

Double entry bookkeeping is the most common system of accumulating information.
This means that every financial transaction affects two accounts that must balance
or equal and offset each other. A check you write may be an expense and cash, or
it could be a loan payment and cash. A check you receive may be revenue and cash,
or it could be a reduction of an expense and cash. Every entry, summary, and report
must balance.

The activities in this paragraph will be performed by you, the business owner.
All of your entries will be entered into a journal. It is commonly defined as
the “book of original entry,” which means it is the first place where a business
transaction is recorded. It is a chronological record of similar activity, such
as cash receipts or cash disbursements, and an organized way to record transactions.
Each transaction is classified into an account in the journal. The journals are then
summarized (totalled) by each account. The cash receipts journal and the cash
disbursements journal are detailed in this guide as the two basic “books of original entry.”

The activities in this paragraph will be performed by your accountant. They will
post (which means enter or transfer) the journal totals to the general ledger.
The general ledger is set up by account, which is each of those classifications
used in the journals. They will then prepare adjusting journal entries to complete
the accounting process, and issue financial statements as the last step.

All of your bookkeeping takes place during a specific time period, or accounting
period, usually monthly, quarterly, or annually. As a new micro business, you will
probably keep your records on a monthly basis, but you will have your accountant
prepare your financial statements annually, along with your income tax return.

Another important accounting concept is internal controls, which is protecting assets
against waste, fraud, and inefficiency, and ensuring accuracy and reliability in
accounting and operating data. For a one-person home-based business, internal controls
are few. For example: don’t keep large sums of cash laying around, secure your
inventory, and prepare the bank reconciliation yourself. If your business is in a
storefront or office with employees, your accountant will help you set up a system
of internal controls.

A clarification of the term “cash” needs to be made. “Cash” includes currency and coins,
plus checks that are written for payment and checks that are received as payment. Unless
otherwise noted, “cash” is used to mean checks written and checks received, and currency
and coin paid out or received.

Janet Redick, Chapter 3 – Bookkeeping Basics | Micro Business Bookkeeping

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You choose the Form of Business which best suits your needs. Each uses a different income tax return (see Chapter 12, Income Tax Returns), and there are some differences in accounting. As you go down the list, each form of business becomes more complicated.

A Sole Proprietorship is reported on your individual income tax return. It is owned by one person and seldom requires any legal documents to get started, and its liabilities are your personal liabilities. You put money directly into the business as it needs money, and you take money out of the business as you need it as “owner’s draw.”

A Partnership is reported on a partnership income tax return, but your share of the taxable income or loss is transferred to your individual return for taxation. It is owned by two or more individuals and may require legal documents to get started. As with a sole proprietorship, you and/or your partner(s) put money directly into the business as it needs money, and you take money out of the business as you need it as “partner’s draw.”

A C-Corporation is reported on a corporation income tax return. It is a separate entity with a continuous life and owned by stockholders, which includes you and any number of others. The stockholders elect a board of directors, which may include themselves, to control and manage the company. Any money that you put into the company is a stock purchase or a loan. Any money that you take out of the company is payroll, a dividend, or repayment of a loan. You are an employee in this form of business so any money paid to you for your services is payroll. There is no such thing as “owner’s draw” in a C-corporation. It should be noted that any money taken out as a dividend is taxed twice – first as part of the net income of the corporation, and second as dividend income to you.

An S-Corporation is reported on an S-corporation income tax return, but your share of the taxable income or loss is transferred to your individual return for taxation. It is a separate entity with a continuous life and owned by stockholders, which includes you and possibly other stockholders. The stockholders elect a board of directors, which may include themselves, to control and manage the company. There are a number of restrictions with this form of corporation, compared to a C-corporation; these are not discussed here. Any money that you put into the company is a stock purchase or a loan. Any money that you take out of the company is payroll, distribution of earnings, or repayment of a loan. You are an employee in this form of business so any money paid to you for your services is payroll. However, the net income of the corporation reported on your individual tax return can be withdrawn as distribution of earnings and not be considered payroll.
A Limited Liability Company is a relatively new form of business. It is flexible and blends elements of both partnerships and corporations. It is most commonly taxed as a partnership but also has legal characteristics of a corporation.

A major question faced by a new business owner is “Should I incorporate my business?” This should be discussed with your accountant and lawyer before you start your business (or at any time after you have started). The major reasons for incorporating are limited liability, continuity of life, centralized management, and transfer of stock. Incorporation requires additional accounting, a more complicated tax return, and payroll accounting because you are now an employee.

Janet Redick, Chapter 5 – Forms Of Business | Micro Business Bookkeeping