Are you wanting to learn more accounting terms to help you effectively run the accounting of your business? Marvin Morse will help you learn many general accounting terms and the different types of mistakes most entrepreneurs make with them.Sign Up to Watch
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-So you continue, as the accountant, to have to be the non-fun guy. You have to bring up all the detailed expenses that entrepreneurs are going to think about.
-No fun at all.
-Now, term number nine here. We're talking about the accounting period. This refers to the amount of time for which financial information is being tracked. Walk me through what that means in layman's terms.
-Well, the accounting period is the period that's covered by the income statement, typically. Preferably you're looking at your monthly accounting period and seeing your results of operations for the month. You probably should be comparing that to the month from the year before. You probably also want to be looking at the year to date accounting period, say the first six months through June 30. And again, comparing that to the prior six month period.
-So if you're talking to your accountant and he mentions the word accounting period, hopefully you're not going to-- anymore. What are some common mistakes people make when they get into their accounting period? Do they kind of every month make it a little different or do they change things around to make the numbers look better sometimes? Or do they get--
-I suppose that's possible, although I don't see that a lot with the advent of the accounting software. It kind of locks you in to your reporting periods. Some businesses might make a mistake on choosing their tax year end. That type of thing. Although most businesses anymore are dictated under Internal Revenue Code regulations to use a December you're year end. But I really don't think it's so important what your year end is as long as you're tracking, and when you're comparing this month and this period to the previous period. I see that as being a big mistake or a big tool that entrepreneurs don't take advantage of.
They tend to just look at here's my profit and loss for the last six months. It looks good. There's money on the bottom line. They don't compare it to the six months a year ago and see that sales are actually trending down. The cost of goods sold are actually trending up. Selling general administrative is up 10%. And over time, that can create problems, of course.
-How often do you recommend someone meets with their accountant so that they can detect these trends? Is monthly a good idea?
-Probably quarterly. I think there should be some initial counseling and training. Ideally, the entrepreneur would learn to do this on their own, and therefore they wouldn't have to go to their accountant unless there was something they didn't understand about their analysis. But I would think a good accountant would attempt to train their client to do some of this analysis themselves, and then maybe meet periodically with their accountant to make sure they're interpreting it correctly and that type of thing.
-How much time should an entrepreneur be devoting to looking at their numbers each month?
-Well, that would vary a tremendous amount about by the size and type of the business. But they should, at a minimum, be studying those financials even for the simplest of businesses. One thing is, they should do it every month.
-Not once a year, or when they get something back from their CPA. Maybe that's too late, of course. So in order to spot trends and identify problems before they get to be a larger problem, you need to be looking at it monthly. Maybe you can look at your financials and it might take you four hours to analyze it. Mine may be very simple and I can look at it in 30 minutes. So I don't think you can say-- I think it's just whatever time is required to get thorough understanding. And if you can't do it on your own, then seek help your accountant.
-But at least every month?
-Minimum every month.
-I just want to make sure you're hearing that. If you're watching this and you're going, I haven't looked at my numbers in a while, that's bad deal. We want to just look at it each month at least. Get in there. Do a deep dive. Know what's going on. So that way you don't get behind the eight ball and find yourself in a bad situation there.
-That's correct. And a lot of entrepreneurs say, I've got money in the bank, I don't need to worry about my numbers. But that of course obviously isn't true, because even though there's money in the bank, there could be liabilities piling up that are more than the money in the bank. Good example, your deposit for future services. Even though you've got money in the bank, if you collected that $4,000 deposit for future services and immediately spent it on a new car, then you've got to do an event in the future for which you won't any more revenue or less revenue coming in. So that's a good example of how just looking at the money in the bank can be very deceiving.
-Yeah. Absolutely. Especially if you're an entrepreneur and you're watching this and you're saying to yourself, man, I have no idea how important this is. Don't feel like you're lost. Don't feel like there's no hope. We just need to find a good bookkeeper, a good accountant, and then have the diligence to monthly look at these
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-Now we're getting here into the term number 10, accounts receivable. This is an account used to track all the customer sales that are made using store credit. This does not refer to credit card style credit, this refers to the actual businesses that allow the customer to have credit so that the customer can provide payment at a later date. What does that mean?
MARVIN MORSE: Well, it just means you're providing a good or service. And you're not getting paid for it. You are extending credit to your customer expecting to be paid for it within a reasonable period of time. It's very common and certain types of business. Of course, the rule of thumb is, if you can get your money, get it now rather than carry accounts receivable. Because the pitfall of carrying accounts receivable is, even though it's a valid asset, it requires capital. So the bigger your accounts receivable, the more capital you got to have in your business to continue paying your bills when they come due.
-This almost wiped me out when I first started in business because I was doing a lot of business for school proms. I was providing entertainment services for schools. And those guys like to pay like, net 30, net 60. I guess when I say net, that means that they're not going to pay me what they owe me for 60 days or 30 days. And I had to pay my staff, and pay for my team, and pay my lease, and pay my ads. And I thought, well, as soon as I DJ for that prom or provide entertainment service, they'll pay me. And I was not the case. And so this was a very--
MARVIN MORSE: It can be very deceiving.
-It was bad. It was bad. So please learn from my errors there. Just make sure your budgeting out and don't count your accounts receivable as cash in hand until you actually have it.
-That's good. Yes.
-Now the term number 11, accounts payable. This is the account that is used to track all the unpaid bills from vendors, consultants, companies, and individuals from whom the company buys goods or services. Talk to me about accounts payable. What does that mean? Why do I need to care about it?
-Well, it's a legal liability. Accounts payable are a legal liability, so you must plan on paying it or having someone probably take you to court to collect it. So it's a legally enforceable obligation. And so therefore, it should be important to you. You've incurred a legal liability pay someone, generally, within a stated time. And so you should have the ability to fulfill that obligation.
And the typical mistake that most entrepreneurs make is not keeping track of the total liabilities they're incurring. They may be piling up unopened on the desk rather than being opened, processed through the accounting system, and appearing on that monthly balance sheet so that you know what kind of liability you're building. That may change your thought process on whether you can buy the new piece of equipment, or that type of thing, with the utilization of your cash.
-So if you're an entrepreneur watching this and you're kind of the, I don't like to open mail guy. Where you typically don't look at the mail, you typically don't deal with bills promptly. This is for you. Open those bills. Process those. Run them through the system. That will affect your spending habits moving forward.
-Now we're moving on to depreciation. This was a term that I never understood at all until about four years into business. And it says it's in reference to the accounting method that is used to track the use of assets and their aging. Every asset a business has ages and will eventually need to be replaced including equipment, electronics, buildings, et cetera.
Talk to me about depreciation and why we need to chart this stuff.
-Well, you sure opened up a topic of conversation on that one, Clay. There's a lot of confusion about depreciation that's allowable for income tax purposes versus realistic depreciation that truly reflects the economic life of any given asset.
The Internal Revenue Code has been very liberal in recent years allowing entrepreneurs to write off assets the very first year that they purchase them, which may be good. We recommend that in a lot of cases. Simply to lower the tax liability.
But the pitfall that most entrepreneurs make in this area is they record that same aggressive, very rapid write off, depreciation, use for income tax purposes. They use that for their financial statements. And so that becomes an expense. It lowers equity. And when you go into your banker to make a loan to buy that new piece of equipment he looks and says, well, you have no equity.
-Let's assume that I'm a third grader. And I'm from a different planet, or at least maybe a different country, and I kind of sort of understand English. So walk me through this because you threw out a lot of terminology there that I think maybe some of those Thrivers might not might get there.
So you're saying that the depreciation, the government allows me to be liberal with it. Let's say I bought a printer for $1,000. The government let's me write all of that off my taxes upfront sometimes.
-OK, so I write the whole thing off. And so I said, I bought for $1,000. When it comes time to pay taxes let's say I owe $10,000 in taxes. I can say, well, I spent $1,000 on my printer and reduce my taxes a little bit.
-Now, where do we make the wrong turn now?
-The wrong turn is on the balance sheet and profit and loss that's maintained and provided to bankers, bonding companies, whatever the case might be. You would want to assign the true economic life to that printer. Let's say that printer will last 10 years, then your depreciation each year would be $100. So that in your financial statement you're showing depreciation expense this year of $100, which therefore, you show a greater profit. Then you show it on your tax return where you're showing depreciation for $1,000, the entire cost of the printer.
-OK. So if you're an entrepreneur, do you recommend that an entrepreneur tries to do their own depreciation schedules? Or do you recommend that they have an account to help them with this?
-I would categorically say they should let an accountant handle that.
-If you're watching this and you're going, no, no, no. I want to do my own depreciation. I love depreciation so much. It's just something I want to do. We strongly recommend that you do not do this.
-Now we're moving on to term number 13, the general ledger. This is the place where the company's accounts are summarized. This ledger is kind of like the big kahuna. I mean, this is the big deal when it comes to your overall bookkeeping system. Why is the general ledger so important?
-Well, the general ledger is used as a summary place for all the transactions that are encountered and entered into by the organization. And so you have to have a general ledger just to have a place in your accounting records to summarize all your activities by category, such as direct labor, insurance expense, both assets, liabilities, income, and expense.
And the general ledger-- the pitfall I see there with entrepreneurs is they don't design their general ledger correctly to begin with. Initially you should develop a coding scenario. It's referred to as a chart of accounts. And then for each item in your chart of accounts, you then have a general ledger account.
And so with the software that's available to do bookkeeping accounting with currently, once you design the proper chart of accounts, that pretty much assures you have the correct general ledger.
So the problem I typically see is that we don't design the chart of accounts properly. We don't put in certain expenses, or we put them in in a broad sense. Like what is a good example? Insurance expense. We have one category called insurance expense, and we're charging medical, liability, workers' comp, disability, fire and casualty, all this going into one category.
And you might say, well, it is all insurance, and I agree. And IRS will accept that. They don't care that you put all your insurance in one category. But my recommendation is that you would split those out into the types, so that when you engage in this comparing of expenses for this six months this year to this six months last year, you can see that this expense is way up, this one's down. In other words, it gives you better ability to manage expenses.
-And kind of adding a little more entrepreneurial spin to this for a second, if you're watching this, and let's say that you spend $1,000 a month on advertising as a big broad brush, advertising. That might not be helpful for you to know that. That might not be helpful at all for you to know that.
But if you know that you spend $900 on your Internet advertising, and you spend $100 on your mailers, and your Internet advertising produces you zero business, and you get all your business off of your mailers, then you can know, hey, next year I need to reallocate. I need to move money from here and focus it here.
Same thing with accounting. I mean, accounting, the more specific it is, the more it gives you mastery over, wow, I'm spending a lot more money than I thought I should in this specific area. But when you group things into big, broad blocks, it becomes impossible to sort them out, right?
-That's correct. And that's another area where good advice or a good accountant can help the entrepreneur when they're starting out, or even after they're already in business. Maybe they need to expand and improve upon the chart of accounts. Their accountant should be able to help them along those lines.
-Now we're getting to term 14. Here we go, talking about interest. Interest. This is defined as the money that a company needs to pay for the use of money it borrows from a bank or other company. Where do companies usually get it wrong as it relates to interest, and what does interest mean?
-Well, interest, of course, is the cost of using somebody else's money. Some people have referred to it as renting money.
-Renting money, OK.
-And so interest is not a bad thing, if it's used correctly. Some of the mistakes I say regarding interest is that entrepreneurs don't split out their principal and interest. So they make a payment to the bank, and they charge the entire payment against the note payable on the balance sheet, and they don't show any interest expense in their profit or loss. I see that quite often.
The other risk of interest is that you have to look at interest from the standpoint of, what does that do to your profitability? With the incurring of this interest, does it still allow you to make profits on your job, or is it going to render you to where, even though you can do more work, maybe, the cost of the interest is so great--
-I see this in small business more than anything, when someone's starting up a business. And let's say they need to borrow $50,000. So they'll put it on an American Express card and they'll charge it up there. Well, now they're paying 15% interest every month just to use the money. They're not even paying the principal down at all.
And so they just spent $50,000 on the card, but their interest payments are substantial. They might be $6,000 or $7,000 a month in just interest. And so it becomes very hard to make a profit there. So you've just got to be mindful of that, right?
-And a good accountant can help you find out if you're wasting money on interest, maybe you consolidate a few loans into one place. There's a lot of things you can do there.
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