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The chart of accounts

Accounting basics

Your bookkeeping is done on either a "cash basis" or on an "accrual basis." You have to make a decision before you start keeping records. You can change, but you cannot change back and forth, month by month, based on what is more convenient at the time.

Cash Basis Accounting

On a cash basis, all sales occur when you get the cash. All expenses occur when you pay the bill. There is no inventory. Nobody owes you money (because the sale hasn't occurred until you get the money). It seems oversimplified, but it is legitimate. Your order of lumber or other supplies arrives, and when you pay for it, that is when the expense occurs. It doesn't matter if you use all of it for the current project, or half of it now, saving some for later. (If you save some for later, you declare it's value to be zero, since the entire expense occurred when you paid for the shipment. Try to sell leftover supplies, and you will see the assumption of zero value is painfully close to true.) If you order supplies in December, and don't use them until February, your accounting may show a loss in one year, because of the large expense, and an exceptionally high profit the next year, because you completed and sold a project without the expense of the materials. You collect sales tax when the sale occurs, that is, when you get paid. You do not owe sales tax before you are paid.

Accrual Basis Accounting

With accrual accounting, if you order some lumber or other supplies, it becomes part of inventory, and the value of that inventory appears on your financial statements. If the supplies arrive and are paid for in December, you have valuable inventory, but do not have any expense since you haven't used any of that inventory. In January you may use part of the lumber (or whatever), so you have an expense for the supplies, in February you sell your product, so you have a sale (and pay sales tax for that sale even if you haven't collected from the customer yet). The customer may pay in March. On a cash basis, you bought supplies in December and had a sale in March, (and pay the sales tax in March). On an accrual basis, you had an expense towards building your project in January, and a sale in February. Of course the cash went out in December, you sent the sales tax to the state in February (that is when the sale occurred - they don't care if you are slow in collecting the money owed you), and you finally get your cash in March.

Accrual is different in other ways as well. If you spend $600 per year on insurance, on a cash basis the entire expense occurs when you pay for the insurance. On an accrual basis, you might assume $50 per month in insurance expense. If you get really fancy, recognize that you aren't likely to get any refund if you cancel that policy after 10 months, so the first 10 months cost $600, or $60 per month rather than $50. In fact, if you cancel after one month, the first month probably cost even more, so it can get complex if you don't just divide annual expenses by 10 or 12.

Typical cash basis transaction

My typical custom furniture transaction consists of several parts:

Chart of Accounts

Accountants like to speak about a "chart of accounts." That has nothing to do with bank accounts, but just different lists or "pockets" or "purses" for money. If you use Quicken, they are often called "categories."

Deposit Liability: If you collect a deposit, that money is still the customer's and not yours. It may be in your bank account, or you may have used it to buy materials, but if you "drop dead" and the sale is not completed, you owe this money back to the customer. This means you should have a liability account for the deposits you have collected. Only when the sale is complete does it become your money, and it is transferred from the "Deposit liability" account (purse) to your "Sales asset" account, and ultimately to your pocket.

Sales Tax Liability: As you collect sales tax, it isn't your money even though it is in your bank account. Therefore it goes into a Sales Tax liability account. When you send the state the sales tax, it comes out of the Sales Tax liability account.

Income - Sales that are exempt from sales tax: If you sell something to a church or to another business for resale, they will provide you with a tax exemption certificate just like you provided your vendors. You must include these sales when calculating your income taxes, but you need to keep a separate record of tax-exempt sales. Sales shipped out of state by common carrier are often tax exempt, and are also recorded here.

Income - sales for each sales tax jurisdiction. Be sure to record the income separately for each tax jurisdiction that you sell in, so that jurisdiction can get their share of the tax you collect. When you pay income taxes, you will add these together, but you need separate totals for reporting sales tax.

Expense accounts: Don't get carried away in setting up a complex system for expenses... I have found a few general categories are helpful, and the rest can be quickly broken out when I do the federal taxes (rather than struggling with each expense). My big categories are

If you are starting a larger full-time business, you will probably want a larger "chart of accounts" to help you manage different expenses, such as utilities, rent, office supplies, dues and contributions, and so forth.

If you work from your home, it is possible to deduct the portion of your home costs that are used exclusively for your business. If you have a room that you use as an office, but occasionally use it as a guest room, or do non-business work in that room, it cannot be deducted. I have not found it worth the effort to totally isolate an area so I can take a business deduction. If I had a separate shop, at my home or elsewhere, then the business use deduction would probably be worthwhile.