Episode #35
The Chart of Accounts (The Sequel) Part 2
Last time in part 1 of this episode, we spoke about half of the accounts on the Chart of Accounts – that is – the accounts that make up the Balance Sheet. The balance sheet is reported in taxes most of the time in S Corporations, C Corporations, and non-profit organizations and partnerships. Unfortunately, most business owners don’t look at their own balance sheet and end up being surprised at how the profit of the company changes after the books are handed to their accountant or tax preparer. As we talked about last time, the balance sheet is made up of Assets, Liabilities, and Equity accounts. Today, let’s move on to the Profit and Loss, AKA “Income Statement” which is the report that most business owners concentrate on. I’m (as always) Paul Rosenblum.
Before I start, please listen all the way to the end of this episode for a request from all of you for the next episode. With that said -- let’s go!
The Profit and Loss or Income Statement is made up of traditionally 3 different types of accounts, and in some cases, only two. It could be as much as 5, if you include ‘Other Income’ and ‘Other Expense’ accounts and not just the ‘regular income and expenses.
They are:
Income
Cost of Goods and
Expenses
We will talk about those ‘other income and expenses’ and give specific examples later.
Income accounts are the easiest. You could have a minimum of one income account on your chart and track all the income through that one category. Depending on the software, and how you are doing the bookkeeping, you could track individual specific types of income with ‘revenue items’ that will show up in the customer invoices that you create and not on the profit and loss reports. If you track specific services or inventory that way, reports are still available, but in sales reports rather than the Profit and Loss statement.
The second, and sometimes optional account is ‘Cost of Goods’. This is a category of expenses that track as ‘necessary’ expenditures for your business to spend to make a sale. For an example, if you hire a person or a company to provide a service for one of your customers that you or your staff can’t provide your customer, then the money that you pay that company could and should be considered a ‘Cost of Goods’ account, or more precisely, a ‘Cost of Labor’ cost of goods account. The COGS act the same way as an expense, but COGS are in a separate category in the P&L report. The formula for the GROSS profit of a company is: Income MINUS Cost of Goods= GROSS INCOME. This is reported on your taxes to the IRS.
Let’s move on to expenses. But before I do, I will have a newsletter at (Paul Rosenblum.substack) that will include links to IRS tax forms so that you can see the categories that the IRS uses for specific kinds of entities. So, keep in mind that the tax preparer has to conform your chart of accounts to the forms with the categories that the IRS uses, so look at these forms carefully to understand how you can help your accountant a little bit with your chart of accounts. However, remember that you are not working for the tax preparer – they are working for you -- so use names on the chart of accounts that make sense for you and your business.
Expenses will most likely have more categories or accounts than any other category on the chart.
I will give you here a short list of some of the accounts that I use, but I will also include in the aforementioned (I’ve always wanted to use that word, sorry) newsletter a longer list of specific ways of naming your expenses.
For example, some of my standard expense accounts are:
Advertising (parent account) with attached ‘subaccounts’ such as
Client Gifts
Marketing
Social Media
Website Expenses
Print Media
Business Meals (Parent account)
Auto Expenses
Bank Service Charges
Dues and Subscriptions
Equipment Rental (if appropriate)
Insurance Expenses
Office Supplies
to name just a few. In that short list, there are, however, some nuances. For example, under Auto Expenses, you probably want subaccounts of Gas, Vehicle Maintenance and in some cases parking. In Bank Service Charges, the subaccounts should be something like Monthly, Credit card annual fees, and wire fees, to name just three. Office supplies could have general supplies, cleaning supplies, hardware supplies, and computer supplies (Unless you want to just memo that information in each transaction rather than creating an individual subaccount for each financially).
Any category that you see on the tax forms, you can add subaccounts for bookkeeping purposes to be as specific in your books as you want or need to be. Your accountant or tax preparer can hide the subaccounts that you have created and only look at the totals of the parent expense accounts.
There are some judgement calls sometimes on where to account for things. For one, merchant fees on customer credit cards when they pay you. Depending on your vendor, the fee could be anywhere from 1 to 2.3% of the sale that you have made when a customer pays using a credit card. What kind of account is that merchant fee? An income, cost of goods, or an expense account? In accounting software, there is nothing stopping you from creating an income account called Merchant Fee, since that 1-2% is being deducted from the money that you will be collecting on that sale. If you do that, your books will reflect a negative income account on reports. However, that’s not the way the IRS wants to see it. It would be correct to place the merchant fee in either expenses OR the cost of goods section. This is the criteria that I use: If your company has only 20% of all of its sales by customers using their credit cards and the rest is cash, then I’d make the merchant fee an expense. However, if your company has 80% of its sales by customers paying using their credit cards, then remember what I said at the beginning – a cost of goods is a kind of an expense that is directly related to making the sale, just like that outside company you hire to perform a service for your customer that your company can’t directly perform. Wherever you put the merchant fee, it doesn’t change the bottom-line profit that your company makes. It does affect the GROSS profit if the merchant fee is a cost of goods.
The full equation of the profit and loss report (or the income statement) is:
Income
MINUS
Cost of Goods
=GROSS PROFIT
MINUS
Expenses
=NET PROFIT
The IRS’s computers pick up the Gross and the net profit of the kind of business you are by the classification on your tax return, and your zip code. They have a range of what to expect the gross profit and the net profit to be according to the revenue that you made.
Now, let’s throw a monkey wrench into the equation (Noooo!)
In episode #4, I talked about Accrual VS CASH based accounting. Using the same chart of accounts, the numbers can radically change. If, for example, you were on accrual-based tax accounting, all of your revenue earned (even uncollected revenue on customer invoices) would be taxable and counted on your tax return with the same income accounts. Most accounting software easily lets you run cash-based reports and accrual-based reports with the click of a mouse.
On the expense side, in accrual accounting, every bill that is unpaid is a deductible expense. But not in a cash-based system. Only the bills that you pay are deductible if your taxes are done in cash. But the chart of accounts doesn’t change – only the reporting does.
Tired of listening to my voice yet? Do you like episodes like this? I am toying seriously (with a little help from my esteemed producer/social media/all around brilliant marketer) with the idea of creating a bookkeeping sampler for a possible bookkeeping course online. Text me with the new feature here if you would be interested in that, as I could visually explain things better than with this podcast and just my voice. Or of course, leave me email at @bookkeepermensch@gmail.
If you’re not tired of hearing my voice, as promised, I have another two possible categories of profit and loss accounts.
They are:
‘Other Income’ and ‘Other Expenses’.
What are these? (I hear you say out loud)
‘Other Income’ accounts could be used for grants that are not going to be income taxable on your tax return, for one example. When the SBA EIDL loans that we knew were going to be forgiven when Covid started back in 2020, I booked them as ‘other income’, knowing that eventually a reversal entry was going to entered. We ended up changing to booking those forgivable loans to a liability, because maybe the loan was received in 2020, but forgiven in 2021 or even 2022. If you had a legal case and you ended up settling and the lawyer or their client paid your company money, you could enter that as ‘other income’ so it stands out to the tax preparer because it’s not considered regular income all the time. Or if you earned any W2 income and deposited that money into your business account, those payments could be ‘other income’ because the W2 income is reported on your personal 1040 tax form, not on the Schedule C, 1065, or 1120 forms.
If you have a home office, and you pay for office expenses out of the business account, you might want to have that home office as an ‘other expense’. The reason? A home office deduction is on the 1040 personal tax form, NOT on the schedule C (sole prop) or 1065 (Partnership) or 1120 or 1120s forms. So, home office deductions, although they are deductible, are NOT part of the profit and loss of the business. If you use a personal vehicle for company business, the expenses for that vehicle could be on in the category of ‘other expenses’ as well. ‘Other Income and Other Expenses’ are below the NET profit line on the Income Statement.
And people wonder why bookkeepers are needed? Don’t worry, fellow bookkeepers, I am not and will not give away ALL of our secrets!
Remember, the chart of accounts is the backbone of the accounting system, and a good bookkeeper with have it under control at all times!
I asked you to listen to the end of this episode for a specific reason. Next episode will be the first ‘Answering YOUR questions episode’. I have started getting consistent emails and texts from people with questions. I have been answering them in email, but not using the text feature people have started to use, because the feature can’t text back! So, if you use that text feature, please include your email or social media so that I can get back to you. So, please email me, voicemail or text me with specific questions based on any of the episodes that are up in this podcast and also let me know if I can use your first name and city, or not. I, for one, am looking forward to that!
Hope you had a great Memorial Day! I’m STILL recovering from tax season and working my fingers to the bone --- Paul Rosenblum