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In simplest terms, deferred revenue is revenue earned before rendering goods or services. Accountants and bookkeepers refer to this revenue as “deferred” because, while present in the books, it has not technically been earned yet; the company still must fulfill its end of the transaction agreement.

For the sake of example, let’s take a sole proprietor jeweler specializing in custom necklaces. A customer orders a custom necklace and is charged the final amount upon placing the order. The revenue earned from this transaction is considered “deferred” — at least until the jeweler fulfills the order by creating and delivering the necklace, completing the purchase agreement. 

For businesses that provide services rather than goods, there are instances in which deferred revenue becomes realized over time instead of all at once. For example, imagine a landscaping company. A client signs a yearlong service contract for a one-time upfront payment with the company. As the landscaper continually renders services over the contract period, equivalent parts of the payment become realized on the income statement.

How to Record a Deferred Revenue Journal Entry

Deferred revenue is listed as a liability on a company’s balance sheet. This represents a good or service that the business still owes to the customer — and if the business fails to hold its end of the bargain, the customer may cancel the transaction and request a refund.

In most cases, the prepayment terms for deferred revenue last for 12 months or less. As a result, bookkeepers will typically classify deferred revenue as a current liability on a balance sheet. However, if a client delivers an upfront payment for a multi-year deal, the resulting deferred revenue becomes a long-term liability.

How Does GAAP Affect Deferred Revenue?

GAAP, or Generally Accepted Accounting Principles, has a wide-reaching influence on all accounting matters — let alone deferred revenue — specifically, the third and tenth Principles of GAAP: the Principle of Sincerity and the Principle of Uberrimae Fidei (Utmost Good Faith), respectively. Deferred revenue has an inherent uncertainty; in adherence to these principles, businesses must report revenues consistent with the lower boundary of uncertainty. To simplify this, let’s take an example: a writing house signs a year-long contract with a publisher. Under the terms of this contract, the writing house will receive an upfront payment plus royalties on print sales. Based on previous data, the writing house expects to receive between $15,000 and $20,000 per month in royalties; on the balance sheet, the writing house should value the deferred royalties at $15,000: the lower boundary of uncertainty. GAAP encourages this practice to promote accounting conservatism and prevent businesses from defrauding investors.

Accounting For Deferred Revenue

As previously mentioned, revenue that is deferred is not considered actual revenue until it is realized upon the delivery of a product or service. Because of this, it is not reported on an income statement; instead, deferred revenue is listed under the liabilities column on a balance sheet. 

To visualize this, let’s take a look at a $5,000 upfront payment that qualifies as deferred revenue. Notice how as the asset column (cash) increases, so too does the liability column (deferred revenue).

Accounting For Deferred Expenses

Since deferred revenue is commonplace in the world of business, it’s only logical that deferred expenses also exist. An example of a deferred expense would be pre-paid rent on office space or a storefront. Deferred expenses follow similar principles as deferred revenue, just reversed; these expenses are listed under the assets column of a balance sheet until realized.

For example, let’s take a look at a business that pays its $60,000 annual rent bill upfront. The relevant balance sheet entries may look like this:

Notice how, with deferred expenses, cash is considered a liability, whereas the deferred expense is considered an asset. 

It is essential to consider that rent is a special case; while the company paid a year’s rent upfront, it will be realized on a monthly basis — in this case, $5,000 at a time. Once a portion of the rent is realized, the business would record an entry like this:

Once one month’s rent — $5,000 — becomes realized, it is subtracted from the prepaid rent figure and added to the realized rent expense.

Related Reading: Small Business Accounting Tips

Journal Entry Example

Let’s take a look at a small IT consultancy firm that contracts its services to clients on a subscription basis. These 12-month subscriptions cost $500 per month, billed as a one-time $6,000 fee.

Let’s say Company A purchases a subscription from this IT firm on July 1st. The IT firm’s specialized small business accountants would make an entry into the balance sheet that looks like this:

Because the subscription costs $500 per month, the first $500 of revenue will be realized on August 1st. The IT firm’s accountants will record the realized revenue on the income statement before making a balance sheet entry that looks like this:

Outsourcing Your Finances Can Help Your Business

When running a small business, a highly competent financial team can provide essential business insights, find crucial tax savings, and allow business owners to spend less time stressing the financials and more time serving customers. If you want to elevate your business’s financial team, look no further than FinancePal’s team of experienced small business bookkeepers and accountants. Sign up to get a custom quote today for FinancePal’s professional financial services.

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• What is Accounts Receivable Factoring?
• How Does Factoring Receivables Work?
• Accounts Receivable Factoring Examples
• Common Factoring Terminology
• The Benefits of Accounts Receivable Accounting
• Special Considerations for Accounts Receivable Factoring
• The History of Accounts Receivable Factoring

What is Accounts Receivable Factoring?

Put simply, accounts receivable factoring entails selling your outstanding receivables to a third party— known as a factoring company or factor— typically for a set percentage of the outstanding amount. This percentage varies (more on that later on) but it can be as high as 97% of the original value of the receivables. After purchasing your receivables, the factoring company is entitled to the outstanding amount once it’s paid.

Accounts receivable factoring is popular among business owners because it serves as a debt-free alternative to loans as a means to obtaining owed income in advance. There is no interest, no fees, and little hassle — factoring is finalized at the point of sale.

How Does Factoring Receivables Work?

Factoring companies charge a “factoring fee.” — a percentage of the total value of the sold receivables. As mentioned previously, this percentage can fluctuate based on five various factors: industry, amount, quality, time, and type.

1.   Industry

The accounts receivable factoring rate often varies from industry to industry. For example, a factoring company will offer a different rate to a construction company compared to the rate provided to a retail company.

2.   Amount

Some factoring companies offer better rates for high-value or high-volume receivables.

3.   Quality

Quality includes the punctuality and creditworthiness of a business’s customers. Factoring companies will offer ideal rates for receivables with high-quality payers — no factoring company wants to find themselves stuck with non-payers.

4.   Time

When looking at potential receivables, factoring companies will consider the average days outstanding to determine how quickly the items will be paid.

5.   Type

Finally, factoring companies will offer different rates whether using recourse factoring or non-recourse factoring.

Recourse Factoring vs. Non-Recourse Factoring

There are two types of accounts receivable factoring: with and without recourse. The type depends on which party accepts the risk: the selling company or the factoring company. With recourse factoring, the factoring company can demand a refund from the selling company in the event that it cannot collect from customers. However, with non-recourse factoring, the factoring company takes on all the risk of uncollectible receivables; the selling company has no liability for uncollectible receivables.

Typically, factoring companies will charge a lower rate for recourse factoring than for non-recourse factoring. When using non-recourse factoring, the factoring company charges a higher rate to better compensate for the risk. However, with recourse factoring, the selling company is liable for the receivables if they aren’t paid. This can be problematic if your business has a shortage of consistent, quick-paying customers.

Accounts Receivable Factoring Examples

Non-Recourse Factoring

To show non-recourse factoring in action, let’s take a look at a hypothetical small business: a B2B supplier called The Money Store, LLC. Stefan, the owner of The Money Store, needs to cover a pressing liability worth $200,000 but doesn’t have the cash on hand to do so. However, The Money Store’s current accounts receivable are worth $500,000 — more than enough to cover this liability. Stefan subsequently decides to factor his accounts receivable on a non-recourse basis. Because non-recourse factoring shifts the risk to the factoring company, Stefan must pay a premium rate — he only receives $400,000 from $500,000 worth of receivables. Nevertheless, Stefan can now settle his liability with cash to spare.

Let’s say Stefan has a perennial problem client, Zach. Half the time, Zach takes months to fulfill his invoices; half the time, he doesn’t pay them at all. However, because Stefan factored his receivables on a non-recourse basis, Zach is no longer his problem; the factoring company must assume all the risk. This risk has been somewhat mitigated by the premium rate Stefan had to pay, but the factoring company is still on the hook for Zach.

Recourse Factoring

If Stefan factors his receivables on a recourse basis, he gets a better initial rate — let’s say $450,000, with a $50,000 hold back — for the same $500,000 worth of receivables. After buying the receivables, the factoring company collects $490,000; Zach accounts for the $10,000 not collectible. In this case, Zach’s outstanding amount is Stefan’s responsibility as this amount is deducted from the holdback before the factoring company remits it to Stefan.

It is essential to exercise caution when factoring on a recourse basis; although one inconsistent customer won’t pose a huge problem, a high volume of nonpayers can quickly turn your accounts into a bottomless pit.

Common Factoring Terminology

Advance Rate

The advance rate is the percentage of an invoice the factoring company pays upfront. Once the invoice is fulfilled, the factoring company remits the remaining value back to the selling business. Typically, this comes in the form of a factoring rebate. The reason for the advance rate is to protect the factoring company from risk. If a high enough percentage of the receivables aren’t fulfilled, the factoring company will not issue a factoring rebate and instead use the money to cover any losses.

Factoring Fees

The factoring fee refers to the fee a factoring company charges when providing a factoring service. Typically, this is applied as a percentage of the value of the receivables. For example, a factoring company may charge 5% for an invoice due in 45 days. However, factoring companies may charge on a weekly or monthly basis instead.

Reserve account

Not all factoring companies hold reserve accounts, but many do. Much like with advance rates, where a portion of the receivables’ value is held to mitigate risk, many factoring companies maintain a reserve account to reduce risk further. Reserve accounts typically contain 10–15% of the selling company’s credit line.

Spot factoring

Spot factoring is becoming more and more prevalent. Traditionally, factoring companies would tie selling companies down in long-term contracts. However, spot factoring allows a company to factor a single invoice. This has made accounts receivable factoring easy to access for small businesses. However, the lack of predictable volume means that spot factoring will typically incur a cost premium to make up for the lack of long-term contracts and minimums.

The Benefits of Accounts Receivable Accounting

A growing number of small businesses utilize accounts receivable factoring to stabilize and accelerate cash flow. Factoring your business’s accounts receivable can provide steady, predictable capital, facilitate expansion, and optimize the payables cycle, enabling discount pricing for early vendor payments.

There are five primary advantages to utilizing accounts receivable factoring:

1. It accelerates your cash flow. Accounts receivable factoring provides almost immediate access to money for delivered goods and services instead of having to wait for 30, 60, or 90 days from the time of an invoice. This is especially ideal for innovative, growing businesses that need quick cash turnover.
2. It’s ideal for small and growing businesses. Accounts receivable factoring provides instant cash flow for immediate use. This cash can be used to expand business operations, staff sizes, marketing, or inventory volume.
3. It doesn’t require additional collateral. Unlike with traditional loans, accounts receivable factoring typically does not require you to set aside additional assets as collateral. This makes factoring especially attractive for smaller businesses with fewer available assets to be used as potential collateral.
4. It increases the availability of capital. Typically, accounts receivable factoring will advance up to 85% of the value of your receivables. As your business’s receivables grow, so does your total availability of capital.
5. It can save you time and money. Accounts receivable factoring can save you much time and effort that would be spent chasing collections. This can help lower operating expenses and free up man-hours for other tasks. After all, small businesses can use all the manpower they can get.

Related Reading: What is Double Entry Accounting

Special Considerations for Accounts Receivable Factoring

When a factoring company takes on receivables, it notifies the selling business’s customers. This is because your customers are no longer paying you — they are paying the factoring company. If your customers receive notice that you sold your accounts receivable without hearing it from you first, they may see this as a sign of financial weakness. While accounts receivable factoring is not a sign of financial weakness, it may be misperceived as one.

Once you hire a factoring company, your business will be able to utilize the factoring company’s internal credit department to qualify your customers. For example, the factoring company may affect your ability to do business with customers with questionable credit histories or ratings. Typically, the factoring company would render these receivables ineligible, so they cannot be advanced against. However, it is ultimately up to you as a business owner to make an informed decision to continue working with that customer.

In addition, while accelerating your receivables has significant inherent benefits, there is a cost. Typically, this cost includes the factoring fee — between 0.5% and 3% — plus interest on the advance. As you factor your receivables, be sure to constantly measure your return on investment based on several factors: expansion, better buying power, enhanced product offering, stabilize working capital, and more. Assess these against the factoring expense.

Related Reading: How to Reconcile a Bank Statement

The History of Accounts Receivable Factoring

Factoring’s origins lie in early international trade. Various sources date the origin of accounts receivable factoring back to the Code of Hammurabi.

Like all financial concepts, factoring has evolved over the centuries. Factoring owes its evolution chiefly to changes in the prevailing business organization, technology, and modifications to the common law framework in the Western World.

In the twentieth-century United States, factoring became the pre-eminent method of accruing capital for growth, especially within the textiles sector. This occurred in part due to the United States banking system’s structure, filled with a plethora of small banks with limitations on advance amounts.

At the start of the 21st century, policymakers recognized the rationale for maintaining factoring as a financial instrument; factoring is ideal for the growing demands of innovative, rapidly growing businesses.

Related Reading: Accounting Terms

Outsourcing Your Accounting

It’s easy to think of accounting and bookkeeping as necessary evils to keep the IRS off your back. But a highly competent financial team can provide essential business insights, find crucial tax savings, and allow business owners to spend less time stressing the financials and more time serving customers. Sign up to get a custom quote today for FinancePal’s professional financial services.

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• What is Burn Rate?
• How to Calculate Burn Rate
• Calculating Average Burn Rate
• Burn Rate and Cash Runaway
• Burn Rate and Cash Runway Example
• How to Reduce Burn Rate

What is Burn Rate?

In simplest terms, burn rate is the rate at which a company loses — or “burns through” — its capital over the course of conducting business operations. The concept of managing your burn rate has become incredibly prevalent in today’s startup sphere as more and more new businesses take longer and longer to turn a profit.

Burn rate is chiefly used to calculate a business’s “cash runway” — the amount of time a business can operate at a loss before the coffers run dry.

​​The term became ingrained in the business lexicon during the rise of startup culture, where many businesses undertake multiple investment rounds before achieving profitability. In between investment rounds, burn rate becomes a crucial metric as it dictates when additional funding stages need to take place in order to avoid insolvency.

Burn rate gained some infamy as a metric due to its role in the dot-com bust; a prevailing financial theory at the time stated that a high burn rate directly correlated with the rate at which the business acquired new clients. Needless to say, this theory was dead wrong, and many startup finance experts have since changed their tune on how to handle burn rate.

How to Calculate Burn Rate

Vital as it is, calculating startup burn rate is a relatively straightforward process. There are two types of burn rate: gross burn rate and net burn rate.

Gross burn rate refers to the amount of cash spent in a single month. To calculate net burn rate, you need to find your net spend by subtracting your revenue from your expenses. While gross burn rate has specific applications in accounting for startups, net burn rate is more helpful in providing a more unambiguous indication of cash runway. Unless you are an accountant, the term “burn rate” simply refers to net burn rate for all practical purposes.

There are two primary methods to calculate your burn rate; one entails using venture capital funding or other investments, and the other does not.

Calculating Burn Rate with Venture Capital or Investment Funding

Calculating your burn rate with venture capital or other investment funding is as simple as looking at the cash flow statement; it will contain all the information you need.

To calculate burn rate for a given month, subtract the cash balance for the month from the cash balance in the previous month like so:

Burn Rate = Previous Month’s Cash Balance – Current Month’s Cash Balance

Calculating Burn Rate without Venture Capital or Investment Funding

Much like when including venture capital or other investment funding, you will gather direct vs. indirect cash flow information from your cash flow statement. The primary difference is that you will exclude all capital from outside investments. Your formula will look more like this:

Burn Rate = (Previous Month’s Cash Balance – Outside Investments) – (Current Month’s Cash Balance – Outside Investments)

Negative or Zero Burn Rate

Typically, the burn rate calculations yield a positive number. But there are a few circumstances that may result in your burn rate coming back negative. If this happens, it simply indicates that your business earned more money than it spent in the past month. If you just underwent a successful round of funding, for example, your burn rate could be negative if calculated with venture capital or investment funding.

If you specifically excluded investor funding in your calculations, it means that your business’s revenues exceeded its expenses. In the event that your burn rate is zero, it simply means that your business earns the same amount of money as it spends.

Once your startup or business earns more than it spends, burn rate is rendered meaningless as a metric; it is only used for companies that are not yet profitable.

Calculating Average Burn Rate

Burn rate isn’t restricted to a monthly basis. In fact, it is easy to calculate your average burn rate over any specific period. To do so, execute a simple mean function: repeat the process above for as many months as desired. Add the monthly burn rates together and divide the sum by the number of months included. For example, you would add six consecutive monthly burn rates together before dividing by six to get your six-month average burn rate.

Burn Rate and Cash Runway

One of the primary uses of burn rate is to calculate runway — the amount of time a business can operate at a loss before you run out of cash. Because burn rate reflects the monthly rate which your business burns through capital, you extrapolate burn trends to figure how many months you have before you “burn” through your cash.

How to Calculate Cash Runway

To calculate cash runway, divide the amount of money you have now by your average burn rate, like so:

Runway = Total Capital ⁄ Average Burn Rate

The resulting figure is how many months you have left before your coffers run dry — assuming constant expenses and revenue and no additional outside investment, of course.

Burn Rate and Cash Runway Example

For the sake of example, let’s say your current cash holdings total $250,000. Last month’s cash holdings totaled $300,000. To calculate your burn rate for the most recent month, subtract 250,000 from 300,000.

Burn Rate = $300,000 – $250,000 = $50,000

Then, to calculate your cash runway, divide your current cash holdings ($250,000) by your monthly burn rate ($50,000).

$250,000 / $50,000 = 5 months

In this example, your business can only operate for five more months before running out of cash. That gives you five months to secure additional investment or mitigate your current burn rate if you need more time.

Related Reading: Accounting Cycle

How to Reduce Burn Rate

If your burn rate turns out higher than expected or otherwise makes you feel uneasy, it may be worthwhile to  employ one of the following strategies to help lower your burn rate. This can be accomplished either by lowering expenses, increasing revenue, or securing additional investments.

1. Go for an MVP — A Minimum Viable Product

A minimum viable product is a sort of early access release — a prototype made available to select customers before the final product is ready for the marketplace. This allows you to obtain initial feedback that will enable you to cut costs on product features that your customers may not want.

1. Focus on return-bearing investments

Every startup owner dreams of rapid scaling. However, truth be told, premature scaling has killed many otherwise promising startups. Instead of spending your dwindling capital on additional workforce or office space, try pledging it towards return-bearing spend only, such as supplemental raw materials for increased manufacturing output.

1. Slash Overhead

Sometimes you have to lose before you can win. If absolutely necessary, consider downsizing your workforce or scaling down production if the lower overhead means you can survive until your next investment round.

Conclusion

Burn rate is a crucial metric that every startup needs to track diligently. Not only does it forebode the potential lifespan of your business, but a favorable burn rate can attract additional investors; cash consumption signals investors whether the company has the potential to be self-sustaining or if it will perpetually need additional financing.

It is easy to think of accounting and bookkeeping as necessary evils to keep the IRS off your back. But a highly competent financial team can provide essential business insights, find crucial tax savings, and allow business owners to spend less time stressing the financials and more time serving customers. Sign up to get a custom quote today for FinancePal’s professional financial services.

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Industry jargon and complex language provides a significant obstacle for most people when trying to learn accounting concepts. That is why we provided this glossary of accounting industry terms from ecpi.edu to gain a solid baseline from which you can explore various accounting topics.

● Accounts Payable

Money a business owes to its suppliers, vendors, or creditors for goods or services bought on credit; considered a short-term debt. Accounts payable is a crucial concept for any business operating with credit—every time a business purchases from a supplier on credit, an accounting entry is made in accounts payable.

● Accounts Receivable

The opposite of accounts payable; money owed to a business by its customers, for goods or services delivered. Accounts receivable refers to money your customers owe for goods or services purchased from you in the past. This money is typically recorded as an asset on your balance sheet; they live under the ‘current assets’ portion on your balance sheet or chart of accounts.

● Accounting Period

An accounting period is a period during the fiscal or calendar year in which accountants perform functions such as gathering and aggregating data and creating financial statements. The financial statements made during these periods are important for attracting potential investors or procuring loans from banks.

● Accruals

A record-keeping adjustment that recognizes business expenses and revenues before exchanges of money take place.

● Accrual-Basis Accounting

An accounting method where revenue and expenses are recorded as they are earned, regardless of when the money is received or paid. Mutually exclusive with cash-basis accounting.

● Assets

Resources with economic value. Assets can reduce expenses, generate cash flow, or improve sales for businesses.

● Balance Sheet

A financial statement providing a picture of an organizations’ liabilities, assets, and shareholders’ equity at a specific moment in time. Compare the balance sheet vs. income statement.

● Capital

A person’s or organization’s financial assets. Capital may include funds in deposit accounts or money from financing sources.

● Cash-Basis Accounting

Under the cash method, income is considered constructively received the moment it is credited to a business’s account, made available without restriction, or received by an authorized agent acting on behalf of the company.

● Cash Flow

Cash flow is the total amount of money that comes into and goes out of a business.

● Certified Public Accountant

Certified public accountants (CPAs) are accounting professionals certified to practice public accounting by the American Institute of Certified Public Accountants.

● Chart of Accounts

An index of the financial accounts in a company’s general ledger, a chart of accounts provides a picture of all the financial transactions a company has conducted in a specific accounting period.

● Closing the Books

An idiom refers to accounting for all financial transactions within a certain period.

● Cost of Goods Sold

Cost of goods sold, commonly shortened to COGS (or, if applicable, referred to as cost of sales or cost of service), is simply how much it costs to produce products or services, including direct material or labor expenses. Cost of goods only includes expenses directly related to products and services. For example, a chandler business would consist of wax, wicks, glass, and ingredients in its COGS. Overhead, such as marketing spend, real estate, utilities, asset depreciation, shipping fees, and other indirect expenses do not count towards COGS.

● Credit

Credits are accounting entries that either increase an equity or liability account, or decrease an expense or asset account.

● Debit

The opposite of a credit, debits either increase expense or asset accounts or decrease equity or liability accounts.

● Depreciation

The depreciation accounting method determines the decreasing value of a tangible asset over its lifetime.

● Diversification

Diversification mixes many different investments and assets in one portfolio, allowing individuals or businesses to spread out risk and protect themselves from financial ruin if any investments or assets fail. Finance Pal’s own CEO and Co-founder, Jacob Dayan, provides his expert investment advice on Finder’s “11 pieces of investment advice from experts for beginners” to provide individuals guidance to the best investment plan.

● Dividends

Company earnings, or profit, which a business pays to its shareholders as a reward for their investment in its equity.

● Double-Entry Bookkeeping

Put simply; double-entry accounting is a ubiquitous bookkeeping system that tracks where the money comes from and where it goes. The central tenet of double-entry accounting is after a financial transaction, each entry made into an account has a corresponding opposite entry made into a separate account. This produces two entries—thus, the name. When shown side-by-side in a ledger, the entry listed on the left side is referred to as a debit entry, while the entry displayed on the right side is called a credit entry.

● Enrolled Agent

Federally licensed tax professionals who can represent U.S. taxpayers. They must pass the three-part special enrollment examination from the IRS.

● Entity Formation

Entity formation is the process of classifying a business as an entity such as an LLC, sole proprietorship, partnership, S-Corp, or C-Corp.

● Expenses

The costs of conducting business. Companies can deduct some eligible expenses from their taxes.

● Equity

The amount of money left over and returned to shareholders after a business sells all assets and pays off all debt.

● Fixed Cost

A type of expense, fixed costs do not change from month to month. Fixed costs include things like payroll, rent, and insurance payments.

● General Ledger

General ledgers include debit and credit account records. Companies use the information in their general ledgers to prepare financial reports and understand their financial performance and health over time.

● Generally Accepted Accounting Principles

Generally accepted accounting principles (GAAP) refer to a group of significant accounting rules, standards, and ways of reporting financial information. The Financial Accounting Standards Board sets GAAP. All publicly traded companies must adhere to GAAP, per the Securities and Exchange Commission (SEC). While not required by law for non-publicly traded companies, GAAP compliance is critical for favorable views from creditors and lenders. Most banks and financial institutions require GAAP-compliant financial statements when issuing business loans.

● Gross Profit

The profit businesses make after subtracting the costs related to supplying their services or making and selling their products.

● Gross Margin

A business’s net sales revenue after subtracting the costs of goods sold. It represents the revenue companies keep as gross profit. An indicator of financial health, higher gross margins typically mean that a company can make more profit on its sales. Lower gross margins may mean a business needs to reduce production costs. The formula for gross margin is “Gross Margin = Net Sales – Cost of Goods Sold.”

● Inventory

A company’s goods and raw materials used for making the products it sells. It appears on a balance sheet as an asset. The IRS permits several inventory cost methods depending on the type of inventory (for example, FIFO or LIFO). A small business accountant will know which method the IRS requires for each specific business. Using the appropriate method, the accountant will calculate your inventory cost and set the cost of goods sold formula into motion.

● Journal Entry

A business transaction recorded in a business’s general ledger.

● Liabilities

A liability is when someone owes someone else money. Types of liabilities can include loans, mortgages, accounts payable, and accrued expenses.

● Liquidity

How easily an individual or business can convert an asset to cash for its full market value. The most liquid asset, cash, can easily and quickly convert to other assets.

● Net Income

The amount an individual or business earns after subtracting deductions and taxes from gross income. To calculate the net income of a business, subtract all expenses and costs from revenue.

● On Credit

An agreement for an individual or company to pay for a good or service later. Usually an invoice will be sent with payment due at a later date.

● Overhead

The ongoing costs of doing business other than those related to directly creating a good or service.

● Payroll

HR and accounting departments typically handle payroll, the total compensation a company pays its employees for a specific time period.

● Present Value

The notion that money is worth more today than it will be in the future. This may seem confusing at first, so let’s look at an example: if you have ten thousand today, you can invest the money, earn interest, and have more than ten thousand dollars in five years. The discounted cash flow model accounts for this, so it can also help compare different investment opportunities.

● Profit and Loss Statement

The profit and loss statement (also called the income statement or shortened to “the P&L statement”) includes vital cash flow information such as revenue, costs of goods sold, and operating expenses during a particular period. It also shows the resulting net income or loss for that specific period.

● Receipts

Written notices acknowledging that one party received something of value from another. An acknowledgment of ownership, receipts are proof of a financial transaction.

● Retained Earnings

The amount of net income left for a business to use after paying dividends to its shareholders. A company’s management typically decides whether to keep the earnings or give them to shareholders.

● Return on Investment (ROI)

The efficiency of an investment, including the amount of return on an investment relative to its cost. Accountants can also use ROI to compare the efficiency of more than one investment. To calculate ROI, subtract the cost of investment from the current value of investment, and divide that by the cost of the investment.

● Revenue

Gross income a business makes through normal business operations. To calculate sales revenue, multiply sales price by number of units sold.

●  Sales Tax

Small business sales tax is an indirect tax that is assessed on a product at the point of sale. Included within the price of the product.

● Single-Entry Bookkeeping

A type of accounting system that records the financial transactions of a business. The system uses one entry per transaction to record cash, taxable income, and tax-deductible expenses going in or out of the business. Businesses can use accounting software or even simple tables to perform single-entry bookkeeping.

● Trial Balance

A periodical bookkeeping worksheet, a trial balance compiles the balance of ledgers into credit and debit columns that equal each other. Companies create trial balances to ensure the mathematical accuracy of their bookkeeping systems entries.

● Variable Cost

Expenses that change depending on the level of a business’s production. Variable costs go up when production increases and down when production decreases. In contrast to variable cost, fixed cost refers to expenses for a company that stays the same, regardless of production. Fixed costs may include insurance, rent, and interest payments.

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• What Is the Role of Accounts Payable?
• What Is the Accounts Payable Process?
• What Is Included in Accounts Payable?
• Outsourcing Your Accounts Payable Department

What Is the Role of Accounts Payable?

Accounts payable departments aren’t just responsible for paying bills and invoices; they typically undertake at least three essential functions in addition to paying bills.

1. Business Travel Expenses

In any company that requires staff to travel, the accounts payable department will manage their travel expenses. This may include placing reservations for airlines, car rentals, and hotels. Depending on the business’s responsibility structure, the accounts payable department may process requests and disburse funds to cover travel expenses. After instances of business travel transpire, the accounts payable department typically settles the difference between funds distributed and actual spend.

2. Internal Payments

Accounts payable is responsible for distributing internal payments, administering minor cash flow matters, and distributing sales tax exemption certificates. To corroborate reimbursement requests, a business’s employees must turn in either a manual log report or receipts—or both. Trivial expenses such as out-of-pocket office supplies, postage, or a small client lunch are considered minor cash flow matters and handled by Accounts Payable. On top of this, Accounts payable is in charge of sales tax exemption certificates—special certificates issued to managers to ensure qualifying business purchases don’t include sales tax in the total.

3. Vendor Payments

The Accounts payable department is responsible for organizing and maintaining vendor information, payment terms, and IRS W-9 information. Accounts payable either handles pre-approved purchase orders or accounts payable verifies purchases after the point of sale depending on a business’s responsibility structure. The Accounts payable department also manages end-of-month aging analysis reports. These reports provide upper-level management with a clear picture of business credit.

Miscellaneous Functions

In addition to the three functions mentioned above, the accounts payable department reduces costs by recognizing credit patterns and developing strategies to save money in the credit department. For example, some invoices contain inherent discount periods. Accounts payable will settle credit liabilities within the defined timeframe to receive the discount. In addition, accounts payable comprises a direct line of contact between a business and its vendor’s representatives. Maintaining robust and positive business relationships between the company and its vendors may lead to certain benefits, such as relaxed credit terms.

Related: Profitable Small Business Ideas

What Is the Accounts Payable Process?

The accounts payable department must follow what is known as the accounts payable process. The accounts payable process is a set of procedures undertaken while making payment to a vendor. Due to the sheer volume of transactions that many accounts payable departments handle, these guidelines are essential to maintaining consistent, accurate reporting.

The accounts payable process is as follows:

1. Receiving the bill: When a business purchases goods, they receive a bill. Bills are important because they quantify what is received.
2. Review bill details: The accounts payable department must ensure that the bill includes vendor name, authorization, date, and verified and matching requirements to the purchase order.
3. Update records: Once the bill is received, ledger accounts need to be updated. An expense entry is typically made. This step may or may not require managerial approval.
4. Make the payment: All payments should be processed before or at the due date specified on a bill as agreed upon between a vendor and a purchasing company. Required documents need to be prepared and verified. Check details, vendor bank account details, payment vouchers, the original bill, and the purchase order need to be considered. Like the previous step, making the payment may or may not require managerial approval.

To ensure the safety of the company’s cash and assets, the accounts payable process must have internal controls to prevent paying a fraudulent or inaccurate invoice—or accidentally paying a vendor invoice twice.

Related: Accounting Tips for Small Businesses

What Is Included in Accounts Payable?

Accounts payable is listed on a company’s balance sheet as a current liability. Accounts payable consists of a collection of short-term credits extended by a business’s vendors and creditors. An accounts payable department also manages internal payments for business expenses, travel, and minor cash flow matters. Compare balance sheet vs. income statement.

Outsourcing Your Accounts Payable Department

Due to tighter margins, many smaller businesses do not retain dedicated accounts payable departments because financial professionals can be costly. However, at FinancePal, we seek to change the narrative that small businesses cannot afford dedicated financial professionals. Outsourcing your accounting and bookkeeping matters, such as accounts payable, to professionals is the most efficient and most cost-effective way to save your business money come tax time. Accounting for startups provided by FinancePal has helped thousands of small businesses with their financials and taxes on a convenient subscription basis.

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This article will go over the inner workings of accounts receivable, how it differs from accounts payable, and how managing your finances can lead to a quicker payment turnaround.

• What is accounts receivable?
• Accounts receivable vs. accounts payable?
• Does accounts receivable count as revenue?
• What is the allowance for uncollectible accounts?
• Why is accounts receivable important?
• How can I make my customers pay quicker?

What is accounts receivable?

Put simply, accounts receivable refers to money your customers owe for goods or services purchased from you in the past. This money is typically recorded as an asset on your balance sheet; they live under the ‘current assets’ portion on your balance sheet or chart of accounts.

Related: Accounting for Startups

Accounts receivable vs. accounts payable

While accounts receivable are considered an asset account—representing money that your customers owe to you—accounts payable are considered a liability account. This is because, with accounts payable, the roles are reversed: you are the customer.

Related: Profitable Small Business Ideas

Does accounts receivable count as revenue?

Accounts receivable is considered an asset account. Subsequently, it is not considered a revenue account. However, due to the inherent mechanisms of accrual accounting, your business simultaneously records revenue and accounts receivable. But remember: if your company operates on a strict cash-only basis, there are no accounts receivable. Under the cash system, transactions aren’t considered sales until the money is physically in your bank account.

Related: Types of Business Partnerships

What is the allowance for uncollectible accounts?

Unfortunately, problem clients exist. These clients often pay late, or not at all. When a client doesn’t pay, their receivables remain uncollectable; this is known as bad debt.

Businesses should estimate their total bad debts ahead of time to ensure the accounts receivable shown on their financial statements aren’t too high. This is made possible by setting up what is known as an “allowance for uncollectible accounts.”

For example, let’s say you expect your total annual sales for the year to be $500,000. Through experience, you expect that you won’t collect 5% of accounts receivable.

To estimate your annual bad debts, you multiply total sales by the expected percentage of bad debt ($500,000 x 0.05). Subsequently, you would then credit the resulting amount ($25,000) to your allowance for uncollectible accounts—and debit bad debt expense by the same amount.

When it becomes evident that an account receivable will not get fulfilled, it must be written off as a bad debt expense. It is important to note that the allowance for uncollectible accounts simply estimates how much you will fail to collect from specific customers.

Occasionally, you may mistakenly categorize a long-time outstanding amount as bad debt, only to have the problem customer end up fulfilling it after all. To record this transaction, you would begin by debiting your accounts receivable by the outstanding amount to get the receivable back on your books and then credit your revenue by the amount. Afterward, to record the cash payment, you would debit your cash account by the amount and credit your accounts receivable by the same amount again. This closes out the transaction once and for all.

Related: How to Set up Payroll

Why is accounts receivable important?

The goal of any business is to have many customers. However, one of the inherent difficulties of having many customers paying on credit is that payment turnaround differs from customer to customer—and some customers tend to pay very, very late.

One of the best ways to keep track of late payments is by calculating your accounts receivable turnover ratio. The accounts receivable turnover ratio refers to a simple financial calculation that portrays the speed at which your customers pay their liabilities.

You can calculate your accounts receivable turnover ratio by dividing your total net sales by your average accounts receivable.

For example, let’s say that at the beginning of the year, you had total accounts receivable of $5,000. At the end of the year, your total accounts receivable is $4,000. Your total net sales for the year were $120,000.

First, you must calculate your average accounts receivable for the year. To do so, add the starting and ending amounts in your accounts receivable and divide by two, like so:

$5,000 + $4,000 / 2 = $4,500

To finally arrive at your accounts receivable turnover ratio, divide net sales—$120,000—by average accounts receivable, like so:

$120,000 / $4,500 = 26.666…

Given these figures, your accounts receivable turnover ratio is 27 when you round up. The higher this figure is, the quicker your customers are settling their liabilities.

Suppose you want to calculate exactly how quickly they are paying you. In that case, you can calculate your average sales credit period by dividing 52—the number of weeks in a year—by your accounts receivable turnover ratio:

52 weeks / 27 = 1.92 weeks

This figure means that it took your customers an average of about two weeks to settle their liabilities in the given year. This example has resulted in a pretty quick turnaround—don’t feel discouraged if your turnaround is not this fast!

How can I make my customers pay quicker?

Improving the turnaround time of your customers takes patience, proactivity, and a little creative gusto. If you implement a well-communicated, well-organized credit policy, for example, your customers will know exactly what you expect of them in terms of repayment. You can request up-front deposits on higher-cost orders or implement interest accrual on late payments. If you clearly communicate these stipulations with your customers, your turnaround will shorten in no time.

However, perhaps your customers respond better to a carrot than a stick. Why not offer a financial incentive, such as a discount for early repayment? This is where knowing your customer base becomes critical — you can use your knowledge to shape your credit policy moving forward.

The post Accounts Receivable appeared first on financepal.

This article examines the cash flow statement—and, specifically, the minutiae of direct vs. indirect cash flow.

• What Is the Direct Method?
• What Is the Indirect Method?
• What Is the Difference Between Direct and Indirect Cash Flow?
• Which Method Is Better?

What Is the Direct Method?

The direct method, also known as the income statement method, is one of two methods utilized while crafting the cash flow statement—the other method being the indirect method, which we will examine later. The direct method is an accounting treatment that nets cash inflow and outflow to deduce total cash flow. Notably, non-cash transactions, such as depreciation, are not accounted for using the direct method.

The direct method is often used in tandem with the cash method of accounting, where money is only accounted for when it changes hands.

While favored by financial guides, the direct method can be difficult and time-consuming; the itemization of cash disbursements and receipts is a labor-intensive process. To add to the complexity, the Financial Accounting Standards Board (FASB) requires a report disclosing reconciliation from all businesses utilizing the direct method. 

This report must plainly show the reconciliation between net income and cash flow from operating activities, listing the net income and adjusting it for non-cash transactions and balance sheet account changes. These added hoops to jump through are enough to persuade many businesses to eschew the direct method in favor of the indirect method.

Related: What is an Accounting Period?

What Is the Indirect Method?

Unlike the direct method, the indirect method uses net income as a baseline. Using the indirect method, after you ascertain your net income for a specific period, you add or subtract changes in the asset and liability accounts to calculate what is known as the implied cash flow. These changes to the asset or liability accounts present themselves as non-cash transactions such as depreciation or amortization.

Because the cash flow statement is more conducive to cash method accounting, one can think of the indirect method as a way for businesses using the accrual method to report in terms of cash on hand. As such, it requires additional preparation and adjustments after the fact. It is also not quite as precise as the direct method.

What Is the Difference Between Direct and Indirect Cash Flow?

Because most businesses operate using the accrual method of accounting, the indirect method is more widely used. The indirect method is also much quicker than the direct method because it utilizes information readily available on the income statement and the balance sheet.

Here are a few other key differences between direct and indirect cash flow:

•     The direct method only utilizes cash transactions, such as cash spent and cash received, to determine net income. On the other hand, the indirect method uses net income as a starting point before tacking on non-cash transactions such as depreciation, amortization, and more.
•     The direct method completely ignores the non-cash transactions, which are core to the indirect method.
•     While utilizing the direct method, cash flow must be reconciled with net income. Under the indirect method, net income is automatically converted into cash flow.
•     Unlike the direct method, the indirect method requires preparation for conversion when accounting on an accrual basis.
•     The direct method of accounting is generally more accurate than the indirect method. The indirect method will require additional adjustments to the cash flow statement.
•     Although the FASB favors the direct method, accountants tend to prefer the indirect method because it can be accomplished much quicker than its counterpart.

Which Method Is Better?

Both methods have their advantages and disadvantages. The direct method is preferred by the FASB and itemizes the direct sources of cash receipts and payments, which can be helpful to investors and creditors. However, it is time-consuming and less popular. Meanwhile, the indirect method has the edge on speed and ease of use, despite lacking accuracy.

The truth is that neither method is genuinely better than the other — it depends on which is right for your business. If you want to talk to a professional small business accountant about which method is suitable for you, schedule a consultation with FinancePal today!

 Related: eCommerce Accountants

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Banks and financial institutions prepare this document each month, allowing people and businesses to monitor and evaluate their finances. All small business owners can benefit from regularly reviewing and reconciling their bank statements.

A bank statement likewise allows you to see your income streams, expenses, spending activity, and profits related to the account. Financial experts recommend understanding the bank statement because it helps you make informed decisions and develop better financial habits. 

However, individuals and small business owners often face bank errors, account balance irregularities, and problems with deposits and withdrawals.

Why Reconcile Bank Statements?

Various reasons to reconcile your bank statement include:

• Data entry validation to evaluate and fix irregularities
• Confirmation of financial statement accuracy
• Tax reporting and assessment
• Cash flow monitoring and analysis
• Irregularities in outstanding check and electronic transfers
• Theft control and proper financial management

Keep reading to learn more about reconciling bank statements, using the links below to navigate to the sections that best answer your questions.

• • • What Is Bank Statement Reconciliation?
    • How Do You Reconcile a Bank Statement?
    • How Often Should You Reconcile Your Bank Account?
    • What is the Purpose of Bank Reconciliation?
    • The Bottom Line

   

What Is Bank Statement Reconciliation?

Reconciling your bank statement is an important process that focuses on finding the difference between your bank balance in the statement and the amount in your company’s cash account at the end of the month.

 Small business owners can take advantage of the process to ascertain their true cash balance by identifying discrepancies and irregularities in their bank accounts. For example, if the bank has cashed a check for a different amount, it is considered a bank mistake. Likewise, you have made deposits, but the bank did not record them, it is considered an online banking software error.

 Another reason bank account reconciliation is necessary is to legitimize automatic deposits and withdrawals that the accounting software hasn’t recorded. Payments taken without your knowledge are considered theft or fraud, meaning you need to reconcile your bank to know what happened.

How Do You Reconcile a Bank Statement?

Reconciling a bank statement helps you identify irregularities, possible bank errors, and fraudulent activities that happened in your individual or company’s bank account during the months. The entire process can keep you informed about authorized and unauthorized transactions, uncashed checks, income and expenses reviews, and more. 

Here are the steps for how to prepare a bank reconciliation statement:

Step 1: Compare the Bank Statement and Cash Account

The bank statement reconciliation process usually starts with comparing your individual or company’s statement and ledger cash account. The process requires you to check off all matching items to ensure all items in the ledger have cleared the bank account. After the item clears your company’s bank account, it means the completion of a specific transaction.

Step 2: Add Deposits in Transit

Adding deposits in transit to your ending balance is the second essential step after completing the comparisons process. The process involves focusing on the remaining items in your company’s general ledger and adding deposits in transit to your ending balance. Bear in mind that deposits in transit refer to the documented or recorded deposits in your register. However, you don’t see these deposits in your bank statement.

Step 3: Deduct Outstanding Checks

Once you have added deposits in transit to your ending balance, it is time to deduct outstanding checks from it. Remember, outstanding checks deduct from your register but do not appear on your bank statement.

Step 4: Analyze Bank Errors

Evaluate the ending balance and based on its status, and then add or subtract bank errors to your ending balance. For instance, these could be irregular or incorrect deposits and withdrawals. Make sure you double-check bank errors before adding or deducting them to the ending balance.

Step 5: Deduct Bank Service Charges 

This is a crucial step in the bank statement reconciliation process. You need to deduct bank service charges, such as wire transfer charges, check overage fees, account maintenance charges and returned check fees.

Step 6: Interest Earned and Check Register Errors

Many individuals and small business owners have interest-bearing accounts, allowing them to earn interest on their deposits. For example, depositing money into a savings account or interest-bearing checking account can help you earn interest on your money.

Therefore, when reconciling your bank statement, make sure you add interest earned to the ending balance. Remember, this is not necessary if you don’t have an interest-bearing account. Moreover, add or deduct errors in your check registers, such as a payment omission or a cash transaction.

Step 7: Prepare Journal Entries

The reconciliation process requires you to prepare journal entries. The purpose is to correct errors found in your general ledger and bank statement. Business owners can post items from the bank statement into the general ledger using the journal entries. It is crucial to re-run the ledger cash account after posting all journal entries. That way, you can update your ending balance for each posted item.

Step 8: Compare Adjusted Statements

Once you have updated journal entries for each posted in the ending balance, compare the adjusted general ledger cash balance and reconciled bank statement balance. Make sure the balances are equal. Otherwise, you will have to go through the steps again. The purpose is to adjust the balance for outstanding checks and deposits in transit.

How Often Should You Reconcile Your Bank Account?

Financial and accounting experts recommend reconciling your bank account every month, especially after the bank sends you the statement. However, you can also reconcile your bank account daily or weekly, depending on your business operations, the frequency of transactions, and irregularities in your general ledger and the bank statement.

Bank account reconciliation every month will help you keep track of your transactions. It also enables you to figure out unusual transactions, accounting errors, fraudulent activities and make efforts to fix them. Businesses that fail to perform bank reconciliations regularly are at higher risks of: 

• Bank errors
• Unauthorized withdrawals
• Fraudulent activities
• Cash flow leaks

 Therefore, it is crucial to check your bank statement and perform the reconciliation process daily, weekly, or monthly, depending on your needs. That way, you can avoid problems like cash flow leaks and streamline your business operations.

 Related Reading: Cash vs. Accrual Accounting

What Is the Purpose of Bank Reconciliation?

The primary purpose of preparing your bank reconciliation report is to identify irregularities between the bank and an entity’s accounting records. Research shows that a time difference is the leading cause of such discrepancies on the part of the bank or your company.

Discrepancies are also due to careless, fraudulent, or illegal activity on the part of your business. Reconciling your bank is an effective method to prevent embezzlements and frauds in your company’s funds.

Experts recommend proper handling of your bank reconciliation to identify errors in your company’s accounting records. Good management can also lead to a more streamlined process in revealing errors in your bank account.

Besides, reconciling your bank every month can help you monitor and evaluate your company’s cash flows. It ensures your bank or private financial institution provides you with proper credits and fees.

 A bank reconciliation process also helps you monitor and control internal functions. For example, these include identifying or tracking unauthorized bank withdrawals and figuring out excessive cash turnover.

The Bottom Line

It is common for many companies to come across discrepancies in their accounting records. The difference in your bank balance on the company’s account and your bank statement’s actual balance is often due to a timing difference.

 Certain transactions do not get updated in your bank even after being recorded by the entity, leading to inefficiencies. A bank reconciliation process is vital to ensure everything goes smooth and optimal.

 If your business needs help with reconciling bank statements at regular intervals, contact the professionals at FinancePal today! Outsourcing your accounting and bookkeeping to professionals is the most efficient and cost-effective way to save your business money come tax time. The small business accountants and bookkeepers at FinancePal have helped thousands of small businesses with their financials and taxes on a convenient subscription basis. We specialize in all areas of small business financials, including payroll, accounting for startups and new businesses, financial statement preparation, catch-up bookkeeping, and more! Schedule a consultation with an experienced small business professional today.

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 An accounting period is a span of time during the fiscal or calendar year in which accountants perform functions such as gathering and aggregating data and creating financial statements. The financial statements made during these periods are very important for attracting potential investors or procuring loans from banks.

 An accounting period can consist of any established time frame, although the most common are the week, the month, the quarter, and the fiscal or calendar year. Publicly-held companies are required to release quarterly reports to the Securities and Exchange Commission (SEC).

 Accounting periods can (and do) overlap. For example, an accountant may aggregate data to create an income statement for the month of February. While the resulting income statement will only represent the February accounting period, the month of February will also be represented on the quarterly financial statements for Q1.

• Accounting Period Requirements
• What Is the Accounting Period Cycle Concept?
• What Types of Accounting Periods Are There?
• Why Is an Accounting Period Important?

Accounting Period Requirements

First and foremost, accounting periods need to be consistent. For example, if an accountant creates financial statements on a monthly basis, they must do so for each month of each calendar year. This is called periodicity, and having good periodicity will give decision-makers, investors, and banks a large, congruent sample size from which to make judgements on a company’s financial health and outlook.

When utilizing accounting periods, another golden rule is the matching principle. The matching principle is a key tenet of the accrual method of accounting. It requires that expenses are reported in the period during which they were incurred; likewise, all revenue must be reported in the period during which it was earned.

What Is the Accounting Period Cycle Concept?

The accounting period is the time it takes to complete the accounting cycle. When the accounting period opens, accountants begin the cycle with reversing entries and end the cycle by closing entries and producing financial statements as the accounting period culminates. The cycle starts over as the next accounting period commences.

What Types of Accounting Periods Are There?

There are several standard accounting periods, including:

• The Calendar Year; The calendar reflects the Gregorian Calendar — 12 months, 365 days (or 366 on leap years), starting on January 1st and culminating on December 31. The advantage to this over the fiscal year is that it corresponds to the same time frame that most events follow.
• The Fiscal Year; Much like the calendar year, the fiscal year is a 12 month, 365 day period. However, the start and end dates are flexible; for example, a business’s fiscal year could start on July 1st and conclude on June 30th. The IRS allows businesses to choose which year to use, but the choice is hard to reverse. Switching from calendar to fiscal or vice versa would require special permission given only if certain circumstances are met.
• The 4-4-5 Calendar Year; typically seen in retail, the 4-4-5 calendar year divides the calendar year into quarters. Each quarter consists of 13 weeks, grouped into two 4-week and one 5-week months, hence the name. The main advantage to this period is that the end date of each period always falls on the same day of the week. This allows periods to accurately reflect the corresponding period of the previous year with as few varying weekdays as possible.

Why Is an Accounting Period Important?

At the end of each accounting period, a business’s accountants will produce financial statements such as the balance sheet, the profit and loss statement, the cash flow statement, and the statement of change in equity. Well-crafted statements coupled with proper periodicity is critical for investors and banks to gauge the financial health of a business.

And, should your business ever trigger an IRS audit, periodicity will be your saving grace. The IRS can be very unforgiving when it comes to mistakes or inconsistencies on financial statements; they have no qualms about adding fines and fees to your balance.

A good accountant is an impeccable rule-follower — and there are a ton of rules in business finance. Many small business owners who attempt to do their own accounting find it to be tedious, complicated, and time-consuming.

For a small business, outsourcing accounting and bookkeeping to an outside firm is quick, easy, and rewarding. Every day, more and more small business owners make the switch to bookkeeping and accounting with FinancePal.

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