Maire Loughran - Financial Accounting For Dummies

Plus, you don’t incur the additional expense to file a separate tax return to report all that income you’re going to be bringing in! Sole proprietorships report their income or loss on the owner’s Form 1040.

And tah-dah! If you don’t have any employees, you don’t need to bother with those pesky employment tax forms. The owner of a sole proprietorship does not get paid like an employee; she receives a draw, which is part of owners’ capital.

Most sole proprietors initially fund their business from personal sources, which can be either cash or noncash. An example of the first is depositing cash that you’ve saved up into the business bank account. I do a step-by-step on process in Chapter 5.

After that initial cash infusion, many sole proprietorships have an on-and-off need over the years for an additional owner influx of cash. It’s a simple fact of doing business that sometimes you have to pay for business expenses before you collect the money from your customers.

When you started your sole proprietorship, you may already have personally owned inventory (see Chapter 13) or computer equipment that you convert to business use. If you decide to make these assets the property of the business, you increase your owner's capital by the amount of the fair market value of the assets, which is what an unrelated third party would pay in an open marketplace.

For example, you’ve decided to upgrade your sewing hobby to handcrafting and selling organic cotton t-shirts. You have a bolt of the organic cotton fabric left over from your home sewing days that originally cost $125. Comparable fabric is selling online for $100. The fair market value for this inventory item is $100.

You have been patiently waiting to see how you get paid your draw as a sole proprietor, so here it is! Generally, the amount you can pay yourself at any time is the total of your cash contributions plus money you bring in by selling your t-shirts less the cost of raw material you had to buy to make your t-shirts such as thread and any other business costs like postage.

Unlike the way your employer pays you, sole proprietors don’t have taxes withheld from their draw. They just write themselves a check, which is an addition to their draw account and reduces overall owners’ equity.

You’ll find a blown-out statement of owners’ equity for a sole proprietorship, which includes the draw, capital and owners’ equity accounts in Chapter 9.

I compare the S Corporation business entity to my small business clients as a revved up sole proprietorship. For a single person, S Corporation day-to-day operations are pretty much the same as a proprietorship with the following exceptions:

You, as the owner, are paid like a regular employee, not by draw. This brings into play all the employment tax filing requirements such as making tax deposits and giving yourself a W-2 at year end.

Generally, you’ll have limited liability for the debits of the S Corporation.

Unlike a sole proprietorship, an S Corporation is separate and distinct from you, the owner/shareholder. With very few exceptions, you, as the owner of the S Corporation, are not personally responsible for any actions taken by the business. Hands down, I consider this a biggest advantage to taking the time and money to operate as an S Corporation.

The owner of an S Corporation is the shareholder. What that means is that after you follow the steps in your state to establish the business, you purchase shares of stock from the business to stake your ownership. Chapter 9gives some fantastic info on this type of accounting transaction, which, by the way, you will be tested on in your financial accounting course!

Okay, so limited liability sounds good but wondering what the tax bite is for an S Corporation? Like a sole proprietorship, the income or loss from the business flows through to the shareholder’s tax return. Most of my small business S Corporation shareholders are husband and wife filing a joint Form 1040. So, the income from the business is taxed at the same federal rate as W-2s, interest and dividend income on that return.

I’ve condensed information about S Corporations to just what you need to know for your financial accounting course and to offer it as an business entity option should you be a budding small business owner reading this book. A great resource on the topic is Starting a Business All-In-One For Dummies (Wiley) by Kenneth W. Boyd, Lita Epstein, Mark P. Holtzman, Frimette Kass-Shraibman, and finally me — Maire Loughran.

The big deal about revenue and cost recognition for your financial accounting course is the matching principle (see Chapter 5). Generally accepted accounting principles (GAAP) dictates you must associate all recognized revenue both earned and realizable with the expenses you incur to product that revenue. Chapter 10gives you the revenue side of the matching principle. Chapters 12and 13walk you through important steps to match inventory and big asset purchases to revenue.

However, as your financial accounting textbook will point out, in some instances, you don’t have to fully utilize the matching principle. For example, many small businesses use the cash method of accounting (see Chapter 6). Under the cash method, revenue is recorded when it is received, and expenses are recorded when they are paid.

The cash method of accounting is especially suited to service businesses, which don’t sell a tangible product. Rather, a service company provides a knowledge-based work product and purchasing inventory for sale (see Chapter 13) and is not a common part of doing business as a service. Examples of this type of business are dentists, accountants, and lawyers.

To add to the excitement, some businesses have specialized generally accepted accounting procedures (GAAP). Classroom discussions about cash based and specialty GAAP is always a lively in my financial accounting courses.

The airline industry is one example of specialized GAAP. While there are many, two interesting items of airline specialty GAAP are recognition of income and accounting for landing and take-off slots. If a passenger fails to use a nonrefundable ticket, airlines can consider the flight closed the next day and record the revenue for this unused ticket. Exchangeable tickets not used within a certain time period set by the airlines are similarly booked as gross receipts. To figure a reasonable time period, the airline looks to historic data reflecting how long in the past it took passengers to reticket their exchangeable flights. This time period is normally between 6 to 24 months, depending on the airlines and their experience in the past.

Landing and take-off slots are the areas owned by airlines to enter and exit airports can be one of their largest assets on the balance sheet. They are accounted for as intangible assets (see Chapter 7), which means their cost is initially taken to the balance sheet and then amortized , which means the cost is transferred to the income statement using an allowable amortization method (see Chapter 7).