Real Accounting

8/13/2019 Real Accounting

1/22

Equity Accounts Its Your Money

01-Oct-07

Equity is the difference between assets and liabilities as shown on a balance sheet. In other

words, equity represents the portion of assets that are fully owned by the owners (stockholders,partners, or proprietor) of a business.

When I prepare financial statements, I always review the general ledger (!) account numbersthat the client has coded on the check register. Whenever I see a balance sheet ! accountnumber, I automatically double"check it. #he reason I do this is that the balance sheet is the leastunderstood part of the financial statements for most clients. #his is especially true regarding theequity section. In a way, this is rather strange, since the equity section represents the owner$sshare of the business. I would want to keep a very close eye on my investment and, to do thateffectively, I would need to know the nature of each equity account and how to interpret thechanges in those accounts as they occur.

If I am a sole proprietor, it$s not as crucial because everything in the equity section is mine.#hat$s not to diminish the importance of knowing what the accounts mean, as there are othergood reasons to track the increases and decreases that occur within them. %owever, if I am apartner in a partnership or a stockholder in a corporation, it is my responsibility to protect myinvestment interest from mistakes and&or deliberate misstatements. #his can be a challenge andaccounting knowledge is required.

It is in this light that I thought a review of the equity accounts for a sole proprietor, partnership,and corporation could prove useful. In order to do this, you need to understand how debits andcredits work. If you need a reminder, you can click on this link'

http'&&www.reallifeaccounting.com&accountingmodel.aspand print out a copy of the*ccounting +odel for a guide.

Sole Proprietor

#he equity section title in a sole proprietorship is most commonly called -wner$s Equity. #heaccounts within this section are usually laid out in this fashion'

-wner$s Equityurrent /ear apital ontributions-wner$s 0raw

1et 2rofit or !oss

!ook at the accounting model chart and find the equity section. *n increase to the equity sectionrequires a credit entry, while a decrease requires a debit entry. 3ollowing this accountinglogic,it makes sense that a contribution of personal money to the business requires a debit entry toash and a credit entry to urrent /ear apital ontributions. -n the other hand, if cash is
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removed from the business for personal reasons, a debit entry to -wner$s 0raw and a creditentry to ash would be required.

3urthermore, if the business showed a profit, that would indicate an increase in equity (credit), orif it showed a loss, that would indicate a decrease (debit) in equity.

4ince the -wner$s Equity account (a credit balance account) is an accumulation account, allthe other accounts are closed out at the end of the year into the -wner$s Equity account. #hismakes perfect sense when you follow the 5ournal entries required to close out the accounts. 3orInstance'

1et 2rofit or !oss is automatically closed into -wner$s Equity at the end of the year by yourcomputer. If a 5ournal entry were written, it would look like this'

DESCRIPTIO

N

DEBI

T

CRED

IT

Net Profit50,00

0

Owners

Equity

50,00

0

-r

DESCRIPTIO

N

DEBI

T

CRED

IT

Owners

Equity

5,00

0

Net Loss 5,000

DESCRIPTIO

N

DEBI

T

CRED

IT

Owners

Equity

20,00

0

Owners

Draw

20,00

0

DESCRIPTION DEBI

T

CRED

IT

Captia

Contri!ution

2,00

0


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Owners Equity 2,000

*s you can see the function of the sole proprietor equity accounts is not complicated or difficult

to understand.

Partnership

0epending on how many partners there are, partnership equity accounts usually are organi6ed asfollows under the title, 2artner$s Equity'

2artner *, apital *ccount2artner 7, apital *ccount2artner . apital *ccount1et 2rofit or !oss

*ll the increases or decreases occur within the partner$s capital accounts. In other words, thepartner capital accounts are the equity accounts. If a partner makes a capital contribution, thenhis&her capital account is increased (credit). If the partner takes a distribution, then the capitalaccount is decreased (debit). If the business has a profit or a loss at the end of the year, then thatprofitor loss is distributed among the partners at whatever ownership interest or other arrangement isappropriate.

eneral partners who work in the business are paid a management fee called a guaranteedpayment. #his fee is a legitimate business e8pense and therefore acts to lower the net profit of

the business. #his fee is similar to a salary paid to a working stockholder in a corporation,e8cept, accordingto 9.4. ta8 law, a fee paid to a working partner cannot be run through payroll. It is treated as adraw, sub5ect to self"employment ta8es. 7oth the general partner$s guaranteed payment and shareof the profits are ta8able and sub5ect to self"employment ta8es.

4ometimes a business may not have enough cash to make a distribution to the partners eventhough the business reali6ed a profit. 2artners may have a rude awakening to discover that theystill have to pay ta8es on those profits regardless of whether they received any money.

*nother scenario to be aware of if you are a non"working general partner or a limited partner is

this one' /ou and your partner contributed an equal amount of cash for working capital. #hereason for investing your money is because you e8pect to share in the profits. /our partner is aworking partner and is entitled to receive a management fee for services rendered. /ou need tokeep an eye on the books because there may never be a profit to share in if your partner simplycontinues to increase his&her management fee. It can be a sticky situation because the workingpartner may feel he&she is never making enough money to 5ustify all the work he&she has to do. Itis best to define what the management fee is going to be in the partnership agreementbeforehand.


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Corporation(2rimarily closely held corporations)

losely held (private) corporation equity accounts are a little more complicated than a soleproprietorship or partnership. #hese are the typical accounts found in the corporation equitysection under the title, 4tockholder$s Equity'

:etained Earnings2aid"in"apital0ividends 2aidommon and&or 2referred 4tock1et 2rofit or !oss

:etained Earnings is similar to the -wner$s Equity account in that the 1et 2rofit or !oss isclosed into that account at the end of each accounting year. 2aid"in"apital is the account used torecord capital contributions made by stockholders. ;eep in mind, as in the e8amples above, thatincreases to an equity account are credits. 3or e8ample'

DESCRIPTI

ON

DEBI

T

CRED

IT

Cas"5,00

0

Pai#-in-

Capita5,000

If dividends were paid the 5ournal entry would look like this'

DESCRIPTI

ON

DEBI

T

CRED

IT

Di$i#en#s

Pai#

10,00

0

Cas"10,00

0

When common stock is sold or issued to raise money or acquire property'

DESCRIPTIO

N DEBIT

CREDI

T

Cas"100,00

0


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Co%%on

&toc'

100,00

0

When 1et 2rofit is closed out for the year'

DESCRIPTIONDEBI

T

CRED

IT

Net Profit20,00

0

(etaine#

Earnin)s

20,00

0

#hese accounts are also found on public corporations, however they may have additional equityaccounts that are necessary to e8plain more comple8 activities.

/ou can see that the equity accounts in all three business entities function in a similar manner.3rom year to year, there should be continuity. #his means there should be a logical e8planationfor any increases or decreases in theequity accounts. *s an investor or owner, you have a right toknow the reasons for any changes. If there has been a mistake, willful or otherwise, it is mostlikely going to show up in the equity section. 4tay vigilant and protect your investment.

*ie# in+ccountin) Concepts Co%%ents 2./

Working with the Equity section of your Balance Sheet

17-ay-0

*s I say in my newly posted article, Equity *ccounts < It$s /our +oney, the equity section ofthe balance sheet is the least understood. I give e8amples of the general ledger accounts that arefound in the equity section for a sole proprietor, partnership, and corporation along with ane8planation of how the accounts function.

#he key to understanding these accounts is having a working knowledge of how debits andcredits are recorded depending on whether a transaction calls for an increase or a decrease. 9sethe *ccounting +odel link in the article if you need brusing up.

3or e8ample, if you are a sole proprietor and you take money out of your business for personalpurposes then you would record an entry on the debit side of the general ledger account-wner$s 0raw. Increases to Equity require a credit entry, while decreases to Equity require adebit entry.

In the e8ample, if you wrote yourself a check you would be decreasing ash, which is an asset.4ince you wrote the check to yourself, it makes sense that you decreased your Equity. %ere is thetricky part and why you need to think out what you are doing using the *ccounting +odel'
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/ou decreased your Equity by making a debit entry to -wner$s 0raw and you decreased cash inyour bank account when you withdrew money for personal reasons and made a credit entry to*4%. 4eems straightforward doesn$t it=

7ut you increased the -wner$s 0raw account while at the same time decreasing your equity.

4ometimes this concept is hard for people to grasp. /ou 5ust have to remember that -wner$s0raw is a general ledger account found within the Equity 4ection.

It is useful to remember the fundamental accounting equation'

*44E#4 > !I*7I!I#IE4 ? E@9I#/

When ash, an asset, was decreased then either !iabilities or Equity would also have to bedecreased in order to stay in balance. In this case, the decrease was in Equity.

#he rule is that in any transaction recorded the 0E7I# 4I0E +94# E@9*! #%E :E0I#

4I0E of the ledger.

*ny questions=

*ie# in3o"n4s Co%%ents Co%%ents /

T-Accounts A !reat Tool for Sol"ing Accounting Transactions

07-Dec-05

T-Account #efine#

* #"*ccount is a template or format shaped like a # that represents a particular general ledgeraccount. 0ebit entries are recorded on the left side of the # and credit entries are recorded onthe right side of the #. It is a tool for organi6ing 5ournal entries and analy6ing accountingtransactions.

Working with T-Accounts

#here are a few business owners or managers who have a fantastic ability to remember details,but I would venture to say that most of us find our memory diminishing over time. #"*ccounts

come in handy when a series of 5ournal entries are required and it becomes too difficult to keepall of them in your head.

When solving accounting problems, you have to think of accounting transactions in terms of theaccounting model. lick this link if you need to refresh your memory regarding the accountingmodel'

http'&&www.reallifeaccounting.com&accountingmodel.asp
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#he accounting model is a template you can use to remember how debits and credits work.#he two most common scenarios for using #"*ccounts are' A) determining why certaintransactions were previously posted to the general ledgerB or, C) working out the mostappropriate place to post certain accountingtransactions.

#"*ccounts work because they are visually effective. #his means they are simple to understandand usually it is possible to portray all the #"*ccounts on one page. !et$s look at a basicaccounting transaction and then translate it into #"*ccount form. *ssume you sold an accessoryto one of your rental inventory assets for DF cash and deposited the money into the bank. /ouoriginally bought the accessory for DCG and put it into inventory until it was sold. #he 5ournalentries for the transaction would look like this'

DESCRIPTI

ON

DEBI

T

CRED

IT

Cas"

650

0

&aes 6500

DESCRIPTIONDEBI

T

CRED

IT

Cost of 8oo#s

&o#

200

0

9n$entory 2000

#he #"*ccounts would look like this'

Cas"

6500

&aes

6500

Cost of 8oo#s &o#

2000

9n$entory


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2000

/ou can easily see that the debits equal the credits. !et$s look at a more comple8 accountingtransaction. /ou bought a company van to delivery your rental inventory for DCF,GGG and youdid this by putting DF,GGG down and setting up a liability (1otes 2ayable) for DCG,GGG. /ou made

your first payment of DHG, of which DHG was interest, and your first month$s depreciation wasDH. #o the unfamiliar, these transactions might appear confusing until #"*ccounts are used.

*i:e# +ssets ;


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* critical step is to make sure that the debits equal the credits. If not, you have made a mistakethat must be solved. 1e8t, simply put these #"*ccounts in 5ournal entry form'

DESCRIPTION DEBI

T

CRED

IT

*i:e# +ssets ;


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11/22

'aluing !oo#will A"oi# (uying a )%ig-in-a-%oke

2=-No$-05

*ll my life I had heard the warning never to buy a pig"in"a"poke. I understood the gist of it butdidn$t really know what a poke was. 4o I looked it up one day and found out a poke was a

bag. #he saying refers to a scam in the late +iddle *ges, at a time when good meat wasscarce. If you bought a suckling pig in a bag without first looking at it, you might be surprised tofind a scrawny cat 5ump out when you later opened it. In fact, that$s where the saying, !et thecat out of the bag, came from < in other words, finding out what was really in the bag.

%aving worked in the field of accounting for twenty"five years, I have had ample opportunity toobserve, first hand, many a client who has bought a business"in"a"poke. In the old days, therewere no accepted valuation formulas available to determine a reasonable price for a business. *sa result, rule"of"thumb methods were used, but often had no correlation to the real worth of abusiness.

hoosing the correct valuation formula and applying it properly can be a daunting task andshould be left to the auspices of an e8perienced professional. %owever, you can become familiarwith the general guidelines of a widely used business valuation formula that will, at a minimum,give you an idea of what$s involved. *rmed with this information, hopefully you can avoid beingscammed into buying a business"in"a"poke.

%ave you ever tried to sell or buy a business= It$s not e8actly a straightforward, easy thing to do.+ost likely, if you are the seller, you will want to get top dollar for your business. *fter all, youworked hard to make your business work and would like to be amply compensated. -ften, smallbusiness owners have a feeling for what they think the business is worth. When asked to 5ustifythe selling price, you may hear all kinds of stories.

3or e8ample, one of the most common reasons sellers give for their asking price is the potentialof the business. #his is sometimes better known as blue sky or pie in the sky. #here is noway to accurately estimate this feeling for potential, yet sellers will tell you that if you buy theirbusiness you will be in a great position when this new technology arrives, or this big store movesin ne8t door, or if you are willing to work e8tra hours, and on and on.

*nother story you will hear is how much money the owner takes out of the business includingsalary and perks. 4omehow the seller is equating compensation from work performed in thebusiness to earnings. #his may impress you if you are looking to buy a 5ob. 7ut even then, youneed to pay only what the business is worth. 4o what do you have to do to determine the true

value of a business= :est assured that the process of valuing a business can be e8ceedinglycomple8. +uch depends on the si6e and nature of the business you are buying or selling. #hevariables can seem unending. *n essential element of valuing a business is determining whetheroodwill e8ists, and if so, what price to put on it.

What exactly is Goodwill?
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oodwill is the difference between the value of a business enterprise as a whole and the sum ofthe current fair values of its identifiable tangible and intangible net assets. 1et assets are theassets that are left after subtracting the company$s liabilities. oodwill is only recorded when itsamount is substantiated by an arm$s"length transaction. oodwill cannot be sold or acquiredseparately but has to be included in a purchase with the net assets of a business enterprise.

How is Goodwill valued?

!et$s say someone is selling a small business and is asking DAGG,GGG. #he first question to ask is,What e8actly is he&she selling= What assets are you going to receive in the deal and what,precisely, is their fair market value= *fter appraising the assets, are they worth DAGG,GGG= If not,the difference is what the seller construes to be oodwill. 3or our hypothetical e8ample, let$sassume the net assets have a fair market value of DG,GGG. #his means the seller wants DJG,GGGfor oodwill.

Is this reasonable= %ere are some general steps you can follow to find out'

3irst, determine what a reasonable rate of return on an investment of DG,GGG should be.(0etermining this rate of return can be comple8 and probably requires the help of a professional.)3or our purposes, let$s use HK.

DG,GGG 8 .GH > DJ,HGG

#his is the amount of normal earnings the company should be making each year.

4econd, determine from an average of five years of financial statements, backed up by ta8returns, what the net profit is. 7e sure to normali6e the earnings, which is to say, remove

e8pense items, such as depreciation and owner$s perks, or add in a manager$s salary if the ownerworked in the business and didn$t record a salary. *dd or subtract any other appropriate items toarrive at a realistic net profit. !et$s say the normali6ed earnings turned out to be DAG,GGG.

#hird, subtract the normal earnings of DJ,HGG from the normali6ed earnings of DAG,GGG todetermine e8cess earnings.

DAG,GGG < DJ,HGG > DF,CGG

3ourth, determine a capitali6ation rate (cap rate). #his also can be comple8 to develop. %owever,the idea behind a cap rate is this' #he lower the risk, the lower the return on investment. #he

higher the risk, the higher the return on investment. 3or e8ample, if you invest your money inyour local bank, the risk of losing your investment is relatively low. #herefore, you only earnabout CK. Invest in the stock market and you can e8pect to earn up to AGK or higher in somecases, because it is a more risky investment. * small business can be a very risky investment,and a rule of thumb says you should at least e8pect to earn CGK. 7ut, if the small business hasfactors that indicate less stability, then an even higher rate of return should be e8pected, perhapsGK or JGK. 0etermining an appropriate and accurate cap rate is probably the hardest part ofvaluing a business.


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%owever, let$s say our cap rate is CGK.

3ifth, divide the cap rate into the e8cess earnings to determine oodwill.

DF,CGG & CGK > DC,GGG

4i8th, add the net assets value and the oodwill to determine the full value of the business.

DG,GGG ? DC,GGG > DH,GGG

-ur seller wanted DAGG,GGG for the business. 1ow you can go to him and say, ee, I 5ust don$tsee it that way, take a look at my analysis. 9sually, the seller will back down when presentedwith a formula approach. If the seller hires his own accountant to provide a formula approachand his value of the business is higher than yours, (you can bet on it) then a common approach isto settle on a price that is the difference between the two.

%ow could the seller$s accountant come up with a different figure than yours= It$s in those ratesand all the variables that go into developing them. It doesn$t take much to skew the percentagepoints one way or another. %ere is a what if'

What if the seller$s accountant came up with a rate of return for net assets of K instead of HK=

DG,GGG 8 .G > D,GG 1ormal earnings

DAG,GGG < D,GG > D,JGG E8cess earnings

*nd, what if the seller$s accountant came up with a cap rate of AHK instead of CGK=

D,JGG & .AH > DF,FF

DG,GGG ? DF,FF > DLF,FF

#his is very close to the seller$s original asking price of DAGG,GGG.

#he name of this formula of valuing a business is called the 1et *ssets plus E8cess Earningsmethod. It does not work on all businesses and there are other methods that can be used. #hemain point is to inform you that formulae do e8ist and not simply to accept the rationali6ations ofthe seller.

Does Goodwill even exist?

#his is a quick and dirty method to see if you want to waste your time negotiating a businessoffering. When the seller provides financial statements for your perusal, look at the bottom line.#ake the time to normali6e the earnings as mentioned above. Is there a profit= If not, you knowthere is not going to be any goodwill. What are the assets worth that you will be buying= *rethey less than the asking price= If so, you can pretty much bank on the fact that the asking price


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is too high. !ook at alternatives. ould you buy new assets for the amount the seller is askingand start your own business from scratch= Why pay for something that doesn$t e8ist=

What happens if the seller has two sets of books?

7usiness owners who keep two sets of books are not altogether uncommon. #hey keep one set ofbooks for the government and another set for internal purposes. #here is nothing wrong with thispractice unless it is for the purpose of hiding income in order to pay lower ta8es. #he problemfor these people arises when it comes time to sell their business. #hey want you (the buyer) toaccept their internal books because they reflect more profit. %owever, you have no way ofverifying that these books are accurate. #hat is why it is important to make sure that the ta8returns of the business support the financial statements. 7usiness owners who follow thispractice of deception want it both ways. What they don$t reali6e is that any wise and astute buyeris not going to go along with it. If a business owner is going to lie and cheat the government,surely that person is capable of lying to a potential buyer. +y recommendation is to walk awayor only pay a price based on information from the ta8 return.

Good financial records

If you are buying or selling your business, good records are a must. 7uyers are going to want anhistorical average of profits so they can develop trends. #rends speak volumes. ood financialrecords are indicators of how the business was managed. * strong prospective buyer will e8pectnothing less than 7alance 4heets and 2rofit and !oss 4tatements that tie directly to the businessta8 returns. I$ve witnessed solid buyers walking away from deals because of sloppy books.4loppy books are a pig"in"a"poke to a prudent buyer.

*ie# in+ccountin) Concepts Co%%ents ./

*ecor#ing !oo#will on the (ooks

2=-No$-05

%ave you ever seen oodwill as an asset category on a set of financial statements= 0o youwonder how the dollar amount was arrived at= 0id you know that the only way oodwill can beentered on the balance sheet is through a purchase=

3or a definition and general understanding of oodwill, be sure to read my blog article titled,Maluing oodwill' *void buying a 2ig"in"a"2oke. !et$s assume you$ve done that and you nowknow that oodwill is the difference between the value of a business enterprise as a whole and

the sum of the current fair values of its identifiable tangible and intangible net assets.

!et$s also assume that you have 5ust purchased a sole proprietorship small business for DAFG,GGG./ou paid for it by making a down payment of DFG,GGG from personal funds and acquired a bankloan for the remaining DAGG,GGG. #he purchase consists of DNG,GGG in 3i8ed *ssets, and DHG,GGGin oodwill. #he 5ournal entry would be'

Account Debit Credit
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3i8ed *ssets DNG,GGG

oodwill DHG,GGG

1otes 2ayable DAGG,GGG

apital ontributions D FG,GGG

/ou know you can depreciate the 3i8ed *ssets, but can you write off oodwill= *ccording tothe Internal :evenue 4ervice, under the +*:4 system, oodwill can be amorti6ed over afifteen year period.

If you bought the business on Ouly A, the first year$s amorti6ation would be DC,.N. Each fullyear would be DF,.. 4imply divide DHG,GGG by AF to get DF,.. 0ivide that amount byC to arrive at DC,.N. 0epending on what month of the year you purchased the businessdetermines the amount amorti6ation e8pense. #he 5ournal entry to record amorti6ation for

oodwill would look like this'

Account Debit Credit

*morti6ation E8pense DC,.N

*ccumulated *morti6ation DC,.N

2retty straightforward, wouldn$t you say=

*ie# in3o"n4s Co%%ents Co%%ents 2/

The +istorical $ost $once,t Accounting %rinci,le

06-Oct-05

Imagine, for a moment, trying to read a financial statement that had listed assets such as' cashDF,GGGB AJ bo8es of orangesB CF bo8es of applesB AGGG board feet of lumberB acres of landB and,H machines. * first question that might pop into your mind is' %ow in the world do I add theseassets to one another=

It is immediately clear that for financial statements to be meaningful, amounts of dissimilar items

must be stated in similar units. +oney becomes the obvious choice of similar units. 7yconverting different kinds of ob5ects into monetary amounts, they can be dealt witharithmetically. #his is called the money"measurement concept and is a fundamental principleof accounting.

#his is great, but the problem is not yet solved. *n asset may be recorded in dollars and cents (orwhatever currency is appropriate for the country in which you live), but at what value= If I wereallowed to choose the value I thought was appropriate for my assets, my tendency would be to
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state their value at the highest amount possible. #hat way, my financial statement would indicatethat my business was strong, healthy, and worth a lot of money. :emember the accountingequation'

*44E#4 < !I*7I!I#IE4 > E@9I#/

%igher assets mean higher equity. Wonderful, but what if I$m wrong= +y banker and myinvestors are trusting that my financial statements are stated accurately. 3urthermore, it is notreasonable to e8pect that every reader of my financial statements can or should have to appraisemy assets.

In order to avoid the sub5ectivity of market value, an ob5ective way of valuing assets had to beestablished. #his was solved by using the historical cost concept. #his concept states that thenumbers reported on accounting financial statements shall be recorded at the amount that wasactually paid for an asset, i.e., historical cost. #herefore, accounting does not record what anasset is actually worth, that is, its market value. #his works out okay because most businesses are

using their assets to conduct operations and are not trying to sell them. When a business offers anasset for sale, or perhaps the entire business, an appraisal to determine fair"market"value of theassets must be performed.

4o we (preparers of financial statements) are going to use money as a measurement system andwe will record our assets at the amount actually paid for them. #his will keep us out of troubleand make it easier to understand what others are doing.

*ie# in+ccountin) Principes Co%%ents 1/

+ow to recor# )contri(ute# la(or on the co&,any (ooks

06-Oct-05

lients ask me this question from time to time and usually don$t like or understand the answer.#he question is, If I donate or contribute my labor to a charitable institution, can I record thecost, at my normal charge rate, as an e8pense on my financial statement= #he obvious result isthat the client$s 1et 2rofit will be lower leading to lower ta8es.

It seems reasonable doesn$t it= *fter all, your time is worth money and you are giving it to aworthy cause. What$s the matter with that= 3irst, read my -ctober article titled, #he %istoricalost oncept *ccounting 2rinciple. It e8plains that money must e8change hands, or a promiseto pay money, before an amount can be recorded on the books because there needs to be an

ob5ective way to determine the value of a transaction. Was there any money or promise of moneye8changed in the e8ample= 1o, there was only a contribution of labor.

4econd, from a debits and credits perspective, how would you record a contribution of labor= Ifyou recorded a debit to an e8pense account called ontributions, what would be the credit entry=1ot ash. 1ot 2ayables. +aybe Equity= !et$s look at that. If you write a credit entry to increaseEquity, then the e8pense entry lowers 1et 2rofit as washes out the increase in Equity. 4ound
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17/22

pretty good= 1ot really, because you 5ust violated the accounting principle of %istorical ost. 1omoney was actually paid, so there was no ob5ective way to value the transaction.

What if you decided that your time was worth DAGGG an hour= /ou worked eight hours so yourecorded an e8pense of DH,GGG. #hat might be a big hit on the old 1et 2rofit. 2lus, it looks like

you contributed a substantial amount to the business. +ore likely, someone who charged DNF anhour might be inclined to up it to DACF an hour if they felt they could. /ou can see why theInternal :evenue 4ervice (I:4) would take a dim view of this. If left up to the discretion ofmillions of ta8payers the potential for abuse would be staggering.

#herefore, this practice is not allowed. #he integrity of financial statement reporting must beprotected, and the I:4 doesn$t want to be cheated.

*fter e8plaining all this to clients, often they still don$t get it. -r, they don$t want to get it. #heyfeel they gave up something so they should get something back, i.e., the write off. #he I:4 saysthat if you performed a service for someone then record that service as income on your books,

then you can deduct it as a legitimate ontribution e8pense. I say, why bother, since they bothwash each other out. It$s 5ust e8tra accounting work.

I welcome your comments or questions on this sometimes confusing concept.


.oans "s .eases Whats it all a(out/

1-+u)-05

-ne of the most frequent questions I get asked is 4hall I lease or buy= +ost likely the lease vs.

buy choice for a business would arise when considering the acquisition of a company automobileor delivery truck, but it could be any e8pensive piece of equipment. #his decision is usuallypredicated by the desire to obtain the highest deduction or ta8 savings. #he first step inanswering the lease or buy question is to clarify the difference between these two purchasingoptions.

uy

When you buy an item you either pay cash for it all at once, or, you sign an agreement, called apromissory note, to pay for it over time. When you buy and make installment payments, you areconsidered to have entered into a contract of sale. 3rom an accounting and ta8 standpoint, you

have purchased an asset and incurred a liability. #he asset cost is deducted over a period of timethrough an e8pense category called depreciation. 9sually, a down payment of a certain amount isrequired to consummate the purchase. 1ote how this transaction is set up on the books using thefollowing 5ournal entry'

DESCRIPTI

ON

DEBI

T

CRED

IT
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18/22

*i:e# +ssets10,00

0

Notes

Paya!e7,500

Cas" 2,500

DESCRIPTION DEBI

T

CRED

IT

Depreciation

E:pense

2,00

0

+ccu%uate# Depr 2,000

When payments are made on the note there are two components to consider, i.e., principal and

interest. 2rincipal is the original amount borrowed and interest is the cost of borrowing themoney. 4ince interest is a cost, it is a deductible e8pense and has its own category. 3or instance'

DESCRIPTIO

N

DEBI

T

CRED

IT

Notes Paya!e 500

9nterest

E:pense50

Cas" 550

0o you see that in a contract of sale the e8pense deduction comes from two sources,depreciation and interest=

!ease

* lease is an agreement under which the owner of property permits someone else to use it for afee. #he owner is the lessor and the user is the lessee. #here are two types of leases from thestandpoint of the lessee' a dirty lease and a true lease. #he dirty lease is called a capitallease or a lease obligation in accounting circles, and, a true lease is called an operating

lease.

* capital leaseis one in which the rights and risks of ownership of the property will betransferred to the lessee. #herefore, the lessee must evaluate the provisions of a lease in order todetermine if the lease should be classified as a capital lease or an operating lease.

%ow does the lessee do this= #his is the tough part. #here are four criteria to use and, if any oneof them fit, the lease should be treated as a capital lease'


19/22

1 ?"e ease transfers owners"ip of t"e property to t"e essee !y t"e en# of t"e ease ter%2 ?"e ease contains a !ar)ain purc"ase option i'e a B100 !uyout/

6 ?"e ease ter% is equa to 75A or %ore of t"e esti%ate# econo%ic ife of t"e ease#property

. ?"e present $aue of t"e %ini%u% ease pay%ents, at t"e !e)innin) of t"e ease ter%, isat east equa to =0A of t"e fair $aue of t"e ease# property

I recogni6e that at this point I may have left many of you scratching your heads. 7ut, don$t giveup 5ust yet. !ook, most of the lease contracts you are going to enter into contain the first twocriteria. If the lease contracts do, don$t worry about the last two criteria. If they don$t and thelease doesn$t appear to have the characteristics of an operating lease (see below), then youshould check with your accountant to make sure you are giving the lease proper accountingtreatment.

In the 9nited 4tates, the Internal :evenue 4ervice (I:4) and the 3inancial *ccounting 4tandards

7oard (3*47) feel that a capital lease type of contract is so similar to a contract of sale that itshould be given the same accounting and ta8 treatment as a normal purchase.

#he cost of leasing is built into the lease payment but is not stated separately (like interest on anote). %owever, the I:4 considers it to be the same. #herefore, a apital !ease is set up the sameas a 1otes 2ayable.

DESCRIPTI

ON

DEBI

T

CRED

IT

+sset10,00

0

Capita

Lease,=00

Cas" 1,100

1ote here that the cash down payment is less than the contract of sale above. #his is oneadvantage of buying through a lease. 1ormally, the down payment includes only the first and lastpayment of the lease (DFFG ? DFFG > DA,AGG).

0epreciation occurs 5ust as in a contract of sale.

DESCRIPTION DEBI

T

CRED

IT

Depreciation2,00

0


20/22

+ccu%uate#

Deprec2,000

-ften you will find that the leasing company does not give you the actual cost of the asset youare buying. What they will do is give you the total cost of the lease. 3or instance, if your leasepayments are DFFG per month for twenty months then the total lease contract will be stated asDAA,GGG. /ou must remember to find out the actual value of the asset (DAG,GGG) in order torecord it accurately on your balance sheet and depreciation schedule.

#he rule is that the cost of the asset can never e8ceed its fair market value. #here may be othercosts called e8ecutory costs included in the lease payments. #hese are items such as insurance,maintenance, and property ta8. #hese items can be e8pensed in each payment as they areincurred.

DESCRIPTIO

N

DEBI

T

CRED

IT

Capita Lease 500

9nterest

E:pense.5

E:ecutory

Costs5

Cas" 550

#he DFFG lease payment is split up in the same manner as the principal and interest payment ofthe notes payable e8cept that you may have to include the e8ecutory costs.

#he only difference between a apital !ease and a ontract of 4ale purchase is that the downpayment on the lease may be less. #he deductible e8pense is the same.

*n operatin" lease(or true lease) is one in which the lessor retains the rights and risks ofownership. #he lessee is simply obtaining the right to use the property for the term of the leaseand no more. If the four criteria above are not met then the lessee should treat the lease as anoperating lease.

If, at the end of the term of an operating lease, you decide to keep the property, then, technicallyyou should be required to pay the fair market value of the item at that time. %owever, manylessors offer the leased property at AGK of its original fair market value. #his practice of using aAGK buyout at the end of the lease term does not constitute a bargain purchase option. Inaddition, the bookkeeping is simpler, because the full cost of the lease payments is treated as arent e8pense each month. #here is no asset recorded on the books, no apital !ease 2ayable orInterest E8pense. %ere is how the 5ournal entry looks each month'


21/22


22/22

If so, you should have treated that lease the same way you would have treated a normal purchaseof equipment in your accounting records. In other words, the lease should have been capitai6ed.#he equipment item should have been recorded in the 3i8ed *ssets section of the 7alance 4heetas a debit, and the down payment a credit to ash, and the remaining balance owed set up as aapital !ease or !ease -bligation in the liability section of the 7alance 4heet. Interest and

depreciation should be e8pensed as with any other purchase of an asset that has an installmentloan associated with it.

It is important to understand what constitutes a true lease from a dirty lease (a capital lease).#he accounting requirements are very different. :ead the article and let me know if you have anyquestions.

Oohn 0ay


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