Depreciation

Depreciation is an expense that we do not pay. Depreciation is how we write down the value of fixed assets as they are "used up" over time. A piece of equipment with a useful life of five years could be depreciated over five years. That way, when it is worthless, it will have no value on our financial statement when it is time to replace it.

Because depreciation is a non-cash expense, we have certain flexibilities. The IRS allows us to use numerous ways to depreciate items. We need to consult with our tax accountant for the method most appropriate for us. Among the ways are "straight line" (the same amount every year) and several "accelerated depreciation" methods.

Why would we want to accelerate depreciation? Anyone who has purchased something new knows that as soon as you "drive it off the lot" it loses a huge amount of its "new" value. In addition, as this piece of equipment ages, it requires more maintenance. The logic is to have depreciation heavier when we first buy it and lower as it gets older because maintenance costs are lower at first and heavier as it ages. The result is that overall "costs" are nearly level. In theory, the usage of the machine and its income or benefits are relatively level too. Using accelerated depreciation matches income with expenses on a fairly even basis.

One more thought about Depreciation. The IRS has a special depreciation provision, called Section 179, which allows us to write off 100% of the purchase of a piece of equipment the year we buy it. There is an annual limit to this generosity, but it is very useful to small businesses, allowing us to reduce our tax liability. Talk to your tax accountant about Section 179 Depreciation.

Before the IRS breathes down our neck and hits us with interest and penalties let’s pay payroll taxes of $500:

Notice that we expensed Payroll Taxes as a Labor Expense. This is because they are part of the cost of having an employee. We don’t have to do it that way. We could have Payroll Taxes as its own account. If we wanted, we could have the Labor be a Master Account and have Subsidiary Accounts of Labor Hours, Group Health Insurance, Worker’s Comp, Matching Social Security and Medicare, Federal Unemployment Tax, etc. Each of these expenses are inherent in the cost of having employees.

A Master Account is an account that totals amounts that are in Subsidiary Accounts. Using Master/Subsidiary Accounts is a trick used to keep our Financial Statement and Profit & Loss short and simple, while having detail available in separate Subsidiary Reports.

Let’s deposit a check for $6,000 for half of the amount our customer owed us on the bill we sent earlier. They called and told us the balance would be coming in next week:

Cash went up by 6,000 as Accounts Receivable went down by the same amount. This is Cash Flow. Profit was unchanged.

This transaction was actually done in the Receipts Entry Screen of the Accounts Receivable Journal. The accounting software automatically posted the amounts where they needed to go.

Let’s pay an outside consultant the $1,200 commission we owe him for his help nailing down a new Job. He brought in his invoice and wants it paid today. We wrote him a check and did the accounting later:

Cash went down by the same amount Other Expenses increased. Accounting for this expense reduced Profit by $1,200. Again the accounting software automatically calculated Year-to-Date Earnings and updated the amount on the Profit and Loss and the Balance Sheet.

As with all prior transactions to Accounts Payable, this was accounted for through the Entry Screen to Accounts Payable. What makes this transaction unique is that it was actually paid at the same time it was entered. The check we gave to the outside consultant is called a "Hand Check" or "Hand Written Check." It is expensed like any other Accounts Payable item except it is marked as "Paid by Hand Check" during entry.

Why wouldn’t we just enter this transaction through the General Ledger? When we have vendors or subcontractors that we have to give a Form 1099, we have to use the Accounts Payable Journal to track the amounts that go on the Form 1099.

Let’s pay our Electric Bill for $1,000:

This is very similar to the last transaction where we paid the consultant a commission. We have the option of expensing the electric bill and letting it sit in Accounts Payable until we are ready to pay it or we can pay it as we enter it and hold the check until it is time to mail it.

Time Saving Tip: Why would you want to pay it and hold the check? First, it’s not an Invoice that needs to be verified by the Job Superintendent. This piece of paper can be handled immediately and then filed away and forgotten. The only thing left to do is mail the check on the right day. Using this process, you have only handled that Invoice one time. If you have a lot of Invoices that can be handled only once, you cut that part of your work in half.

We found out that $500 of our Electric Bill was a deposit, so we have to correct our accounts. We do a Journal entry using the General Ledger :

We reduced Other Expenses by $500 by making it a Deposit. This adjustment increased Profit by $500.

Once a year, after the year is all accounted for, after closing the books for the year, Year-to-Date Earnings are added to "Retained Earnings." The process of closing the books is a journal entry that reverses income and expenses for the year into a single net figure and offsets it against Retained Earnings on the Balance Sheet. When the books are closed for the year, all Income is reversed to zero to start out the new year. Likewise, all expenses are reversed to zero. In order for this transaction to balance, there has to be an offsetting Journal Entry to Retained Earnings. As always, the Debit side of a transaction equals the Credit side of that transaction.

A Reversing Journal Entry is a transaction that, like all transactions, includes a Debit and a Credit. There are a number of Reversing Journal Entries that might be made. If a $47 bill was expensed to Job 101 and it was supposed to go to Job 110, it must be reversed out of 101 and into 110. The entry would be:

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