Appendix B

If Numbers Are Your Friends

You don’t need to know much about accounting or about double-entry bookkeeping to use QuickBooks — which, as you know, is most of its appeal. If you’re serious about this accounting business or serious about your business, consider finding out a bit more; setting up QuickBooks and understanding all the QuickBooks reports will be easier, and you’ll be more sophisticated in your accounting, too.

Just because the accounting in this appendix is a little more complicated doesn’t mean that you can’t understand it. To make this whole discussion more concrete, I use one running example. I hope it helps you! If nothing else, it’ll inspire you to get into the rowboat-rental business.

Keying In on Profit

Start with the big picture. The key purpose of an accounting system is to enable you to answer the burning question “Am I making any money?”

Accounting is that simple. Really. At least conceptually. So throughout the rest of this appendix, I just talk about how to calculate a business’s profits in a reasonably accurate but still practical manner.

Let me introduce you to the new you

You just moved to Montana for the laid-back living and fresh air. You live in a cute log cabin on Flathead Lake. To support yourself, you plan to purchase several rowboats and rent them to visiting fishermen. You’ll probably need to do quite a bit of fishing, too, of course, but just consider it the price you pay for being your own boss.

The first day in business

It’s your first day in business. About 5 a.m., ol’ Peter Gruntpaw shows up to deliver your three rowboats. He made them for you in his barn, but even so, they aren’t cheap. He charges $1,500 apiece, so you write him a check for $4,500.

Peter’s timing, as usual, is impeccable. About 5:15 a.m., your first customers arrive. Mr. and Mrs. Hamster (pronounced “ohm-stair”) are visiting from Phoenix. They want to catch the big fish. You’re a bit unsure of your pricing, but you suggest $25 per hour for the boat. They agree and pay $200 in cash for eight hours.

A few minutes later, another couple arrives. The Gerbils (pronounced “go-bells”) are very agitated. They were supposed to meet the Hamsters and fish together, but the Hamsters are rowing farther and farther away from the dock. To speed their departure, you let the Gerbils leave without paying, but you’re not worried. As the Gerbils leave the dock, Mrs. Gerbil shouts, “We’ll pay you the $200 when we get back!”

Although you don’t rent the third boat, you do enjoy a sleepy summer morning.

About 2 p.m., the Hamsters and Gerbils come rowing back into view. Obviously, though, a problem has occurred. You find out what it is when the first boat arrives. “Gerbil fell into the lake,” laughs Mr. Hamster. “Lost his wallet, too.” Everybody else seems to think that the lost wallet is funny. You secretly wonder how you’re going to get paid. No wallet, no money.

You ask Mr. Gerbil whether he’ll come out to the lake tomorrow to pay you. He says he’ll write you a check when he gets home to Phoenix. Reluctantly, you agree.

Look at your cash flow first

I just described a fairly simple situation. But even so, answering the question “Did I make any money?” won’t be easy. You start by looking at your cash flow: You wrote a check for $4,500, and you collected $200 in cash. Table B-1 shows your cash flow.

TABLE B-1 The First Day’s Cash Flow

	Cash In and Out	Amount
Add the cash.	Rent money from Hamsters (pronounced “ohm-stairs”) Rent money from Gerbils (pronounced “go-bells”)	$200 $0
Subtract the cash.	Money to purchase rowboats	($4,500)
Your cash flow:		($4,300)

To summarize, you had $200 come in but $4,500 go out, so your cash flow was –$4,300. (That’s why the $4,300 is in parentheses.) From a cash-flow perspective, the first day doesn’t look all that good, right? But does the cash-flow calculation show you whether you’re making money? Can you look at it and gauge whether your little business is on the right track?

The answer to both questions is no. Your cash flow is important. You can’t write a $4,500 check unless you have at least $4,500 in your checking account, for example. Your cash flow doesn’t tell you whether you’re making money, though. In fact, you may see a couple of problems by looking just at the cash flow of the rowboat-rental business.

Depreciation is an accounting gimmick

Here’s the first problem: If you take good care of the rowboats, you can use them every summer for the next few years. In fact, suppose that the rowboat rental season, which runs from early spring to late autumn, is 150 days long and that your well-made rowboats will last ten years:

• You can probably rent the rowboats for 1,500 days.

  (150 days per year × 10 years = 1,500 days)

• Each rowboat costs $1,500.

  The depreciation expense for each rowboat is only $1 per day over 1,500 days. That’s a whopping $3 for all three boats.

Do you see what I’m saying? If you have something that costs a great deal of money but lasts a long time, spreading out the cost makes sense. This spreading out is usually called depreciation. The little $1 chunks that are allocated to a day are the depreciation expense.

Accountants use the terms cost and expense to mean distinctly different things. A cost is the price that you pay for something. If you pay Peter Gruntpaw $1,500 for a rowboat, the rowboat’s cost is $1,500. An expense, on the other hand, is what you use in a profit calculation. The little $1 chunks of the rowboat’s $1,500 cost (that are allocated to individual days) are expenses.

If this depreciation stuff seems wacky, remember that what you’re really trying to do is figure out whether you made any money your first day of business. What I’m really saying is that you shouldn’t include the whole cost of the rowboats as an expense in the first day’s profit calculation. Some of the cost should be included as an expense in calculating the profit in future days. That’s fair, right?

Accrual-basis accounting is cool

You don’t want to forget about the $200 that the Gerbils owe you, either. Although Mr. Gerbil (remember that the name is pronounced “go-bell”) may not send you the check for several days or even for several weeks, he will pay you. You earned the money.

The principles of accounting say that you should include sales in your profit calculations when you earn the money, not when you actually collect it. The logic behind this include-sales-when-they’re-earned rule is that it produces a better estimate of the business you’re doing.

DIFFERENT NAMES, SAME LOGIC

I don’t see any point in hiding this nasty little accounting secret from you: Accountants call this cost-allocation process by different names, depending on what sort of cost is being spread out.

Most of the time, the cost allocation is called depreciation. You depreciate buildings, machinery, furniture, and many other items as well. Allocating the cost of a natural resource — such as crude oil that you pump, coal that you dig, or minerals that you extract — is depletion. And allocating the cost of things that aren’t tangible — franchise agreements, copyrights, and patents, for example — is amortization.

Suppose that the day after the Gerbils and Hamsters rent the rowboats, you have no customers, but Mr. Gerbil comes out and pays you $200. If you use the include-sales-when-they’re-earned rule, which is called accrual-basis accounting, your daily sales look like this:

	Day 1	Day 2
Sales	$400	$0

If you instead use cash-basis accounting (in which you count sales when you collect the cash), your daily sales look like this:

	Day 1	Day 2
Sales	$200	$200

The traditional accrual-based accounting method shows that you have a good day when you rent two boats and a terrible day when you don’t rent any boats. By comparison, when you use cash-basis accounting, your sales record looks as though you rented a boat each day, even though you didn’t. Now you know why accrual-basis accounting is a better way to measure profit.

Accrual-basis accounting also works for expenses. You should count an expense when you incur it, not when you pay it. Suppose that you call the local radio station and ask the people there to announce your new boat-rental business a couple of times over the course of the day for a flat fee of $25. Although you don’t have to pay the radio station the day your announcement airs, you should still count the $25 as an expense for that day.

Now you know how to measure profits

With what you now know, you’re ready to measure the first day’s profits. Table B-2 is a profit and loss statement for your first day in business.

TABLE B-2 A Profit and Loss Statement for the First Day

Description	Amount	Explanation
Sales	$400	Rental money from the Hamsters and Gerbils
Depreciation expense	$3	Three rowboats × $1/day depreciation
Advertising	$25	Radio advertising
Total expenses	$28	Depreciation expense plus the advertising
Profit	$372	Sales minus the total expenses

Although the first day’s cash flow was terrible, your little business is quite profitable. In fact, if you really do make about $370 per day, you’ll recoup your entire $4,500 investment in less than three weeks. That’s pretty darn good.

Some financial brain food

Now that you know how to measure profits, I can fill you in on some important conceptual stuff:

• You measure profits for a specific period.

  In the rowboat-business example, you measured the profits for a day. Some people actually do measure profits (or try to measure profits) on a daily basis. Most times, though, people use bigger chunks of time. Monthly chunks of time are common, as are three-month chunks of time (quarters). And everybody measures profits annually — if only because the government makes you do so for income tax accounting.

• When people start talking about how often and for what chunks of time profits are measured, they use a couple of terms.

  The year that you calculate profits for is the fiscal year. The smaller chunks of time for which you measure profits over the year are accounting periods or interim accounting periods.

  You don’t need to memorize these new terms. But now that you’ve read them, you’ll probably remember them.

• The length of your accounting periods involves an awkward trade-off.

  Daily profit and loss calculations show you how well you did at the end of every day, but you have to collect the data and do the work every day. And preparing a profit and loss statement is a great deal of work.

  I made the example easy on purpose by including only a few transactions. In real life, you have many more transactions to worry about and fiddle with.

• If you use a quarterly interim accounting period, you don’t have to collect the raw data and do the arithmetic very often, but you know how you’re doing only every once in a while.

  In my mind, checking your profits only four times per year isn’t enough. A lot can happen in three months.

In the Old Days, Things Were Different

If you’re new to the arithmetic and logic of profit calculation — which is mostly what modern accounting is all about — you won’t be surprised to hear that not all that long ago, most people couldn’t and didn’t do much profit calculating.

What they did instead was monitor a business’s financial condition. They used (well, actually, they still use) a balance sheet to monitor the financial condition. A balance sheet lists a business’s assets and its liabilities at a particular point in time.

Say that at the start of your first day in the rowboat-rental business — before you pay Peter Gruntpaw — you have $5,000 in your checking account. To make the situation interesting, $4,000 of this money is a loan from your mother-in-law, and $1,000 is cash that you invested in your business.

Here’s a key to help you understand the balance sheets and cash flow in this section:

• A business’s assets are composed of things that the business owns.
• Liabilities consist of the amounts that the business owes.
• Equity is the difference between the business’s assets and its liabilities. Interestingly, equity also shows the money that the owners or shareholders or partners have left in the business.
• If you correctly calculate each of the numbers that go on the balance sheet, the total assets value always equals the total liabilities plus total owner’s equity value.

Your balance sheet at the beginning of the day looks like the one in Table B-3.

TABLE B-3 The Balance Sheet at the Beginning of the Day

Description	Amount	Explanation
Assets	$5,000	The checking account balance
Total assets	$5,000	Your only asset (cash), which is your total, too
Liabilities	$4,000	The loan from your mother-in-law
Owner’s equity	$1,000	The $1,000 you put in
Total liabilities and owner’s equity	$5,000	The total liabilities plus the owner’s equity

If you construct a balance sheet at the end of the first day, the financial picture is only slightly more complicated. Some of these explanations are too complicated to give in a sentence, so the paragraphs that follow describe how I got each number.

Even if you don’t pay much attention, I recommend that you quickly read the explanations. Mostly, I want you to understand that if you try to monitor a business’s financial condition by using a balance sheet, as I’ve done here, the picture gets messy. Later in this appendix, I talk about how QuickBooks makes all this stuff easier.

Table B-4 shows the balance sheet at the end of the first day.

TABLE B-4 The Balance Sheet at the End of the Day

	Description	Amount
Assets
	Cash	$700
	Receivable	$200
	Rowboats	$4,497
Total assets		$5,397
Liabilities and owner’s equity
	Payable	$25
	Loan payable	$4,000
Total liabilities		$4,025
	Owner’s equity	$1,000
	Retained earnings	$372
Total liabilities and owner’s equity		$5,397

Cash, the first line item shown in Table B-4, is the most complicated line item to prove. If you were really in the rowboat-rental business, of course, you could just look at your checkbook. But if you were writing an appendix about being in the rowboat-rental business (as I am), you’d need to be able to calculate the cash balance. Table B-5 shows the calculation of the cash balance for your rowboat-rental business.

TABLE B-5 The First Day’s Cash Flow

Description	Payment	Deposit	Balance
Initial investment		$1,000	$1,000
Loan from mother-in-law		$4,000	$5,000
Rowboat purchase	$4,500		$500
Cash from the Hamsters		$200	$700

The $200 receivable, which is the second line item shown in Table B-4, is the money that the Gerbils owe you.

The third line shown in Table B-4 — the Rowboats balance sheet value — is $4,497. This is weird, I’ll grant you, but here’s how you figure it: You deduct from the original cost of the asset all the depreciation expense that you charged to date. The original cost of the three rowboats was $4,500. You charged only $3 of depreciation for the first day, so the balance sheet value, or net book value, is $4,497.

The only liabilities are the $25 that you owe the radio station for those new-business announcements (shown on the seventh line in Table B-4) and the $4,000 that you borrowed from your mother-in-law (shown on the eighth line in Table B-4). I won’t even ask why you opened that can of worms.

Finally, the owner’s equity section of the balance sheet shows the $1,000 that you originally contributed (see line 10 in Table B-4) and also the $372 that you earned (see line 11 in Table B-4).

It’s not a coincidence that the total assets value equals the total liabilities plus the total owner’s equity value. If you correctly calculate each of the numbers that go on the balance sheet, the two totals are always equal.

A balance sheet lists asset, liability, and owner’s equity balances as of a specific date. It gives you a financial snapshot at a point in time. Usually, you prepare a balance sheet whenever you prepare a profit and loss statement. The balance sheet shows account balances for the last day of the fiscal year and interim accounting period. (I think that it’s kind of neat that after only a few pages of this appendix, you’re reading and understanding such terms as fiscal year and interim accounting period.)

What Does an Italian Monk Have to Do with Anything?

So far, I’ve provided narrative descriptions of all the financial events that affect the balance sheet and the income statement. I describe how you started the business with $5,000 of cash (a $4,000 loan from your mother-in-law and $1,000 of cash that you invested). At an even earlier point in this appendix, I note that you rented a boat to the Hamsters for $200 and that they paid you in cash.

Although narrative descriptions of financial events — such as starting the business or renting to the Hamsters — make for just-bearable reading, they’re unwieldy for accountants to use in practice. Partly, this awkwardness occurs because accountants are usually (or maybe always?) terrible writers. But an even bigger problem is that using the lots-and-lots-of-words approach makes describing all the little bits and pieces of information that you need difficult and downright tedious.

Fortunately, about 500 years ago, an Italian monk named Lucia Pacioli thought the same thing. No, I’m not making this up. What Pacioli really said was “Hey, guys. Hello? Is anybody in there? You have to get more efficient in the way that you describe your financial transactions. You have to create a financial shorthand system that works when you have a large number of transactions to record.”

Pacioli proceeded to describe a financial shorthand system that made it easy to collect all the little bits and pieces of information needed to prepare income statements and balance sheets. The shorthand system he described? Double-entry bookkeeping.

This system enabled people to name the income statement or balance sheet line items or accounts that are affected and then give the dollar amount of the effect. The profit and loss statement and the balance sheet line items are accounts. You need to remember this term.

A list of profit and loss statement and balance sheet line items is a chart of accounts. You may already know this term from using QuickBooks.

Pacioli also did one wacky thing. He used a couple of new terms, debit and credit, to describe the increases and decreases in accounts:

• Debit: Increases in asset accounts and in expense accounts are debits. Decreases in liability, owner’s equity, and income accounts are also debits.
• Credit: Decreases in asset and expense accounts are credits. Increases in liability, owner’s equity, and income accounts are also credits.

Keeping these terms straight is a bit confusing, so see Table B-6 for help.

TABLE B-6 The Only Stuff in This Book I Ask You to Memorize

Account Type	Debits	Credits
Assets	Increase asset accounts	Decrease asset accounts
Liabilities	Decrease liability accounts	Increase liability accounts
Owner’s equity	Decrease owner’s equity accounts	Increase owner’s equity accounts
Income	Decrease income accounts	Increase income accounts
Expenses	Increase expense accounts	Decrease expense accounts

I’m sorry to have to tell you this, but if you want to use double-entry bookkeeping, you need to memorize the information in Table B-6. If it’s any consolation, this information is the only chunk of data in the entire book that I ask you to memorize. Failing that, dog-ear this page so that you can flip here quickly, or refer to the online Cheat Sheet at www.dummies.com. (See the introduction for information on how to find the Cheat Sheet for this book.)

And now for the blow-by-blow

The best way to help you understand this double-entry bookkeeping stuff is to show you how to use it to record all the financial events that I’ve discussed thus far in this appendix. Start with the money that you invested in the business and the money that you foolishly borrowed from your mother-in-law. You invested $1,000 in cash, and you borrowed $4,000 in cash. Here are the double-entry bookkeeping transactions — the journal entries — that describe these financial events.

Journal Entry 1: To record your $1,000 investment

	Debit	Credit
Cash	$1,000
Owner’s equity		$1,000

Journal Entry 2: To record the $4,000 loan from your mother-in-law

	Debit	Credit
Cash	$4,000
Loan payable to mother-in-law		$4,000

If you add all the debits and credits in a journal entry, you get a trial balance. A trial balance isn’t all that special, but you use it to prepare profit and loss statements and balance sheets easily. If you add the debits and credits shown in journal entries 1 and 2, you get the trial balance shown in Table B-7.

TABLE B-7 Your First Trial Balance

	Debit	Credit
Cash	$5,000
Loan payable to mother-in-law		$4,000
Owner’s equity		$1,000

This trial balance provides the raw data needed to construct the rowboat-business balance sheet at the start of the first day. If you don’t believe me, take a peek at Table B-3. Oh, sure, the information shown in Table B-7 isn’t as polished. Table B-7 doesn’t provide labels that tell you that cash is an asset, for example. And Table B-7 doesn’t provide subtotals showing the total assets (equal to $5,000) and the total liabilities and owner’s equity (also equal to $5,000). But it does provide the raw data.

Take a look at the journal entries you’d make to record the rest of the first day’s financial events:

Journal Entry 3: To record the purchase of the three $1,500 rowboats

	Debit	Credit
Rowboats (fixed asset)	$4,500
Cash		$4,500

Journal Entry 4: To record the rental to the Hamsters

	Debit	Credit
Cash	$200
Sales		$200

Journal Entry 5: To record the rental to the Gerbils

	Debit	Credit
Receivable	$200
Sales		$200

Journal Entry 6: To record the $25 radio advertisement

	Debit	Credit
Advertising expense	$25
Payable		$25

Journal Entry 7: To record the $3 of rowboat depreciation

	Debit	Credit
Depreciation expense	$3
Accumulated depreciation (fixed asset)		$3

To build a trial balance for the end of the first day, you add all the first-day journal entries to the trial balance shown in Table B-7. The result is the trial balance shown in Table B-8.

TABLE B-8 The Trial Balance at the End of the First Day

	Debit	Credit
Balance sheet accounts
Cash	$700
Receivable	$200
Rowboats — cost	$4,500
Accumulated depreciation		$3
Payable		$25
Loan payable		$4,000
Owner’s equity		$1,000
Profit and loss statement accounts
Sales		$400
Depreciation expense	$3
Advertising expense	$25

The trial balance shown in Table B-8 provides the raw data used to prepare the balance sheet and profit and loss statement for the first day.

If you look at the accounts labeled Balance sheet accounts in Table B-8 and compare these with the balance sheet shown in Table B-4, you see that this trial balance provides all the raw numbers needed for the balance sheet. The only numbers in Table B-4 that aren’t directly from Table B-8 are the subtotals that you get by adding other numbers.

If you look at the accounts labeled as Profit and loss statement accounts in Table B-8 and compare them with the profit and loss statement shown in Table B-2, you see that this trial balance also provides all the raw numbers needed for the profit and loss statement. Again, the only numbers in Table B-2 that aren’t directly from Table B-8 are the subtotals that you get by adding other numbers.

Blow-by-blow, Part 2

If you understand what I’ve discussed so far in this appendix, you grasp how accounting and double-entry bookkeeping work. I want to show you about a half-dozen more transaction examples, however, to plug a few minor holes in your knowledge.

When you collect money that you’ve previously billed, you record the transaction by debiting cash and crediting receivables (or accounts receivable). In the rowboat business, you make this basic entry when Mr. Gerbil later pays you the $200 that he owes you for the first day’s rental.

Journal Entry 8: To record a payment by a customer

	Debit	Credit
Cash	$200
Receivable		$200

Don’t record a sale when you collect the cash. The sale has already been recorded in Journal Entry 5. When you pay the radio station for the advertising, you record the transaction by debiting accounts payable and crediting cash.

Journal Entry 9: To record your payment of $25 to the radio station

	Debit	Credit
Payable	$25
Cash		$25

The one other thing I want to cover, ever so briefly, is inventory accounting. Accounting for items that you buy and resell or the items that you make and resell is a bit trickier, and I don’t have room to go into a great deal of detail.

When you buy items to resell, you debit an asset account, often named Inventory. If you purchase 300 of the $10 thingamajigs that you hope to resell for $25 each, you record the following journal entry:

Journal Entry 10: To record the cash purchase of thingamajigs

	Debit	Credit
Inventory	$3,000
Cash		$3,000

When you sell a thingamajig, you need to perform two tasks: Record the sale, and record the cost of the sale. If you need to record the sale of 100 thingamajigs for $25 each, for example, you record the following journal entry:

Journal Entry 11: To record the sale of 100 thingamajigs for $25 apiece

	Debit	Credit
Receivable	$2,500
Sales		$2,500

You also need to record the cost of the thingamajigs that you sold as an expense and record the reduction in the value of your thingamajig inventory. That means that if you reduce your inventory count from 300 items to 200 items, you need to adjust your inventory’s dollar value. You record the following journal entry:

Journal Entry 12: To record the cost of the 100 thingamajigs sold

	Debit	Credit
Cost of goods sold	$1,000
Inventory		$1,000

The cost of goods sold account, by the way, is just another expense. It appears on your profit and loss statement.

How does QuickBooks help?

If you keep (or someone else keeps) the books for your business manually, you actually have to make these journal entries. When you use QuickBooks to keep the books, however, all this debiting and crediting business usually goes on behind the scenes. When you invoice a customer, QuickBooks debits accounts receivable and credits sales. When you write a check to pay some bill, QuickBooks debits the expense (or the accounts payable account) and credits cash.

In the few cases in which a financial transaction isn’t recorded automatically when you fill in an onscreen form, you need to use the General Journal Entry window. To display the General Journal Entry window, choose Company ⇒ Make General Journal Entries. You use the General Journal Entry window to create journal entries. An example of one of these noncash transactions is depreciation expense.

QuickBooks automatically builds a trial balance, using journal entries that it constructs automatically and any journal entries that you enter by using the General Journal Entry window. If you want to see the trial balance, just choose Reports ⇒ Accountant & Taxes ⇒ Trial Balance. QuickBooks prepares balance sheets, profit and loss statements, and several other reports by using the trial balance.

Two Dark Shadows in the World of Accounting

The real purpose of accounting systems, such as QuickBooks, is simple: Accounting systems are supposed to make succeeding in your business easier for you. You may think, therefore, that the world of accounting is a friendly place. Unfortunately, this scenario isn’t quite true. I’m sorry to report that two dark shadows hang over the world of accounting: financial accounting standards and income tax laws.

The first dark shadow

“Financial accounting standards,” you say. “What the heck are those?”

Here’s the quick-and-dirty explanation: Financial accounting standards are accounting rules created by certified public accountants (CPAs). These rules are supposed to make reading financial statements and understanding what’s going on easier for people. (I happen to believe that just the opposite is often true in the case of small businesses, in case you’re interested.) But because of what financial accounting standards purport to do, some people — such as bank loan officers — want to see profit and loss statements and balance sheets that follow the rules. The exact catchphrase is one that you might have heard before: “Prepared in accordance with generally accepted accounting principles.”

Unfortunately, the rules are very complicated, the rules are inconsistently interpreted, and actually applying the rules would soon run most small businesses into the ground. (And you’ll be happy to know that as you were running your business into the ground, your CPA would make a great deal of money helping you figure out what you were supposed to be doing.) So what should you do about this first dark shadow?

Glad you asked:

• Know that it exists. Know that sometimes people, like your banker, honestly think that you should follow a super-complicated set of accounting rules.
• Don’t get sucked into the financial accounting standards tar pit. Tell people — your banker included — that you do your accounting in the way that you think enables you to best manage your business. Tell people that a small business like yours can’t afford to have an in-house staff of full-time CPAs. Finally, tell people that you don’t necessarily prepare your financial statements “in accordance with generally accepted accounting principles.”

Do attempt to fully and fairly disclose your financial affairs to people who need to know about them. Lying to a creditor or an investor about your financial affairs or getting sneaky with one of these people is a good way to end up in jail.

The second dark shadow

Here’s the second dark shadow: income tax accounting laws. You know that Congress enacts tax legislation to raise revenue. And you know that it does so in a political environment strewn with all sorts of partisan voodoo economics and social overtones. So you won’t be surprised to find out that the accounting rules that come out of the nation’s capital and your state capital don’t make much sense for running a business.

You need to apply the rules when you prepare your tax return, of course, but you don’t have to use them the rest of the year. A far better approach is to do your accounting in a way that enables you to run your business best. That way, you don’t use accounting tricks and gambits that make sense for income tax accounting but foul up your accounting system. At the end of the year, when you’re preparing your tax return, have your tax preparer adjust your trial balance so that it conforms to income tax accounting laws.

The Danger of Shell Games

This appendix is longer than I initially intended. I’m sorry about that. I want to share one more thought with you, however. I think that it’s an important thought, so please stay with me.

You could use the accounting knowledge that this appendix imparts to do the bookkeeping for a very large business. As crazy as it sounds, if you had 3,000 rowboats for rent — perhaps you have rental outlets at dozens of lakes scattered all over the Rockies — you might actually be able to keep the books for a $200 million–per-year business. You’d have to enter many more transactions, and the numbers would all be bigger, but you wouldn’t necessarily be doing anything more complicated than the transactions in this appendix.

Unfortunately, the temptation is great — especially on the part of financial advisers — to let the money stuff get more complicated as a business grows. People start talking about sophisticated leasing arrangements that make sense because of the tax laws. A customer or vendor suggests some complicated profit-sharing or cost-reimbursement agreement. Then your attorney talks you into setting up a couple of new subsidiaries for legal reasons.

All these schemes make accounting for your business terribly complicated. If you choose to ignore this complexity and go on your merry way, very soon, you won’t know whether you’re making money. (I’ve seen plenty of people go this route — and it isn’t pretty.) On the other hand, if you truly want to do accurate accounting in a complex environment, you need to spend a great deal of cash for really smart accountants. (This tactic, of course, assumes that you can find, hire, and afford these really smart accountants.)

If you’re unsure how to tell whether something is just too complicated, here’s a general rule you can use: If you can’t easily create the journal entries that quantify the financial essence of some event, you’re in trouble.

So what should you do? I suggest that you don’t complicate your business’s finances — not even if you think that the newfangled, tax-incentivized, sale-leaseback profit plan is a sure winner. Keep things simple, my friend. To win the game, you have to keep score.