The goal of business (and to keep the doors open) is to earn money. You also know that eventually
money will go out. As an accountant, one of the most common errors I run into is money that has gone in or come out and is not classified correctly. I thought long and hard about how I could explain this to the average business owner. I think in pictures, so I’m going to use my crude artistic ability to help illustrate my examples.
The most common way we envision the inflow and outflow of money is the typical revenue in, expense out cycle:
In this example, the money that flows into your business is revenue from operating activities: selling your item or service to customers. This could also be considered “new money” or money not previously held within your business. The money that flows out of your business is for expenses: payroll, utilities, rent, etc. This lies to the right of our money cycle due to the fact that we are taking money that was already earned by our business and sending out to pay for others’ goods and services.
It is our perception therefore, that any number with a “positive” sign should be classified as income and anything “negative” as an expense. Before we make such a determination, we need to step back and take a look at the bigger picture. We need to assess which side of the money cycle is impacted by our various transactions. This is a large topic, so I’ll be splitting this into two blog posts. We will start with “money coming in.”
Besides income from operations, how else could money come into your business? Let’s say you noticed payroll was coming but you didn’t have enough cash in your checking account to cover the full amount. Therefore you decided to inject $500 from your own pocket to cover payroll. Is this income from operations? No. This is an increase in owner’s equity (remember our Balance Sheet lesson?). Any money that an owner, partner, or shareholder puts INTO the company without expecting it back is considered an increase in Equity, not an increase in revenue. We still put this injection into the top of our money cycle because it is new money coming into the business; it is not money that was already in the business.
Now, let’s say you buy a new clock for your office and after a week it stops working. You head to the office supply store, and request a full refund in lieu of an exchange. Would this be considered money coming into your business? Yes, it would. Would it be revenue generated from operating your business? No. An injection of cash from a shareholder? No. Any time your business receives a REIMBURSEMENT of funds that was initially an EXPENSE (buying a clock is definitely an expense), this money coming in will go against the same expense account it was initially drawn from. For this example, when we purchased the clock, we put it to “office supply expense.” Now, as we get our money back, we will pull it from “office supply expense,” thereby completely removing the expense of the clock from our books. As you can see, this “money in” is on the “outflow” side of the money cycle.
So, what could go wrong if we misclassify the money coming in to our business? First, your income would be overstated, causing your business to owe more in excise taxes than you should be paying. Your expenses would also be overstated. And finally, the Equity section of the balance sheet would may not reflect the cash you’ve just put into your business, decreasing your net worth. I’m not sure about you, but I’d like to show as much profit as possible and get credit for the money I’ve invested into my business while paying the government as little as humanly possible.
Part 2 of the money cycle will involve “money going out” of your business and how to handle the most common scenarios. Stay tuned!