Accounting Terms

What is cash flow management?

Cash flow management is the process of tracking how much money is coming into and going out of your business. This helps you predict how much money will be available to your business in the future. It also helps you identify how much money your business needs to cover debts, like paying staff and suppliers.

Cash flow is the term used to describe changes in how much money your business has from one point to another. Cash flow management is keeping track of this flow and analyzing any changes to it. This helps you spot trends, prepare for the future, and tackle any problems with your cash flow.

It pays to practice cash flow management often to make sure your business has enough money to keep running.

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How to calculate gross profit

To calculate gross profit, take your total sales and subtract the cost of making or selling your product.

Total sales - cost of goods sold = gross profit

Let’s say your business sells $12,000 worth of your product, and it cost you $8,000 to make those products. This would leave a gross profit of $4,000.

$12,000 total sales - $8,000 cost of making the product = $4,000 gross profit

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What is a profit and loss statement?

A profit and loss statement shows how much your business has spent and earned over a specified time. It also shows whether you’ve made a profit or a loss over that time. This shows whether your business has made a profit or loss during that time – hence the name. A profit and loss statement might also be called an ‘income statement’, a ‘statement of operations’, a ‘statement of earnings’ or a ‘P&L’.

A profit and loss statement shows all your revenue and expenses. This includes things like payroll, advertising, rent and insurance. It will also show your earnings from sales and other forms of income.

Your total profit or loss for the time period you’ve chosen is what you’ve earned minus what you’ve spent. If this amount is positive, it’s called a net income. If it’s negative it’s called a net loss.

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What is the difference between bookkeeping and accounting?

Bookkeeping and accounting are both important parts of managing your finances. At first glance, the two can seem quite similar, but there are a few main differences.

Bookkeeping focuses on recording and organizing financial data. Accounting is the interpretation and presentation of that data to business owners and investors.

Bookkeeping typically consists of:

payroll
invoicing
receipts and bills
recording business transactions.

Accounting typically consists of:

financial statements and reports
budgets
tax returns
analyzing business performance.

The tasks that bookkeepers and accountants do vary between businesses. Bookkeepers working for smaller businesses might do some basic accounting duties. There’s often overlap, and the duties may change a lot from one business to another.

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What can I write off on my taxes?

When filing your taxes, you can write off any expense that’s involved in the running of your business. This could include office rent, equipment and business travel.

The IRS states you can only write off a business expense if it’s:

ordinary – common in your line of work, and
necessary – helpful for your business (but not necessarily indispensable)

This means buying a camera is a legitimate business expense for a photographer – but not for a writer.

You can’t write off personal expenses, like groceries. But if an expense is partially personal and partially business, you can claim the business component. If you buy a new cell phone and use it for business 80% of the time, you’re allowed to deduct 80% of that cost.

Regardless of what you’re writing off, make sure you keep receipts of all your expenses. Keeping proof of your expenses will keep you out of trouble if the IRS audits you.

Tax write offs can save you hundreds of dollars a year – but they can be complicated. It’s worth checking with an accountant or tax agent to make sure you’re claiming the right things.

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What is net income?

Net income is the total amount of profit your business makes after deducting expenses. This includes:

the cost of goods sold
overhead
tax

Net income is a good way of measuring how profitable your business is. Annual net income is your net income for one year.

Net income is also called net earnings and net profit. Because it’s on the last line of an income statement, it’s also known as ‘the bottom line.’

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How do I send an invoice?

To make sure you get paid on time, it’s important to send your invoices on time and to the right person. How you send an invoice will depend on:

how you’ve made the invoice
who you’re sending it to

If you’ve written an invoice by hand, you can mail it to your customer or deliver it in person. Remember to write the name of the person you’re sending it to – not just the name of the company. This ensures the invoice gets to the right person.

If you’ve made an invoice using online accounting software, you can:

send it as an email attachment
send your customer a link to the invoice they can view online

How you send your invoice might also depend on what your customer wants or expects. Some businesses might prefer electronic invoices. Government agencies might need a physical copy for their records.

Related terms:
What is an invoice?
How do I make an invoice?

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What is an invoice?

An invoice is a document that charges a customer for goods or services you’ve provided. Also called a bill, an invoice shows all the information about a transaction. This includes:

the quantity of any goods or services provided
the rate charged
the total cost
a description of the transaction (so your customer knows what they’re paying for)
when and how the customer should pay

Invoices differ from quotes. A quote provides an estimated cost. An invoice shows the actual time taken and actual cost of a job or transaction. For a customer, the invoice is a “purchase invoice.” For a supplier, it’s called a 'sales invoice'.

Another function of an invoice is to remind your customer that they haven’t paid you yet. Larger companies may lose track of payments if they deal with many suppliers at once. For this reason, an invoice shows your customer when they should pay you. This is called a payment term. This might be 7 days, 14 days or even a month depending on the agreed terms. It’s often written as 'Net 14 days'.

Invoices should always be accurate, descriptive and timely. This is vital to keeping a steady cash flow for your business.

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What is an executive summary?

An executive summary is a simplified, condensed version of a longer document. This is useful for business plans and financial reports. In a business plan the executive summary contains the purpose and goals of the business.

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What is business accounting?

Business accounting is the systematic recording, analyzing, interpreting and presenting of financial information. Accounting may be done by one person in a small business, or by different teams in large organizations.

Accounting is the way a business keeps track of its operations. Accountants analyze the business finances so the owner can make better decisions. This information is organized into reports that show the financial health of a business.

Accounting helps business owners meet their compliance obligations. It also helps them make smart decisions with their money.

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What is the objective of financial reporting?

The objective of financial reporting is to track, analyze and report your business’ income. The purpose of these reports is to examine resource usage, cash flow, business performance and the financial health of the business. This helps you and your investors make informed decisions about how to manage the business.

There are three main goals of financial reporting:

Provide information to investors
Investors will want to know how cash is being reinvested in the business, and how efficiently capital is being used. Financial reporting helps investors decide whether your business is a good place for their cash.
Track cash flow
Where is your business’ money coming from? Where is it going? Is the business making a profit or a loss? These answers are important to know – they show how well your business is performing, and whether it can cover its debts and continue to grow.
Analyze assets, liabilities and owner's equity
By monitoring these, and any changes to them, you can work out what to expect in the future, and what you can change now to prepare. This also shows the availability of resources for future growth.

Financial reports adhere to a group of taxation, accounting and legal requirements, called the International Financial Reporting Standards. This is so a business’ finances can be understood all over the world – a necessity with the increase of global companies and international shareholders.

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When are 1099s due to contractors?

You need to submit a 1099-MISC form to any contractors you’ve paid during the year. A contractor is somebody who isn’t your employee, but who you’ve hired to do work for you. For example a freelance writer, designer or web developer.

The IRS uses 1099 forms to keep track of payments made to contractors. You need to mail or email the 1099 forms to any contractors your business paid before February 1. You’ll also need to send a copy of the 1099 to the IRS by February 28. If you’re unsure whether you need to submit a 1099 or not, check with an accountant or financial advisor.

What is a cash flow statement?

A cash flow statement is a financial report that shows where your money is coming from and where it’s going. It’s also known as a ‘statement of cash flows’ or a ‘CFS’.

At first glance, a cash flow statement looks similar to an income statement. But cash is different to income – cash only includes spendable money. Income includes fixed term assets, long term assets and sales made on credit.

Cash flow statements show whether you’re able to cover short term expenses like bills and staff wages. It is also useful for investors, as it shows how well your business can bring in money.

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How to write a business plan

A business plan should be short and focused. It should evolve with your business and help you identify strengths weaknesses, opportunities and pitfalls. A good business plan will also make it easier for investors to understand your idea.

To write a business plan, start with these five points:

Executive summary
- This is your elevator pitch. Describe your company, your product or service, who will buy your product, and your business goals.
Target audience
- Are you selling to consumers or businesses? Include details about your target audience, such as age, gender, social status, location and profession.
Opportunities and scope
- How will you grow your business? If you plan to sell over the internet, for instance, plan how you’ll attract visitors to your site. If you plan to have a retail store, think about whether you’ll need to hire staff.
Your competition
- Listing your competition shows you’ve done your homework – investors like this. It also helps you understand what other businesses in your market are offering. Include your:
  
  i. Direct competition: companies offering the same product or service as you
  
  ii. Indirect competition: companies who are in the same market as you
  
  iii. USP: your Unique Selling Proposition – what sets you apart from competitors.
Financial Plan
- This shows the costs involved in setting up and operating your business, including:
  
  i. cost to make or buy products
  
  ii. labor, material and manufacturing costs
  
  iii. staff costs
  
  iv. distribution and marketing costs
  
  v. overhead costs – like rent and power if you have an office space or a shop.

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What is retention rate?

‘Retention rate’ refers to the percentage of customers you’ve kept over a period of time. This might be a month, a quarter or a year. Retention rate is the opposite of your customer attrition, or churn rate.

There are three things you need to know to work out your retention rate:

How many customers you have at the start of the period you’re measuring.
How many customers you have at the end of that period.
How many new customers you’ve gained during that period.

To calculate your retention rate, use this equation:

((customers at end of the period - new customers) ÷ customers at start of the period) × 100

As an example, let’s say you have:

500 customers at the start of the month
530 customers at the end of the month
75 new customers gained during the month

((530 customers at end of the month - 75 new customers) ÷ 500 customers at the start of the month) × 100

= (455 ÷ 500) × 100

= 0.91 × 100

=91

In this example, 455 of your original 500 customers, or 91% of them, are still using your product or service. Most businesses aim for a retention rate of 90% or higher.

Retention rate is a good way to measure how satisfied your customers are. This is important because loyal customers create more money for your business. Also, getting new customers costs a lot more than keeping existing ones. It pays to keep an eye on your customer retention rate – happy customers means better business.

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How to start a business

There are no rules for how to start a business. All you need is an idea, a plan and some money to get it off the ground.

Write a business plan
This will help focus your idea. You need to identify target customers, research competitors, and plan how to grow your business.
Decide how to manage your finances
Keeping track of your money is an important part of running a business. Choosing the right accounting software and working with a bookkeeper or accountant is a great way to track your cash flow. It’s also important to open a separate business bank account to avoid mixing up personal and business finances.
Register your business
Depending on your business structure, you may need to register your business. The IRS website has more detail for the requirements of each business entity.
Create your brand and logo
This will help make your business stand out. There are plenty of affordable design agencies online that can help you design something professional.
Build a website
This will help you market and possibly sell your product or service. You can make your own website using resources like Squarespace or Wordpress. You could also hire a professional to build a website from scratch.
Launch your business
It’s natural to feel underprepared – starting a business is a big journey. But doing your homework and using the tools that are right for you is a great way to hit the ground running.

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What is financial management?

Financial management is strategically planning how a business should earn and spend money. This includes decisions about raising capital, borrowing money and budgeting. Financial management also involves setting financial goals and analyzing data.

Financial management starts with recording all the money your business earns and spends. Accountants then prepare reports that help owners understand the financial health of their business. These include profit and loss statements, balance sheets, cash flow statements and budgets.

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What is a bank statement?

A bank statement is a document that shows all the transactions that have happened in your bank account. This includes deposits, withdrawals, interest earned, bank fees paid and the total balance on the day the statement was sent.

Bank statements are usually sent every month, and show the transactions of that month. Some banks mail bank statements to the account holder. But online bank statements are becoming much more popular. You can often view these on your bank’s website or mobile app.

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What is electronic funds transfer?

An electronic funds transfer (EFT) is moving money from one bank account to another electronically.

ATMs, credit cards and online banking are all examples of EFT. Most businesses use EFT to pay their employees because it’s much faster than checks. Businesses can also use EFT to pay suppliers.

EFT transactions have a few advantages over traditional payment methods:

It’s safer than checks – EFT payments are processed by the bank, so they cannot be lost or misplaced.
All transactions are recorded by the financial institution involved, so it’s easy to keep track of your spending.

Related terms:
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How can I calculate my net worth?

Net worth is the monetary value of your business. To calculate your net worth, subtract your total liabilities from your total assets. In other words, net worth is everything you own minus everything you owe.

Total assets - total liabilities = net worth

Net worth is different to working capital. Net worth measures all your assets minus all your liabilities. Working capital only measures your current assets minus your current liabilities.

Fixed assets have low liquidity – difficult to turn to cash. This includes vehicles and property. Current assets have high liquidity – meaning they are easy to turn to cash. This includes accounts receivables and inventory.

Fixed liabilities are long term debts, such as mortgages and long term loans. Current liabilities are short term debts like accounts payable, payroll and unpaid taxes.

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What is bank reconciliation?

There can be times when your financial records might not be the same as your bank’s. Bank reconciliation involves comparing these records and identifying any differences between the two. This is important for keeping track of your business’ money.

There are a few reasons the balance on your records may not be the same as the bank’s:

When someone hasn’t yet cashed a check you’ve sent: The money owed from that check is still in your bank account – but it’s no longer yours to spend.
Changes to bank accounts at the end of a month: This can happen when you withdraw or deposit money just before the bank sends a statement. Those changes to the account might not show until the following month’s statement.
Deposits in transit: Deposits you’ve made and recorded in your books that haven’t yet processed through the bank.
The bank deducts loan payments: The bank can deduct money for loans before you enter that information into your systems.

For example, if you’ve sent someone a check but they haven’t cashed it yet. That money is still in your bank account – but it’s no longer yours to spend.

If you withdraw or deposit money just before the bank sends a statement, those changes to your balance might not show up. This normally happens at the end of the month. If you make a deposit to the bank on October 31, for example, it might not show on the bank’s records until the November bank statement.

Another example is when the bank deducts money for loans before you’ve entered that information into your system.

Bank reconciliation helps you identify these cases so you know exactly how much money is available to your business. It’s also needed to identify any cases of human error, bank charges and possible fraud.

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How to calculate net profit margin

Your net profit margin shows what percentage of your sales is actual profit. This is after factoring in your cost of goods sold, operating costs and taxes. To calculate your net profit margin, divide your net income by your total sales revenue.

Net income ÷ total sales = net profit margin

The result is your net profit margin. You can multiply this number by 100 to get a percentage.

Let’s say your business makes $12,000 in sales, it cost you $8,000 to make your products, and you spent another $2,000 on operating costs (such as overhead and taxes).

Total sales - (cost of goods sold + operating costs) = net income
$12,000 - ($8,000 + $2,000) = $2,000

Net income ÷ sales = net profit margin
$2,000 ÷ $12,000 = 0.1667

0.1667 × 100 = 16.67%

In this example, your business would have a net profit margin of 16%. In other words, 16% of your total sales revenue is profit.

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What is accounts payable?

Accounts payable refers to the bills you need to pay. They’re sometimes called payables or AP.

It might help to think of accounts payable as a bill that your business hasn't paid yet. You might owe a supplier for raw materials, for example. Or you may owe money for an unpaid electrical or phone bill.

Let’s say you buy some materials from a supplier on credit. They’ll send you an invoice for those materials. In your records, the amount on that invoice is part of your accounts payable. In your supplier’s records, that invoice will be part of their accounts receivable. In this way, accounts payable and accounts receivable are two sides of the same transaction.

Accounts payable might also refer to the person or team who processes invoices and pays your bills. A supplier who hasn’t yet received payment for the goods they’ve provided might want to talk to 'accounts payable'.

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How do I make an invoice?

Creating accurate invoices is important if you want to get paid on time. To make an invoice, you need to provide the details about a transaction you’ve made with a customer. This includes:

a description of the product or service you provided
how much the customer owes you
how and when they should pay

The easiest way to make an invoice is to use a good accounting software. Your invoice should include the following items:

1. Business name and logo: This shows your customer that the invoice is from you. If your business is registered for sales tax, you also need to make it clear this is a tax invoice. If not, it’s a regular invoice.

2. Your contact details: A phone number, email address and physical address.

3. Your customer’s contact details: A phone number, email address and physical address.

4. An invoice number: This is important if you send more than one invoice to the same customer.

5. The date: The date the invoice was issued.

6. The details of the transaction: This reminds your customer what they’re paying for. Provide a description of what you provided the customer, and when the transaction happened:

If you provided a service:

the amount of time you worked
the rate you charge
the total price of the job

If you sold a product:

the quantity of products sold
the price of each product
the total price of the transaction

7. The total price: Remember to add any extra fees, such as delivery fees and tax to the total.

8. Invoice payment terms: This is the time period you want your customer to pay within. Anywhere between 7 and 30 days is standard.

9. Preferred payment method: This might be cash, check, direct credit or PayPal.

10. Any late payment fees or early payment discounts.

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What is accounting software?

Accounting software is software that does various accounting and bookkeeping tasks. It stores a business’ financial data, and is often used to perform business transactions.

Most modern accounting software is always connected to the internet. This means you can connect from any internet-capable device, like your laptop or smartphone. This online space where you can access your data is called the cloud. Online accounting software automatically receives and updates because it’s always connected to the internet.

Different kinds of accounting software do different things. Most of them automatically enter, store and analyze data for you. This is especially useful for saving time on tasks like bank reconciliation. Accounting software also offers useful tools like invoicing, bill payment, payroll, and financial reporting.

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What is working capital?

Working capital is the amount of cash your business has after factoring in your short term debts. Your working capital is your current assets less your current liabilities.

Your current assets
include:

cash (and cash
equivalent items)
accounts receivable
prepaid expenses
inventory

Your current liabilities
include:

accounts payable
payroll
loans and debts
unpaid taxes

Let’s say you have $5,000 of current assets and $4,000 of current liabilities. This means you have a working capital of $1,000.

Current assets - current liabilities = working capital

$5,000 current assets - $4,000 current liabilities = $1,000 working capital

Working capital is a good way to judge the financial health of your business. This is useful because:

it helps you see how well your business is performing
it tells investors if your business is a good place for their money

If your working capital is low, your business might struggle to grow. But your working capital can also be too high – which is a sign you’re not properly reinvesting your cash. Keep in mind how soon you can turn your assets into cash. Even businesses with large amounts of working capital might have poor cash flow if they struggle to convert assets to cash.

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How long to keep payroll records?

In the US you’re required to keep payroll records for three years. This is to make sure your employees’ rights are protected. The IRS can audit your payroll records. If there are any problems with your employees’ details or pay – you may be subject to penalties.

Employee payroll records include PAYG payslips, payment summaries, tax reports and all payment details. This includes hours worked and wages earned. These documents must all be legible and in English.

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What are pay stubs?

A pay stub is a document that’s given to an employee with each paycheck. It shows their total wages earned for a set period. This might be from a salary, hourly wages or commission.

Pay stubs also lists any tax withheld and personal deductions made. This include insurance and pension contributions. Pay stubs are also known as ‘pay slips’, ‘paycheck stubs’, or ‘pay advice’.

Traditionally the pay stub was a paper document attached to a physical check. Today, most employers prefer to use electronic pay stubs.

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What is inventory management?

Inventory management is the process of managing the goods your business plans to sell. This involves acquiring, storing, organizing and tracking those goods.

Inventory management also involves keeping records of changes in your inventory over time. This helps you keep the right amount of each product or item in stock to keep up with customer demand.

Sales forecasting is another big part of inventory management. If your inventory gets too low, you might not be able to keep up with your customers’ demands. But if your inventory is too high it will tie up your money and increase storage costs. You’ll also have to pay higher taxes because of the large value of your inventory.

It’s often useful to have safety stock, also known as buffer stock. This means keeping slightly more goods than you expect you’ll need. This is useful if demand is unusually high or if you need to exchange a faulty or damaged product.

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What is a financial statement?

A financial statement is a report that shows the financial information of a business. There are four main types of financial statement:

Balance sheet: a snapshot of your business’ financial condition at a single point in time, such as 12/31/2016. Shows your business assets, liabilities and owner's’ equity at that time.
Profit and loss statement: also called an income statement. Shows your business’ revenues, costs and expenses over a period of time, such as 1/1/2016 to 12/31/2016.
Cash flow statement: also called a statement of cash flows. Shows changes to the cash coming into and going out of your business over a period of time. Only records cash (not all income). Shows whether you can cover short term expenses like bills and payroll.
Statement of changes in equity: also called a statement of retained earnings. Shows changes in the equity of your business for a set time period. In other words, changes in how much money your business keeps (rather than pays out to shareholders).

Combined, these statements provide a good view of the financial health of your business.

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What is gross profit?

Gross profit is the amount of money your business makes from sales after deducting the cost of making and selling your product. This amount is before you pay operating costs, payroll, tax and overhead.

Gross profit reflects how profitable a product is. The less it costs to make, and the higher you can sell it for, the larger your gross profit will be. Gross profit is also known gross income, and appears on the income statement.

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What is accounts receivable?

Accounts receivable are invoices owed to you by customers. They’re sometimes called receivables, trade debtors, or AR. It might help to think of accounts receivable as a sales invoice that your customer hasn't paid yet.

Let’s say you sell your product to a customer on credit and send them an invoice for the sale. The amount your customer owes you from that invoice is part of your accounts receivable. In your customer's records, that invoice will be part of their accounts payable. In this way, accounts payable and accounts receivable are two sides of the same transaction.

Accounts receivable might also refer to a person or team in charge of receiving or chasing up payments owed to your business. Your 'accounts receivable' might want to talk to a customer who is overdue on their payment to you.

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What is sole proprietorship?

Sole proprietorship is a type of business with only one owner. The owner has complete authority over every aspect of the business.

A sole proprietorship is not a separate legal entity – it’s considered an extension of the owner. But you can operate under a trade name, like “Bob Smith Plumbing.”

Sole proprietorships are easy to set up. Because the business uses your individual tax code, you don’t need to register as a business. But depending on your field you may need a license – such as a food and liquor license, or an admission to practice law.

Sole proprietorship taxes are easy, because all income the business earns is treated as personal income. But this also means the owner is accountable if the business runs into financial trouble, like debt or bankruptcy. The owner’s personal assets can also be at risk if a claim is made against the business – for faulty workmanship or malpractice, for instance.

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What is a commercial invoice?

A commercial invoice is a document used in international shipping. It gives information about the product being sent, including:

what the item is
the seller and buyer
the date and terms of the sale
the quantity and weight
the value of each individual item
the total value of the package
any insurance and shipping costs

Customs officials use commercial invoices to work out the value of the goods being traded. This is so they can work out tariffs, which are taxes imposed on imported goods.

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What is self-employment tax?

Self-employment tax is the tax you pay if you’re self-employed. This is when a self employed individual pays Federal Insurance Contributions Act (FICA) tax, which includes Social Security and Medicare, by themselves.

The cost of this FICA tax is normally split between employer and employee. Because self-employed workers don’t have their taxes withheld by an employer, they have to pay both the employer and employee shares of the FICA tax. This is called self-employment tax.

What are fixed assets?

Fixed assets are any assets that cannot be easily converted to cash. They are typically tangible, physical things that have an economic life of longer than a year. These include buildings, vehicles, furniture and office equipment. Fixed assets normally don’t include intangible things like royalties and brand names.

Fixed assets are also known as non-current and long-term assets. They may also be referred to as property, plant and equipment. They are assets intended to be used within the business, not sold or converted to cash.

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How do I write a check?

To write a check, you’ll need to fill out the necessary spaces on a blank check.

Date of payment: when payment is being made – written as month/day/year.
Payee: who you’re making the payment to. This can be a person or a company.
Amount being paid (numbers): In the blank space next to the dollar sign, write the amount being paid. If there are no cents you put two zeros. For instance one hundred and twenty three dollars would be written as 123.00.
Amount being paid (words): space before “dollars,” write the amount being paid again, this time in words.
Description of payment: for example “electricity bill.” This is optional, but it helps the payee remember what the payment is for. It also helps with bank reconciliation.
Signature: signing the check confirms the payment is under your name. Keep in mind you must use the same signature you used when you opened your bank account. You may also need a signature from the business if it's from a general business account.

Related Xero feature:
Accounts payable software that keeps you up to date

Related Small Business Guide:
How to create a small business budget

Accounting Terms

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Accounting Terms