Starting Your Small Business - Part 2 - Accounting Basics
The business world often refers to accounting as the ‘language of business’, accounting is the language your business uses to communicate its health to you. You then use accounting to communicate about your business with lenders, investors, advisors and the government. So as you can see, accounting is a very vital aspect to any company. Most business owners have an accounts department and/or a CPA or CA, they are very rarely involved in the Accounting process or do they have knowledge of Accounting. It is recommended that business owners should know the basics of accounting for the following reasons;
- · An accounting literate owner is better able to converse with the professionals whose jobs it is to assure the integrity of the books. Saving time and money.
- · A financially literate owner is also more likely to be in control of the business
- · Being able to understand accounting procedures and programs means owners can spot problems earlier. (e.g. late payments, black ink turning into red and the possibility of fraud)
- · Use financial information to make decisions that increase income, decrease expenses and allow you to know where the money is going.
Not only is accounting important for maintaining/ running a business, if you are interested in starting a business of your very own it can be very beneficial to understand the rules of accounting.
Accounting is a vast subject; at universities it is a three year degree to become a first level accountant. It is then further years of study to become a CPA. So how do you fit years of accountant practices into one article? You don’t, you focus on the basics of accounting. The basics are all business owners really need to know, the first is some basic accounting terms.
Having knowledge of the regular terms used in accounting can really benefit when engaging in conversation about your business with either your CPA or future investors. Below are some of the most regular terms used and their definitions-
- - Fixed Costs - these are costs which do not change when your business fluctuated, they are a fixed price expense. Example: rent, salaries (excluding performance or volume based salaries) and interest.
- - Variable Costs - these are costs that do change with your business, especially when your business changes in volume. Example: labour, overhead and materials.
- - Cash Method - an accounting method where expenses are recorded when you actually pay the bill or when the revenue is paid.
- Accrual Method - this is where expenses and revenues are recorded at the time of the actual transaction. (Accounts payable and accounts receivable are included in this method)i.e. an invoice (either payable or receivable) which is issued or received in May must be declared in May even if it isn’t due for payment until July.
- - Account Payable - these are the amounts that are owed to vendors and suppliers for anything that the business has purchased or received from a supplier.
- - Accounts Receivable - these are the amounts that are owed to the business by the customers or clients.
- - Write-down- it is when a reduction is made to the valuation of an asset, the asset has only lost a percentage of their worth not all.
- - Write-off- this is where the reduction in valuation is complete. The asset has lost all its value and worth.
The ‘balance sheet’ is compiled of the records of assets, liabilities and equity. The relationship to each other is represented below in the accounting equation.
The reason why the balance sheet is important is because it represents the true value of the business including expenses, revenue, assets and liabilities. If your assets outweigh your liabilities then your equity will be a decent sum, this shows a healthy business. But if your liabilities outweigh your assets then your equity could venture into the red, this means your business is unhealthy.
Assets = Liabilities + Equity
Accounting is a system of organizing, recording and analysing. Keeping the equation balanced ensures that each transaction has been accounted for.
To understand the equation you can relate Assets to being the ‘Resources’ and Liabilities and Equity to being ‘Claims on the resources’.
- - Assets (Resources) include vehicles, cash, supplies, equipment and accounts receivable.
- - Liabilities (claims on the resources) include loans payable, interest payable, accounts payable and wages payable.
- - Equity (claims on the resources) is known as the ‘book value’ of a company. Accounts that could be seen within Equity are common stock, retained earnings and current year’s net income. Equity is also the sum of Assets – Liabilities.
Double Entry Bookkeeping
Double entry bookkeeping can be confusing to most business owners, but it is an efficient way to present your accounts, in this method every transaction has a ‘credit’ and ‘debit’ entry. Debit ( ‘+’ )and credit (‘-‘)entry . Assets will normally have a debit balance and Liabilities and equity will normally have a credit, for example if you want to increase the value of an asset you would ‘debit’ the asset account. Another would be if you want to increase the value of a liability or equity account you would ‘credit’ the account.
The ‘income statement’ is a financial statement that measures a company’s financial performance over an accounting period. This performance is assessed by producing a summary of how the business incurs the revenues and expenses. This is through both operating and non-operating activities. It also shows the net profit or loss incurred over a period of time; this is usually the span of a fiscal year. And what is generally included in an income statement whether it’s a ‘Multi-step’ format or ‘Single-set’ Format is listed below.
- - Net sales - gross sales reduced by customer discounts, returns, freight out, and allowance
- - Gross profit - the net sales minus the cost of goods and services sold
- - Selling, general and administrative expenses - Expenses such as sales people’ssalaries and commissions, advertising and promotion, travel and entertainment, office payroll and expenses, and executives' salaries
- - Operating income - In accounting and finance, earnings before interest and taxes, is a measure of a firm's profit that excludes interest and income tax expenses. It is the difference between operating revenues and operating expenses.
- - Interest expense – interest paid on loans.
- - Pre-tax income - The income earned by a business prior to the provision for federal or state income taxes.
- - Income tax - tax levied directly on personal income.
- - Extraordinary expenses - Not the usual or ordinary costs or expenses, sometimes defined in marital settlement agreements as any expense in excess of a certain dollar amount.
- - Net income - the excess of revenues over outlays in a given period of time (including depreciation and other non-cash expenses).
Statement of Cash flow
A cash flow statement shows the changes in the balance sheet accounts and how the income affects the cash and cash equivalents. Overall the cash flow statement is concerned with the flow of cash both in and out of the business. Used as an analytical tool it can give insight into the short term viability of the company. The statement of cash flow is broken down into operating, investing and financial activities.
- - Operating Activities - examples of what could be included are the purchase of raw materials, building inventory, advertising and shipping products.
- - Investment Activities- Examples of Investing activities are; purchase or sale of an asset (assets can be land, building, equipment, marketable securities, etc.), loans made to suppliers or received from customers and payments related to mergers and acquisition.
- - Financing Activities- this activity includes the inflow of cash from investors such as banks and shareholders, as well as the outflow of cash to shareholders as dividends as the company generates income.
If someone is knowledgeable with the basics of accounting they will reap the benefits. They will be able to easily converse with their accounts department or investors, be able to analyse their business and have an understanding of its health and they will also be able to use that knowledge to make educated decisions regarding their business. Accounting is the language of any business; and it’s time to speak it. Good Luck.