Basic Accounting Principles
What business topic can induce deep sleep faster than a cocktail of warm milk and Ambien? If you said “Accounting-ssssssnnnnnk-zzzzzzzz” and then dozed off, you nailed it.
By now, your lids may be drooping and you’re fighting back a yawn, so it’s time to get up, pour yourself some strong coffee and clear your head enough to wrap it around this simple truth:
You can’t afford to be bored by accounting. Not if you hope to stay in business.
It's All About the Numbers
It’s not enough that you’re good at your profession or trade or craft. Like it or not, if you want your business to succeed, you need to have – or develop – a head for numbers and financial reports.
Accounting is more than just a way to keep track of business transactions. It’s your most important managerial tool. It’s the compass that points out the right course, the scorecard that tells whether you’re ahead or behind. Accounting helps you:
- Price your products or services accurately
- Know if you’re making or losing money
- Monitor your cash flow
- Work with bankers and investors
- File accurate tax reports
Some Basic Principles
Accounting is the process of collecting, organizing, maintaining, reporting and interpreting financial data about your business. That financial information is essential for owners and managers to operate the business profitably and to make important decisions like how to set prices, cut costs, use business resources, or structure transactions for the lowest tax liability, for instance.
It’s important to outsiders, too. Investors, bankers and creditors all require a picture of the business’ financial position and performance before deciding whether to invest, lend money or grant credit.
The information collection, organization and maintenance parts of accounting are called bookkeeping. The reporting and interpreting parts are called statement preparation.
The complexity and sophistication of bookkeeping and statement preparation depend on the size and nature of a business (and its markets) and could never be addressed here in any meaningful way.
So, at the very least you should know that there are some generally accepted accounting principles. In many cases you can choose the principles your business will use as long as they’re consistently applied and any changes are disclosed to those who rely on the business’ financial statements. Certain industries have specialized accounting principles.
Also, there are too many accounting concepts and types of financial statements to cover here. So we’ll focus on the three key financial statements that everyone in business should understand:
- The balance sheet
- The income statement
- The cash flow statement
The Balance Sheet
The balance sheet is a summary of a company’s assets (what it owns, like buildings, equipment, inventory and cash); liabilities (what it owes to banks or creditors); and equity (the money invested by owners or shareholders).
Why is it called a balance sheet? Think of the report as a teeter-totter. With assets on one side and liabilities and equity on the other, the report balances. Assets = liabilities + equity.
The balance sheet paints a picture of the company’s financial position – or net worth – at a certain point in time. Subtract the liabilities from the assets and you get the net worth.
The Income Statement
Also called a profit-and-loss or P&L statement, the income statement measures a company’s financial performance. It sets out revenues and expenses and shows net profit or loss over a set period of time.
The statement is divided into “Operating” and “Non-Operating” sections. The “Operating” section includes revenue and expenses that result from normal business operations like the sale of products or services. This section tells you a great deal about how a company’s doing.
The Non-Operating section highlights revenue and expenses that come from other sources, the sale of company assets, for instance.
The Cash Flow Statement
As the name implies, this statement shows how cash moves in and out of your business. Say you sell $10,000 worth of clown costumes to a circus. On paper you account for that sale as revenue. It may show up on your income statement, but it’s not cash until the circus finally pays the bill – which won’t be for another 90 days. Meanwhile you’ve got suppliers and employees and other business expenses to pay.
Managing cash flow is crucial to survival. Profitable companies large and small end up in bankruptcy all the time because they become cash-strapped.
Getting Professional Help
Some people who start their own businesses need the advice of an accountant from the get-go. No shame in that. If you need help, admit it. Then get it. Others are perfectly capable of handling things with some off-the-shelf business software. But even they would do well to have an accountant help set the system up.
In selecting an accountant, choose someone experienced in small business organization and processes, pricing and marketing, and tax and managerial issues. It’s also good to have some idea what you most want and need from an accountant.
Do you just need help setting up your system? Will you want someone to review your statements for lenders or at tax time? Do you want someone to handle more of the detail work, like compiling the financials, preparing the statements or conducting audits? An initial consultation with an accountant can help you answer those questions and more.
Consultants at our Small Business Assistance Office can help you understand more about accounting. And our network of Small Business Development Centers has experts located in nine main regional offices and several satellite centers statewide.
Our Guide to Starting a Business in Minnesota provides a detailed look at this and other important issues.
Watch this 30-minute Introduction to Accounting tutorial from the U.S. Small Business Administration.