Here are some basic principles that every business owner should know about accounting.
1. Financial vs. Managerial:
Accounting has two main disciplines: managerial is the one you use internally for keeping track of things and financial is the one you present externally to investors, banks and the government. For instance, in your managerial accounting you will enter the day-to-day expenses and sales, while your financial accounting will be a summary of all those transactions.
2. Double Entry Book-Keeping:
Every transaction must be entered in two accounts and these must eventually balance. This ensures that you are on the right track. Although accounting is as old as human civilization, double entry book-keeping was invented only in the 14th century. Fundamentally, all an accountant does is balance the books, making sure all the transactions are entered in two accounts and they all eventually balance.
3. Assets and Liabilities:
These are the foundations of accounting. Assets include everything you own—your home, car, factory, equipment—these are all your assets. Liabilities include everything you owe—this includes all your loans. A lot of transactions involve increasing both. For instance, when you buy a home with a loan, you increase both your assets and liabilities.
The gap between assets and liabilities is your fundamental worth or your equity. For instance, if you own a car worth $10,000 and your auto loan balance is only $3,000, your equity in the car is $10,000: $3,000 = $7,000. If your overall equity is less than zero, that means you are operating at a deficit.
Equity = Assets – Liabilities
5. Credit vs. Debit:
This is the ying & yang of the accounting system. A credit is an entry that increases your liabilities and a debit is an entry that increases your assets. Debit in general means adding a positive number to an account and credit in general means adding a negative number. Credit is traditionally written on the right side of a ledger, and debit is usually written on the left side of a ledger.
A ledger is a principal book, where you enter the money transactions in a particular format. Companies typically keep three types of ledgers: general ledger: for keeping track of all expenses, income, assets, liabilities and equity; sales ledger: for keeping track of customers who have purchases, but not yet paid for their goods and; purchase ledger: for keeping track of all purchases that have been made, but have not been paid yet.
From the ledger, we create financial statements that summarize a company’s overall position. International standards mandate companies to keep four main types of financial statements.
7. Balance Sheet:
This is the snapshot of a business. It states how much assets there are in various categories (bank accounts, buildings, equipment, and the amount you need to receive from your customers), how much liabilities there are in various categories (short term loans, long term loans, amount you need to pay your suppliers, etc.), and the overall ownership equity (how many shares of the company are held and how much money was received from the owners).
8. Income Statement:
This records the income and expenses in various categories. Profits are written in the bottom line, hence the common expression “bottom line” that refers to the final results, while topline is used to show the overall sales that a company makes.
9. Cash Flow Statement:
If you have run a business, you know that cash is king and it is very important to understand how a business manages its cash. For instance, if you have made sales of $10 million, but none of your customers have paid yet, you can no longer afford to be happy that you have made $10 million in sales. The cash flow statement records how a company got and spent its cash. The cash flow statement shows whether the company is growing its cash and how it is spending the cash (new equipment, repaying loans, paying more wages, etc.).
Accounting, contrary to popular perception, is not an exact science, but involves a lot of judgment. For instance, if three of your customers have not paid in six months, you must decide if you have to keep them in the account receivables or write it off. Also, you are required to understand tax policies, how inventories are increasing or decreasing in prices and what is the lifetime of the assets you are own.
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