You didn’t get into business to be an accountant, so why do you need to know basic accounting concepts? Many business owners rely exclusively on their bookkeeper or accountant to tell them what they need to know about their financial statements, and most bookkeepers and accountants love discussing a business’ numbers.
However, by knowing these three basic accounting concepts, you can understand what your business is telling you between meetings with your financial advisers.
This, in turn, makes it so you can have more meaningful conversations when you do meet with them. And this knowledge will lead to wise decisions about your business.
Basic Accounting Concept #1: Profit and Cash
First of all, “profit” appears in three different places on your profit and loss statement. Start off with gross profit, which is calculated by the following equation:
Sales – Cost of Good Sold = Gross Profit
Then you have operating profit, which is your profit after paying your operating expenses. This is calculated as follows:
Gross Profit – Operating Expenses = Operating Profit
Finally, you have net profit. This is the “bottom line” on the profit and loss statement. Net profit is calculated using the following equation:
Total Income – Total Expenses = Net Profit
Most of the time, when a business owner—or an accountant, for that matter—refers to profit, they are referring to net profit.
While the concept of profit seems pretty simple, many business owners find themselves scratching their heads over their net profit. Why is this? Well, it’s because net profit very rarely represents the business’ cash on hand. A number of business activities involve the movement of cash but do not appear on the profit and loss statement.
Your profit and loss statement gives you vital information about your business’ income and expenses, and your balance sheet shows you what you own (assets and equity) and what you owe (liabilities).
The third core financial statement—the statement of cash flows—ties the activity on the profit and loss statement and the balance sheet together, to give you a summary of your cash position. For this reason, you should examine your statement of cash flows along with your profit and loss statement to determine the cash position of your business (and how you got there).
Basic Accounting Concept #2: Accrual Basis vs. Cash Basis
I’ll spare you the bad joke about it being an accrual world, but accrual basis financial statements do give you a much better understanding of your business’ financial position than cash basis statements.
What’s the difference between accrual basis and cash basis financial statements? And why do most business owners review their cash basis statements rather than their accrual basis statements?
Accrual basis financial statements match income and expenses to the periods in which they are incurred. Cash basis statements, on the other hand, only reflect income and expenses when they are received or paid.
What does this mean?
Let’s say you invoice a customer for services rendered on March 15, and you give the customer 30 days to pay the invoice. If the customer is a good customer, the check will arrive on April 15, or maybe a few days earlier. On your accrual basis financial statements, the income will appear in March, as an increase in sales and a corresponding increase in accounts receivable. On your cash basis financial statements, the income won’t appear until April.
Similarly, let’s say you had to pay a subcontractor to fulfill the services for which you invoiced the customer. The subcontractor billed you on March 31 for services rendered that month, and they gave you 45 days to pay the invoice. This means you will pay them on May 15. On your accrual basis financial statements, the expense will appear in March—the same month as you invoiced your customer. On your cash basis financial statements, the expense won’t appear until May.
Another example of accrual vs. cash basis can be seen in the case of missed bill payments. Maybe you overlooked your phone bill in June, and so July’s bill includes phone service for two months instead of just one. Your accrual basis statements will show a phone expense in both June and July, even though you only paid the bill once, in July. Your cash basis statements will only show one very large phone expense in July.
The ability to match income and expenses to the period in which they are incurred can help you more accurately identify expenses and trends in your business. This is why accrual basis financial statements are superior to cash basis financial statements for business management purposes.
So, why do most business owners review their cash basis financial statements rather than their accrual basis statements? There are three main reasons:
- Most small businesses file their tax returns on cash basis. For this reason, some accountants encourage their clients to review cash basis financial statements in order to keep an eye on their expected tax liability for the year.
- While a cash basis profit and loss statement does not reflect all inflows and outflows of cash in a period, it comes closer to showing cash flow than an accrual basis profit and loss statement. Since many business owners don’t understand how to read their statement of cash flows, they choose to review their cash basis profit and loss instead.
- Many businesses do not fully utilize their accounting software. Maybe the business has a billing system outside of its accounting system, or maybe the business owner still keeps a manual checkbook and check register. If invoices and bills are not entered into the accounting software, it is impossible to produce accurate accrual basis financial statements, which reflect accounts payable and accounts receivable.
Basic Accounting Concept #3: Recognizing the Purchase of Assets
When you make a large purchase for your business—be it a computer, a vehicle, or a building—the purchase appears on the business’ balance sheet, not on the profit and loss statement. Even if you pay the entire purchase price upon acquisition instead of financing the purchase, you cannot usually recognize the full expense in the period in which the purchase is made (some exceptions exist for tax purposes).
Instead of recognizing the expense when the asset is purchased, the expense is recognized over a period of time in the form of depreciation of the asset.
You can look at asset acquisition and depreciation like eating a pie: Though you make a pie on Sunday morning, you (probably) won’t eat the entire pie for Sunday dinner. Instead, you will consume a slice of the pie on Sunday and another slice each of the next five days, until the pie is gone. The enjoyment of the pie is stretched out over a period of time. Such is the case with an asset and the depreciation of the asset.
The depreciation expense appears on the profit and loss statement, and the accumulated depreciation appears on the balance sheet as a negative asset amount. The original cost of the asset, minus the accumulated depreciation, gives you the book value of the asset.
While the book value does not necessarily indicate how much someone might pay you for that asset, if you decide to sell it, it does tell you how much value that asset still has to your business, in financial terms.
You don’t need advanced accounting knowledge to effectively run your business. However, equipping yourself with an understanding of these three basic accounting concepts can help you review your financial statements with greater confidence. The additional value you will get from your conversations with your financial advisers will make the effort to understand these concepts well worth your while, too.
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