Accounting and financial concepts may be as alien to you as a foreign language. Still, the ability to understand and communicate financial information is critical to every entrepreneur. To succeed at business, you need to learn the language of business, which will enable you to understand the financial reports and information generated from your business and to communicate this information to others.
The Accounting System
Financial transactions occur every day in business. Each time a bill is paid or a sale is made, a financial transaction takes place. These financial transactions can't be interpreted unless they are arranged into a useful format. The transactions must be recorded in a way that easily provides the information an entrepreneur needs to make good financial decisions. The accounting system provides this organization. The accounting system takes business transactions and categorizes them into accounts, such as Utility Expense, Consulting Revenue, and Bank Loans. Accounts are grouped into categories and then arranged into several reports, mainly the Income Statement, Balance Sheet, and Cash Flow Report or Cash Flow Statement.
When beginning to learn a new language, it is always helpful to learn a few basic rules-pronunciation, grammar, and syntax, for example. This information provides a basis of understanding about language. Accounting systems arebuil on rules as well. You need to understand the two basic methods of accounting that businesses use, since specificrules are associated with each. They are the accrual basis andcash basis methods of accounting.Based on the accounting method you choose, your financial reports will communicatea different message.
Accrual Basis Accounting- Most businesses use the accrual basis accounting method, which reports income at the time it is earned and expenses when they are incurred, without regard to when thecash changes hands. This method presents a very accurate financial position.For example, if insurance is paid every six months, it is recorded as a prepaid asseton the Balance Sheet at the time it is paid. Each month, a portion of the insurance will be recorded on the Income Statement to represent the portion of insurance associated with that specific month.
Cash Basis Accounting- Some businesses use the cash basis accounting method, which records revenue when cash is received and expenses when bills are paid. This method is very simple to use, but doesn't provide the most accurate financial picture, because income may not be appropriately matched with related expenses. Looking at the insurance example, every six months a payment to the insurance company is reported in the month it ispaid, but it represents half the yearly insurance due. This allocation may be true from a cash perspective, but does not show an accurate account of expenses as they relate to monthly revenue.
Reporting Cash vs. Profits- Although the Income Statement reports the profitability of the business, Net Income doesn't always indicate positive cash flows for the following reasons:
- When using the accrual basis accounting method, the Income Statement reflects income earned and expenses incurred, without regard to whether the cash changed hands.
- Non-cash expenses such as depreciation and amortization are included in the Income Statement.
- Cash outflows for debt repayments, purchases of inventory, and payments to the owners of the business (dividends or draws) and cash inflows from borrowings from banks and other lenders do not show up on your Income Statement.
These discrepancies between what is shown on the Income Statement and what is actually flowing into and out of your business make it critical for you to understand all three financial statements-Income Statement, Balance Sheet, and Cash Flow Report.
For more information about financial statements, see the following FastTrac articles:
- Sample Income Statement
- Sample Balance Sheet
- Sample Cash Flow Report
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