The core functions of accounting are bookkeeping and financial reporting to managers and investors. However, the accounting department of a business is usually also responsible for payroll, cash inflows, cash payments, purchases and inventory, and property accounting. If these functions are not done efficiently and on time the business will not survive.
Many of these functions, and much of accounting, focus on business transactions. These are economic exchanges between the business and persons or other businesses that the business deals. Accounting means understanding how these transactions are accounted for. Most businesses carry on economic exchanges with six basic groups:
1) customers, who buy products and services,
2) employees, who are paid wages and salaries and are provided benefits for working for the business,
3) suppliers and vendors, who sell to the business,
4) debt sources of capital, who loan money to the business,
5) equity sources of capital, who invest in the business expecting a profit on the capital invested, and
6) the government, who collects various taxes.
There are also other events that have economic impact on the business that must be recorded, such as lawsuits, uninsured flood or other loss, severance pay to laid-off employees, and other non-planned circumstances and events.
The first core function of accounting is too keep track of and record all the above economic exchanges, while the second is to report it. Accountants prepare financial statements for businesses to report to managers and investors. The three most basic financial statements are the statement of financial condition or balance sheet, the income statement and the cash flow statement. Everyone in business should understand and know how to read these three statements.
The Balance Sheet
The balance sheet, or statement of financial condition, summarizes the assets owned by a business on one side and the sources of its assets on the other. Sources of assets are divided into two basic categories: liabilities and owners’ equity. Some assets come from borrowing money or buying on credit that has not been paid yet. These are liabilities. The remaining assets come from owners’ equity which consists of the money invested in the business by the owners and the profit the business has earned and retained. It is important to remember that the balance sheet is like a snapshot and only shows how much the business is worth on the day the balance sheet is drawn up.
You generally see balance sheets like this:
Basic Balance Sheet
List of Assets List of Liabilities
Total Assets = Total Liabilities + Owners’ Equity
Sometimes you will also see owners’ equity referred to as net worth. This is computed as Assets – Liabilities = Net Worth. While this may imply that the business is worth the amount recorded in the owners’ equity accounts, it does not necessarily mean the business could be sold for this amount. Much more needs to be addressed when determining the selling price of a business. Nevertheless, the balance sheet is an important report that indicates how much you have and how much you owe at a certain point in time.
The Income Statement
The Income Statement, or profit and loss statement, measures income and expenses. It summarizes the profit-making activities of the business over a period of time. One section of the report lists all income: earned, passive or portfolio. The other section of the report lists all expenses. It often looks like this:
Basic Income Statement
= Net Income
Preparing income statements on a regular basis assist in measuring financial progress. Most managers and investors pay more attention to the income statements and you will often see abbreviated versions in the financial pages reporting the top line of sales revenue and the bottom line of net income.
The Cash Flow Statement
Cash flow refers to the stream of cash coming in as income and going out as expenses. The cash flow statement summarizes the sources and uses of cash in the business during a financial period. A successful business must manage both profit and cash flow, they do not equal each other. Cash flow statements often look like this:
Basic Cash Flow Statement
Part 1. Operating Activities. Cash flow from the profit making transactions of the business
Part 2. Investing Activities. Cash inflow and outflow from investing activities.
Part 3. Financing Activities. Cash inflow and outflow from the financing activities.
Summing the three types of cash flows from above determines the bottom-line net increase or decrease in cash during the period. Net cash flow from part one, operating activities, will not always match the profit reported in the income statement. This is because actual cash flow and expenses from sales are on a different time table that when sales revenue and expenses are recorded on the books. Profit performance of a business gets the most attention, but it is also important to understand and know the cash flow from profit and that is found in this important statement.
You do not need an MBA, nor do you need to be a CPA, to run a business. However, understanding basic accounting will assist you with the financial aspects of your business, investments, taxes, and financial management. You will be at a disadvantage if you do not understand accounting basics. If the accounting functions and three basic accounting statements covered in this section are new to you, it is imperative you seek out resources to learn more on this subject. If you already have a basic understanding of accounting principles and statements, make sure you are keeping on top of them in both your business and personal life.