In order to run a successful business, you need to know:
- Where money is coming from;
- Where money is going;
- What the business owns; and
- What the business owes.
Without this information, it is impossible to determine:
- How well your business is performing; and
- Where improvements can be made.
Further, you will experience difficulty:
- Preparing taxes; and
- Obtaining financing.
Accounting helps you run a successful business.
In this video, we explain:
- What is accounting;
- Why accounting is needed;
- What can happen if accounting is not performed;
- The basic concepts of accounting;
- How you can get started with accounting; and
- How accounting can help your business grow.
Let us begin with:
What is accounting?
Accounting is the process of recording and gaining insight from the financial transactions of a business.
Accounting is often called the language of business because it is how business financial data is communicated.
In the United States, many businesses adopt what are known as Generally Accepted Accounting Principles, or GAAP. For publicly traded companies, use of GAAP is mandated by the Securities and Exchange Commission, or SEC.
In addition to accounting, you might also have heard of bookkeeping.
Bookkeeping is part of accounting. But, there is much more to accounting than just bookkeeping.
Bookkeeping concerns the making of entries in accounting journals and ledgers, which we talk about later in this video. Accounting includes the process of transforming these journal and ledger entries into useful financial statements, which we also talk about later in this video.
Why is accounting needed?
All businesses need to perform accounting, no matter if they are:
- A business that sells goods;
- A business that provides services; or
- A business that sells both goods and provides services.
Business owners and management use accounting to, among other things:
- Keep track of inventory;
- Manage employee payroll;
- Make sure vendors are paid on time;
- Help prepare customer invoices;
- Evaluate business cash flows;
- Generate reports for investors and creditors; and
- Prepare taxes!
Proper completion of these tasks is critical to the success of a business. So:
What can happen if accounting is not being performed?
Businesses that do not perform accounting or that perform it poorly face many negative consequences.
First, you cannot know whether the business is operating at a net profit or at a net loss.
Businesses realize a net profit if the amount that is brought in, known as revenue, is greater than the expenses of the business.
Conversely, businesses realize a net loss if the expenses of the business are greater than the revenue.
Without accounting, businesses cannot know precisely if revenues are exceeding expenses. Business losses tend to happen slowly over time, and for that reason can be difficult to identify.
Second, without accounting, you cannot know what the business owns and what is owed to the business.
In other words, you do not know your business assets. Assets include:
- Bank accounts;
- Equipment; and
- Goodwill, such as reputation or name of the business.
Part of the assets of a business are accounts receivable. Accounts receivable include invoices that need to be paid by customers. Without accounting, you do not know if the invoices have been paid, or if the customer has even been sent an invoice to collect.
It is important to know and be able to communicate what your business owns.
For example, when you write a check, how do you know if there are enough funds in the bank account for the check to clear?
And also, if a potential investor or partner comes along, how will you be able to show them what they are getting in return for their investment?
Third, without accounting, you cannot know how much debt, or liabilities, the business has.
If a business is not performing accounting, the business can easily fail to make timely debt payments. Failing to make timely debt payments can result in:
- Loss of vendors;
- Delinquent taxes;
- Fines and penalties;
- Bank account garnishments; and
- Difficulty obtaining credit in the future.
Also, when a business is not aware of the amount of debt it has, it can be difficult for the business to earn a profit.
Now that you know why accounting is needed; and what can happen if accounting is not being performed; let us start understanding:
The basic concepts of accounting
To perform proper accounting, every transaction must be accurately recorded. For the purposes of accounting, a transaction is any event that has a financial impact on the business.
Examples of transactions include:
- Bank account deposits and withdrawals;
- Payments collected on customer invoices;
- Purchases of goods from vendors; and
- Payments of rent.
Each of these events has a financial impact on the business since they each increase or decrease the amount of money available to the business. Accordingly, each of these events is a transaction.
All business transactions are recorded by making an entry in a journal. In the past, entries were handwritten in a paper journal. Modernly, however, journals are maintained in electronic form with accounting software.
We explain later in this video how software can be used to simplify accounting. But, it is important to understand what the software is doing behind the scenes.
Whether the journal is maintained in paper form or in electronic form, two account entries are always made: one called a debit; and the other called a credit. This is known as double-entry bookkeeping. Double-entry bookkeeping helps to prevent errors from being introduced into the journal.
Every time a debit entry is made in the journal, an opposite credit entry is also made.
Here are a couple of simple examples to illustrate how double-entry bookkeeping works:
Bob is in the business of selling widgets.
Bob pays for his widget inventory using cash.
When Bob uses cash to purchase widgets for his inventory, he makes a debit entry in his accounting journal to reflect the increase in inventory.
At the same time, he makes a credit entry in the journal to reflect the payment, or decrease in cash.
Bob is also paid cash to repair widgets.
When Bob is paid to repair a widget, he makes a debit entry to cash in his accounting journal. This entry reflects the increase in cash, due to the cash payment Bob received.
The second, opposite journal entry is a credit to revenue, to reflect the money earned for the repair.
Since the journal is used to record all transactions, it can be difficult to locate transactions concerning a specific account. To solve this problem, transactions are posted to ledgers. Ledgers contain only the entries related to a specific account.
Once transactions are recorded in the journal and posted to ledgers, the transactions go through a multi-step accounting cycle. The accounting cycle is largely automated by software now, so we will not go into the details of the accounting cycle in this video.
Most importantly, at the end of the accounting cycle, financial statements are produced.
Business financial statements include the:
- Balance sheet;
- Income statement; and
- Statement of owners’ equity.
The balance sheet is a snapshot or overview of the finances of a business on a particular date.
From looking at the balance sheet, business owners and management can know the business:
- Liabilities; and
- Owners’ (or shareholders’) equity.
As we mentioned earlier in this video, assets include:
- Bank accounts;
- Equipment; and
Liabilities are debts owed by a business.
- Bank loans;
- Unpaid taxes; and
- Accrued payroll.
Finally, in a balance sheet, you will see owners’ equity or shareholders’ equity listed.
Owners’ equity is the value of the investment in the business made by the business owner.
The owners’ equity in the business increases as contributions are made into the business and as the business earns a net profit.
The owners’ equity in the business decreases as withdrawals are made from the business or the business operates at a net loss.
The income statement, sometimes known as a profit and loss statement or P&L statement, shows the revenues and expenses of a company. Income statements are prepared for a specific period, for example, the previous year or year-to-date.
Income statements show business owners and management:
- Operating revenues (revenues from business operations);
- Non-operating revenues (revenues not from business operations, such as interest charged on unpaid accounts); and
- Expenses incurred by the business.
Statement of owner’s equity
The last major financial statement produced by the accounting process is the statement of owners’ equity. The statement of owners’ equity shows the value of the investments in the business. The statement also explains why the value of the investments has changed over a period of time.
As was previously mentioned in this video:
- The value of a business increases when contributions are made and the business earns a net profit; and
- The value of a business decreases when funds are withdrawn from the business or the business has a net loss.
How financial statements are used
By studying the financial statements, business owners and management are able to gain a valuable understanding of the health of the business.
For example, by comparing the balance sheet of the current month to the balance sheet of the previous month, owners and managers are able to know:
- If bank account balances have increased or decreased;
- If debts have been paid or if they are increasing; and
- If customers invoices are being paid.
By analyzing income statements, business owners and management are able to understand if certain operations are causing the business to make money or to lose money.
Also, income statements can be used to compare how well the business performed during a certain period of time to another period of time. For example, the performance of the business this year can be performed to the performance of the business last year.
By reviewing statements of owners’ equity, business owners are able to understand if the value of their business is growing or if it is decreasing, and why.
Now that you have the basics of accounting and why accounting is important, you need to know:
How you can get started with accounting
Fortunately, with modern accounting software suites, many of the tedious tasks associated with accounting can be automated, or at least made simpler. This means to you, as a business owner, that you can focus your efforts on growing your business, rather expending time on accounting.
Modern accounting software integrates with other products and services so data can be conveniently important and exported. For example, many accounting software suites are able to link with bank accounts to automatically pay bills and keep track of debit card charges.
Also, many accounting software suites are able to connect with point-of-sale (POS) systems and online merchant software to keep accounting data updated in real time.
When it comes time to prepare taxes, accounting software can export data so that it can be used with tax software or can be provided to an accountant.
How accounting can help your business grow
Now that you have a better understanding of how accounting works and why it is important, you should start developing a suitable accounting solution for your business.
You should search for accounting software suites that are recommended for your industry. You can speak with other business owners to see what they use. Or, your accountant might be able to suggest software that will meet the needs of your business.
You might want to choose accounting software that is compatible with the software your accountant uses to help prepare your taxes.
By developing a suitable accounting solution for your business, you will find that you have a better picture of:
- How well your business is growing;
- What makes your business the most money; and
- Where your business can cut costs.
And, you will find that you have an easier time:
- Collecting from customers;
- Paying your vendors;
- Managing inventory;
- Reducing debt;
- Obtaining financing; and
- Preparing your taxes!
After your business has developed and implemented an accounting solution, it is important to take the time to learn how to properly use it and what features you can take advantage of.
The goal of every business owner is to make a consistent profit and keep customers satisfied. Only by performing accounting can these goals be met.