“Data! Data! Data! I can’t make bricks without clay.” Sherlock Holmes famously told Dr. Watson in “The Adventure of the Copper Beeches” contained in The Adventures of Sherlock Holmes by Sir Arthur Conan Doyle. Similarly, in business you need to know your accounting numbers in order to be successful and make informed decisions.
Now, I hear you saying, “But I use accounting software, so why do I need to know this?” Firstly, so do I (QuickBooks online, for the record), but to validate the numbers and to deal with particular cases, you need to understand the underlying principles. Second, to understand your financial statements and numbers compiled by your accounting software, you also need to know the basics to make sure that your numbers were actually compiled correctly.
So that’s take a look at some basic accounting principles in order to help you get the data that you need to make the right choices for your business.
There are four main concepts that you have to understand: assets, liabilities, revenues, and expenses.
Assets comprise everything which has a value to your business on a given day. For example, bank accounts, accounts receivable, equipment and machinery, and inventory are some of the main types as well as the raw inputs necessary for production, such as raw materials.
Liabilities comprise everything which is a debt of your business on a given day (whether due or not). For example, loans, credit cards, accounts payable, and unremitted sales tax.
Notice how both assets and liabilities apply on a particular day. This is very important as assets and liabilities form part of something which is called a balance sheet which is the financial position of your business at a specific time. This is different from an income statement which tells you whether the business is making or losing money over a certain period.
Revenues comprise all forms of money coming into your business whether or not it has been collected yet. For example, sales, interest earned, and any other source of income which your business might have.
Expenses comprise all forms of money leaving your business whether or not it has actually been paid yet. For example, cost of goods sold, rent, salaries and compensation, professional fees, and any other costs which your business might have to pay to operate.
Balance Sheet & Income Statement
Revenues and expenses are normally calculated over a certain period of time in order to allow you to evaluate whether or not your business is profitable (revenues are greater than expenses) or losing money (revenues are less than expenses). This is compiled together in an income statement also known as a profit and loss statement.
So at this point, we have been able to identify both our business’ financial position (balance sheet) and its profitability (income statement).
Strictly speaking, in the balance sheet there is another category called equity or shareholders’ equity. This is where the difference between the assets and the liabilities goes and it includes previous profits or losses of your business, known as retained earnings. And, what is interesting is that the increase of the retained earnings in your balance sheet should match the profit on your income statement.
What I mean by that, is that if you have a balance sheet, for example as of December 31 of a given year, and then you have another balance sheet one year later, the increase (decrease) of the shareholders’ equity (strictly speaking compiled in retained earnings) will match the profit or loss during that same time period from your income statement.
Both the balance sheet and the income statement have their respective purposes. The balance sheet is very helpful to allow you to value the business because you are able to tabulate the difference between the business’ assets and liabilities. On the other hand, the income statement enables you to forecast your business’ future profit and to determine whether or not it is viable. A balance sheet is normally the basis of obtaining credit for a business as lenders are much more interested in assets upon which they can take security than a future stream of income which can always be different from that which was initially predicted.
In practice, what this means is that in order to record any business transaction in the accounting books of your business, you need to make two entries. As long as we are not talking about a transfer or conversion of one asset or liability into another, each inflow of money into the business should be reflected both through an increase of the assets of the business and an increase in the business’ revenues. The same thing for an outflow from the business which means that as an expense has been paid, an asset has been depleted.
Now, I mentioned earlier a carve-out for the transfer or conversion of one asset or liability into another. For example, this would apply to purchasing inventory using money from a bank account. In such a case, the business’ bank account (asset) would go down and the business’ inventory (asset) would go up. There can also be a shift from either the assets or the liabilities category to the other. For example, your business takes out a bank loan which increases the liability bank loan and also increases the asset bank account (since this is where the loaned funds were deposited).
So let’s apply all of this to a cookie-making business. In this scenario, the business owner incorporated a company which issued her 100 shares which she purchased for $1 each and then loaned her company an additional $900 to help it get started. She then used that money to purchase ingredients to bake her cookies ($500), to rent a table at the local flea market on market day ($100), to purchase display cases and posters for market day ($50), to hire a friend’s son to help out on market day ($150), and to pay for gas to and from the flea market ($20). Breaking all of these transactions down, we get the following:
Bank account (asset): +$100
Share capital (shareholders’ equity): +$100
Bank account (asset): +$900
Shareholder loan (liability): +$900
Raw ingredients purchase:
Bank account (asset): -$500
Raw ingredients (asset): +$500
Flea market table rental:
Bank account (asset): -$100
Rent (expense): +$100
Display cases and posters:
Bank account (asset): -$50
Marketing (expense): +$50
Bank account (asset): -$150
Salaries and labour (expense): +$150
Gas for travel:
Bank account (asset): -$20
Transportation (expense): +$20
On market day, the business sells all of the cookies which the business owner baked for $1,000. Adding this last point to our figures:
Bank account (asset): +$1000
Sales (revenue): +$1000
All raw ingredients were used:
Raw ingredients (asset): -$500
Cost of goods sold (expense): +$500
We can now compile everything together to produce an income statement to figure out the profitability of this cookie business as well as the balance sheet at the end of the market day. Notice how the profit generated matches the retained earnings.
–Cost of goods sold: $500
–Salaries and labour: $150
–Bank account: $1,180
–Raw ingredients: $0
–Shareholder loan: $900
–Share capital: $100
–Retained Earnings: $180
On paper at least, this business is profitable as it generated a profit of $180 on market day.
Now, you occasionally hear discussion about the terms “debits” and “credits” in the context of accounting and how confusing it is to figure out which is which. Debit simply refers to a money outflow into a given account and credit refers to a money inflow into a given account. This can get confusing at times because when a liability account is credited, this means that the amount of your liabilities has increased, so to say the business owes more money whereas when an asset account is credited, this means that the amount to your assets has increased, so to say the businesses has more money or value. As long as you view the question of whether something is a debit or credit from the perspective of the account in question as opposed to from the perspective of the business as a whole, you should be able to determine whether or not something has been credited or debited to the account.
Hopefully, this has clarified certain accounting basics and has given you a foundation to better understand and interpret your business’ accounting and financial statements. Best of luck!