You didn’t get into business to be an accountant, so why do you need to know basic accounting concepts?
For starters, understanding basic accounting concepts can help you make predictions about your company’s future based on past trends in sales and costs. This will help you make smarter financial decisions in the long run.
Understanding basic accounting principals will also help you make quick but informed operational decisions on a day-to-day basis. This will save you time and money—two of your most valuable resources as an entrepreneur.
Finally, having a basic understanding of accounting concepts will ensure you have productive conversations with your financial advisors when planning strategically for your company’s future.
Understanding accounting, even from a basic level, is a critical skill for any small business owner. But what are some of the basic accounting concepts that you need to know?
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 basic accounting 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).
If you’re looking to understand basic accounting concepts, this is a critical one. 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.
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:
Last but not least in terms of basic accounting concepts is 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.