Understanding Accounts – Running a business is hard work. Wearing all the hats is daunting. Understanding accounts and all the financial terminology is a tough feat. It is highly likely that, as a business owner, you will need to analyze a spreadsheet at some point or delve into some form of financial recording software as part of the day to day running of your business.
Fixed assets, profit or loss statement, balance sheet, cash flow statement, profit margin, income statement, depreciation, gross profit the list goes on. Financial management is a crucial aspect of any thriving business and you making solid, financial decisions is what could make your business sink or swim in the industry. In order to gauge a good understanding of accounts and the accounting/bookkeeping process, it is recommended that you can interpret the below accounting terminology. In this article, we take a quick look at the most confusing terms and shed some light on the process from start to finish.
The Accounting Process Flow
Every time your firm conducts a business transaction, the status of the accounts changes – this is all based on the double entry system of accounting.
Double–entry accounting is based on the fact that every financial transaction has equal and opposite effects in at least two different accounts. Accounting is based on the fundamental accounting equation:
ASSETS = LIABILITIES + EQUITY
To help keep track of transactions effectively a general ledger is used. The journal records what happened, the accounts affected and the amount. Once the accounts used have been identified the transaction analysis will be applied:
- Asset and Expense accounts are increased by a debit and decreased by a credit.
- Liabilities, Equity and Revenue accounts are increased by a credit, and decreased by a debit
A simpler way to remember which accounts increase on the left or right is to use the DEAD CLIC rule as per below:
D – DEBITS (increase LEFT)
E – Expenses
A – Assets
D – Drawings
C – CREDITS (INCREASE right)
L – Liabilities
I – Income
C – Capital
Accounting is a language in itself. The bookkeeping process is how day to day transactions are recorded. Balances in the various accounts are tracked and summarized in the financial statements, which reflect the changes that occurred during the accounting period.
Having a record of your business transactions is very useful. The accounting process can be quite confusing and many business owners use the services of a remote bookkeeper to help them save time and frustration and ultimately lower their accountant costs.
What is the difference between the cash method of accounting and the accrual accounting method?
The most important difference between the two accounting methods is based on when the expenses and revenue are accounted for.
This method can also be known as cash-basis accounting or cash accounting. The cash method is used when revenue and expenses are recorded as they enter and leave the business bank account. This type of accounting method may suit smaller businesses as revenue is only declared when it comes in or leaves the business. Moreover, an additional benefit for business owners is that they only pay income tax on funds that were physically received, not funds in the pipeline or work in progress. It is important to understand that limited companies and limited liability partnerships are not permitted to use the cash method of accounting.
This method differs from the cash method as revenue is accounted for regardless of when it is obtained. Therefore, the expenses for any goods or services offered to the client are recorded despite funds being received for these. Accrual accounting is used for year-end accounts so that all income and expenses are recorded, whether they have been paid or not. Larger businesses also use this method to get a more realistic picture of how their finances are looking and what their cash flow is likely to be.
An asset is an item of value that is controlled by the business. These items can either be tangible (physical items – buildings) or intangible (non-physical form – patents) that add value to the business. For example, IT equipment that is owned and controlled by a business and is being used as part of the business would be classed as an asset.
Assets are then further split down in the statement of financial position:
- Non-current assets
These types of assets are the ones that are purchased with the intention of long-term use within the business. These items tend to be expensive and ones that the business is hoping to keep long-term. Therefore, many businesses that want to have control over which non-current assets they have will keep a record of them on a non-current assets register.
- Current assets
These types of assets are vital to the business operation as they can be in the form of cash or funds that are expected to be generated into the business within the financial year, Current assets are, therefore, important when understanding accounts as they are linked directly to forecasting and cash flow.
Depreciation is a measure of the cost of the economic benefits of a tangible non-current asset (physical item) that has been devalued during the accounting period. For example, purchasing a car at the start of the financial year and the value of the car at the start of the next financial year will differ as the car has diminished in value.
It is important to realise the basic principle of depreciation, whereby, a portion of the cost of the non-current asset is charged in the statement of profit or loss for each period. This is then deducted from the actual cost of the non-current asset in the statement of financial position. Therefore, as the asset gets older its value in the statement of financial position will reduce each year
There are 3 main methods for calculating depreciation.
- Straight line method
This method calculates a consistent amount of depreciation over the life of the asset. This method works best for assets such as vehicles
- Units of production method
This method is based on the actual use of the asset. Therefore, higher depreciation will be charged when there is higher activity and vice versa. This method is especially useful for a production line
- Diminishing balance
The diminishing balance method allows for a higher level of depreciation to be charged in the early years of the asset’s life in comparison to the later years.
Profit or loss statement
This is a summary of all the income and expenditure of the business over an accounting period. It helps to determine whether the business has made a profit or a loss in a particular financial year. The statement of profit or loss will include entries such as business revenue, expenses and gross profit.
Statement of financial position
Balance sheet – a financial statement that summarizes a company’s assets, liabilities and shareholders’ equity at a specific point in time. This differs from the statement of profit or loss as it shows a summary of all the assets and all the liabilities of the business and not income and expenses.
Cash flow statement
Also known as a statement of cash flows. A cash flow statement is a financial statement that provides an overview of the amount of cash and cash equivalents coming into and leaving a business
In summary, there are many key elements to consider when undertaking bookkeeping and accounting practises. There could be various reasons for you to want to understand accounting practices You may want to interpret your cash flow, start a new company or even gain a little more insight into the world of accounting. Understanding accounts can be tricky and is a great task to outsource to a remote bookkeeper or accountant, whereby, you can concentrate on the expansion of your business.