Accounting 101

When we think of starting our own business, we dream about the services or products we can provide, the revenue we could ultimately generate, and the life we could have as a result. However, in those dreams, we usually skip over all of the responsibilities we inherit once we apply for the federal tax ID number and begin operations. A major part of those responsibilities includes properly accounting for your business operations. Not only does proper accounting help give an accurate picture of how well a business is doing, it also helps us seek additional funding through outside investment or bank loans. In addition, poorly managed books can cause business owners to incur additional fees at the time of preparation as CPAs will "clean up" the financials prior to preparing the tax return.

MAIN ACCOUNTS

Accounting involves tracking and recording of five main accounts: revenue, expense, assets, liabilities, and equity. Revenue is the money earned from providing customers or clients with products and services. Expenses are the monies spent by a business to pay to maintain business operations. These accounts are reported on a profit and loss statement. Assets are property that will help produce revenue for your business and can be liquidated to help meet and outstanding liabilities. Some examples of assets are cash and capital assets like buildings and equipment. Liabilities are current and future obligations a business must meet. Examples of liabilities are short and long term debt, mortgages, lines of credit, and credit card payables. Equity is the current investment by its owner(s) in the business. To properly account for a business as a whole, financials must balance. To balance, revenue minus expenses equal net income which is closed to equity in the form of retained earnings. Assets must equal the sum of liabilities plus equity.

PROFIT AND LOSS

The first type of accounts every business owner considers are revenue and expense. These accounts are reported on a profit and loss statement that should be provided to your CPA for tax preparation and can be provided to banks, if necessary. Revenue and expense accounts show the amount of money into a business in exchange for products and services and the amount of money spent to maintain business operations. The combination, or net, of these numbers is called "net income". Net income is merely the remaining earnings within a business after all expenses are subtracted. For example, if a business brought in $200,000 of revenue and had $150,000 of expenses, its net income or earnings remaining in the business is $50,000. Why is this is important? Well, first, the $50,000 shows an owner they are in fact making money. Secondly, the $50,000 shows how much is left after a period of operations available to them for further investment. Third, and not least important, the $50,000 number is the amount that will be subject to tax.

BALANCE SHEET

The balance sheet is a little harder to conceptualize. However, if you think of the balance sheet as the health of your business at a period in time, then things start to make a bit more sense. As stated above, assets are property that help you earn revenue and can be liquidated to meet any obligations of the business (liabilities). Businesses want assets to be greater than liabilities because that means they have the ability to pay back debts. For banks, assets greater than liabilities are important because if the company runs into cash flow issues and cannot pay back its loans, a bank knows that assets can be converted to cash to help pay the loan. Liabilities are the "enemy" of most businesses because they stunt growth and usually require a business to use otherwise allocated cash to pay back a loan, mortgage, or credit card balance. Keeping liabilities fairly low is generally most helpful for the survival of any business. The net of assets and liabilities is equity. Equity is a measurement of investment in a firm by its owners. Think of it this way...a business earns revenue, pays expenses, and the net income left over is retained by the business as left over cash and increases cash (assets) on the balance sheet. That cash can either be used to pay back obligations thus reducing liabilities or it can be kept in equity as an increase in investment to help pay for additional assets in the future.

CONCLUSION

Accounting basics are not the easiest concepts but can be conquered with a little bit of patience. Revenue minus expenses is net income. The higher the net income, the better the health of your business and (potentially) the higher your tax bill. Higher net income increases your business' cash reserve causing assets to increase on the balance sheet and your overall investment (equity) to increase. If you have any questions or need bookkeeping help, please book a free 15-minute consultation.