Accounting – The practice of recording, classifying and reporting on a business's financial activities
To remember what accounting means use the following mnemonic:
A count was made of everything (accounting). The accountants recorded every business activity.
In accounting, there are three essential financial reports needed to run a business:
- Income statement (profit and loss)
- Cash flow statement
- Balance sheet
Profit and Loss (Income Statement)
At a basic level, a count of every bill/invoice that has come into a business (costs) and every sale ticket charged out (revenue) is added up. The difference between revenue and costs should, hopefully, provide your business with a profit. Accounting for the profit and loss is necessary even for a small company. It is a legal requirement that the profit or loss is worked out because if any profit is made, the company will be required to pay a tax to the government.
Cash flow statement
A cash flow statement is the amount of money in a company’s bank account. Companies can usually predict how much money they will have in their bank account at a future date using what’s called a cash flow forecast. Cash flows into the bank account when customers pay. Cash flows out of the bank account when the company pays their suppliers' bills/invoices and pays the employee wages and other costs. When a business has just a few large customers and fail to pay on time, the business’s cash flow position is badly affected.
A balance sheet is a document that lays out the company’s assets and liabilities at a point in time, usually at the end of a financial year. The balance sheet shows what a company owns and what a company is owed. Assets (what a company owns) are listed on the balance sheet in order of their liquidity (i.e. the ease with which an asset can be converted into cash). Current assets are possessions that can be converted into cash within one year.
Current assets include:
- Shares of other companies.
- Money that customers owe the company.
Long-term assets are possessions that are not likely to be converted to cash within one year include:
Liabilities (what the company owed) are listed in order of their due date.
Current liabilities include:
- Any part of a mortgage needed to be paid within a year (i.e. with a 10-year mortgage only the first year’s payments shown here).
- Wages payable to staff.
- Any customer’s money where the customer hasn’t received the goods they paid for.
- Payment to suppliers.
Long-term liabilities include:
- Any part of a mortgage over one year (i.e. with a 10-year mortgage only the final 9 years to be included).
Even for a small business, you would always hope to own more than you owe.
Quite often for any small business, the profit and loss, cash flow statement, and balance sheet can be worked out by a chartered accountant (or a certified public accountant in the USA) who will help you work out how much you owe the government in tax.
For larger companies, they will have an in-house accountant.
There are two types of accountancy. Financial accounting is as above i.e. profit and loss, cash flow statements and balance sheet. Managerial accounting is used within a company to assess:
- Cash impact on business decisions.
- The cost of a product by adding one additional unit into production.
- Break-even analysis to look at prices for products and services.
- Allocation of company costs such as managerial expenses and government rates to each department to assess their profitability.
- Work out where manufacturing bottlenecks are occurring and the cost of them.
- Helping to analyse the benefits of large capital expenses such as buildings or machinery.
Managerial accounting is used to provide information to internal users such as managers and employees.