Accounting for Non Accountants : Debit, Credits and Financial Statements

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When people hear the term accounting, there is an involuntary reaction whereby the comprehension centres (the medical term) of their brains tend to shut down, and sleep mode is activated.  This is unfortunate, as accounting, especially to a small business owner, can actually be quite interesting.  It is one of the primary tools by which business owners and other interested parties can gage the success of their business, as well as identify areas that require attention andneed improvement.  To understand accounting, business owners need to have a basic understanding of how it works (debits and credits) and it's results (financial statements), explained below:

Debits and Credits: The language of accounting is debits and credits, in which any financial transaction can be expressed. Contrary to popular belief debits are not "bad" and credits are not "good".  They just represent two sides of the same transaction.  Accounting is based on a foundation of double entry;  for every action there is an equal and opposite reaction (I imagine Mr. Newton was referring to accounting).  So, for example, let's say that you sell a jar of pickles for $100 (they are very rare pickles) to Mr. Pilbeam.  Let's also assume that Mr. Pilbeam will pay you in ten days.  The accounting entry for this is:

Debit:  Accounts Receivable$100

Credit: Pickle Sales$100.

Translated into English, this means entry would result in an increase in accounts receivable and sales.

When Mr Pilbeam, who is very prompt, pays you the $100, the entry is as follows:

Debit: Cash $100

Credit: Accounts Receivable $100

i.e. your cash increases by $100 and your accounts receivable decreases by $100

You will note that you debitedyour cash to record an increase.  Debits are good with respect to cash.

A solid understanding debits and credits is fundamental to students of accounting. For non accountants, it is just important to know that every transaction should have an equal amount of debits and credits.  A good software will take care of the rest.

Financial Statements: (or, if you prefer, "les etats financieres" ). 

Financial Statements essentially summarize all the transactions of the business (usually input via an accounting software) into a meaningful and comparable format.  They present the financial condition of the business and through the use of analytical tools like ratios and eyeballing, can be extremely informative.  They also provide the basis for which future results can be estimated through the use of budgets and projections.  The major components of the financial statements are discussed below:

Balance Sheet:

There are three parts to a balance sheet, which are represented in the following equation:

Assets = Liabilities + Equity

This is kind of fun since, as long as your accounting is being done correctly, your balance sheet will always balance.  Your balance sheet also gives you a lot of valuable information.  Your assets tell you how much cash you have, your accounts receivable from pickle customers, how many pickles you have in inventory and loans receivable from your brother-in-law.  Your liabilities, which are a little less fun, tell you what you owe to vendors (accounts payable) and banks.   Theequity is the difference between the two, and represents the owners/shareholders share of the business, usually at book value.

Income Statement:

Pickles sales , costs of cucumbers, jars and pickle making machines,  and all other costs of the business (rent, utilities, insurance) are included in the income statement.  If your sales are higher than all of your expenses combined, you will have a profit.  If your sales are lower than your expenses you will have a loss.

Statement of Cash Flows:

How much cash is generated by the business is represented in the statement of cash flows.  The starting point is your income statement and adjustments are made depending on whether a transaction had a cash impact.  For example since you've extended credit terms to Mr. Pilbeam, it means that you are not receiving cash for your sales right away.  This will be reflected as a sale on your income statement (i.e. revenue) butwill not contribute to cash flow.

Although many business owners have an intuitive sense of how their business is doing, understanding how accounting works helps to reinforce and hone this intuition .  Even if you have made the (often wise) decision to outsource your accounting, you need to spend time reviewing and analyzing your financial statements to determine areas of both strength and weakness and let them be a guide to where you want to go in the future.