The simplest way to think of accounting is to look at it from the key users of financial statements.
- Tax authorities want to assess profitability so they can work out how much tax should be paid.
- Investors want to compare different businesses to work out which one would provide the best return.
- Government wants to see evidence that businesses are complying with all relevant accounting and reporting laws and regulations.
Financial Statements typically consist of a Profit and Loss Account (or Income Statement), Balance Sheet and often a Cash Flow Statement (or Statement of Source and Application of Funds). These are formal documents with formats that are provided by national governments. However, they all depend on the underlying record keeping for their accuracy and legitimacy.
The ‘Accounting Equation’
Financial record keeping is known as bookkeeping (or double entry bookkeeping, to use its proper name) and was first described in the 15th Century. Traders and merchants needed a system to keep track of who owed them money or who they owed money to. The system developed was both simple and elegant. It recognized that in business there are the following:
- Resources that the business owns (Assets)
- Resources that the business owes (Liabilities)
- Resources that have been invested in the business (Capital including long-term loans and profits not taken out)
- Day to day trading that affects the current value of each of the above (sales and purchases)
A simple formula describes the relationship between the first three of these. The value of resources owned (A) less the value of resources owed (B) equals the resources invested in the business (C). This is sometimes called ‘The Accounting Equation’.
The difference between what is owned and what is owed, is often called net worth. The net worth must always be the same as the capital invested. That is what gives rise to the Balance sheet. The two sides must always be in balance. Each element indeed must be represented by cash, a promise to pay, or some other item with real value. The Profit and Loss Account describes the daily trading that results in movements in each of the elements of the balance sheet.
You can find here some useful tools that will help explain you how financial statements are put together:
- How statements interconnect: Accounting equation at work
- Balance sheet and Profit and Loss Statements examples: Chakriya business story
- Cash Flow Statement example: Chakriya business story
How financial records are kept
Of course, understanding financial statements is not much use if you do not have an accounting system to generate them. There are basically three approaches you can take in maintaining accounting records:
- Try to keep all the details in your head using bank statements and supplier statements to guide you.
- Use physical books of account (either on paper or in a spreadsheet) where detailed records are kept of each transaction and the balance on each account and basic reports are produced.
- Use a computerized accounting system to keep all your records, produce reports and provide detailed analyses, all while ensuring that the basic accounting equation and principle of ‘balanced books’ is automatically maintained. There are several levels of complexity of computerized accounting systems.
You will find a flowchart here that describes the options open to most businesses. As with many things in life, it is wisest to purchase the best that you can afford both in terms of finances and the capacity of the people who will be using it.