In past columns, we've hit the highlights of general business records. It's now time to turn attention to financial (or accounting) records.
This is an area in which I have no particular expertise... I'm an engineer — not an accountant. So accountant readers — if I say things in this series that you feel are wrong or misleading, please let me know by phone, note or article and I'll pass them on in subsequent columns.
Business accounting causes a great deal of confusion — if not out-and-out fear and avoidance — among many beginning entrepreneurs. And needlessly so. It's just not that complicated. Accounting is not rocket science. It's based on a brilliantly-elegant concept from the Middle Ages — double-entry bookkeeping.
Someone way back when recognized:
1) that the "value" of any financial entity could be described in terms of only five "accounts" — assets, liabilities, equity, and accumulated revenue and expense.
2) that every financial transaction (i.e., "change in value" of the entity) affects at least two such accounts, and can be recorded in the form: assets plus, liabilities minus, equity minus, revenue minus, expense plus, equals zero, and
3) that if every transaction sums to zero, the sum of all the transactions must equal zero!
No matter how many transactions you've recorded — and in a thriving business you'll have many — you'll know you've recorded them correctly — if and only if they sum to zero.
Let's look at an example.
Assets are what you own, e.g., cash in bank.
Liabilities are what you owe.
Equity is your "net worth".
Revenue is what you get in.
Expense is what you pay out.
Suppose you set up a company and put $1,000 into it. We need an asset account — cash (Cash In Bank) — and an equity account — equity (Paid-In Capital). The transaction is cash/1000+ equity/1000–. Your company books now show its equity is $1,000 and it's all in the bank.
Note: Your accountant will describe this transaction as "debit cash, credit equity". When you hear accountants use the words "debit" and "credit", just mentally translate debit to "+ (plus)" and credit to "– (minus)".
Now say someone pays you $200 to do something for them. We need a revenue account — revenue — and the transaction is cash/200+ revenue/200–.
And you spend $100 to buy something. We need an expense account — expense — and the transaction is cash/100– expense/100+. Your company books now show:
Still sums to zero.
Your "Balance Sheet" is the top 3 lines with Revenue and Expense netted into Equity:
Your "Earnings Statement" is the negative of the bottom 2 lines:
That's cash-basis accounting — and that's all there is to it.
In the real world, most business isn't conducted in cash — rather you "invoice" them and they "invoice" you. You'd kinda like to keep track of what it is you're owed and what you owe. So accrual accounting is used — which is really just an extension of the above. We add two more accounts: An asset account — receivable — that keeps track of what you're owed and a liabilities account — payable — that keeps track of what you owe.
When you invoice someone for something you sold (for say $200), the transaction is receivable/200+ revenue/200–, and when they pay you, it's cash/200+ receivable/200–.
Likewise, when someone invoices you for something you bought (for say $100), the transaction is payable/100– expense/100+, and when you pay them, it's cash/100– payable/100+.
If you net these two pairs of transactions together, you'll see that you have the same end result as if they had paid you, or you had paid them, in cash — but in the interim, you know what's coming in and what's going out.
These last 4 transactions are common to every business and — for many businesses — constitute 99% of the transactions you'll ever need.
You may add some asset accounts, like Money Market, so you can track the cash in your bank and money market accounts separately... Or some liability accounts, like Bank Loan (what you owe the bank), Accrued Payroll (what you owe employees), and Accrued Payroll Taxes (what you owe the government on that payroll)... Some revenue accounts, like Consulting, Product, Lease Income, etc., if you want to track different revenue sources separately... Some expense accounts, like Rent, Utilities, Supplies, Product Materials, etc., if you want to track different expense categories separately... But the basic transactions are all the same.